In the past five years, a new type of financial advisor has emerged to compete with traditional investment advisory firms. Funded by venture capitalists, these new advisors exploit the latest technology to offer competent investment advice in exchange for drastically reduced fees.
Just as technology changed the full-service brokerage industry by lowering transaction costs and enabling online trading, it will also ultimately change the practice of investment advisors by automating portfolio management and investment advice. According to Grant Easterbrook, analyst at Corporate Insight, “These newcomers offer average Americans access to low-cost advice and investment solutions with fewer potential conflicts of interest and greater performance transparency.”
The Rise of the Virtual Advisors
Automated online portfolio management services – what many have dubbed “robo-advisors” or virtual advisors – have been available for the past decade. They offer convenient, transparent portfolio management for accounts both large and small through easy-to-use websites – and all for 20% to 30% of the cost of traditional advisory firms. According to Institutional Investor, Corporate Insights estimates that this group currently manages almost $17 billion in U.S. assets.
Robo-advisors generally share a common philosophy of money management:
Passive Investment Strategy
Based on the concepts of Nobel Prize-winning economists Eugene Fama (Efficient Market Hypothesis) and Harry Markowitz (Modern Portfolio Theory), robo-advisors do not attempt to “time the market” by projecting its direction up or down. Nor do they try to pick “winners” and “losers” of individual stocks. They invest in broad sectors of securities or market indexes—exchange-traded funds (ETFs)—to diversify risk and secure average stock market returns.
Algorithm-Based Advice
Robo-advisors rely on proprietary software to automatically create and maintain portfolios of index funds. These portfolios are designed to fit broad client investment goals, and are tailored to factors such as age, risk tolerance, expected retirement date, and so on. For example, the criteria to select a specific portfolio might be based upon a goal, such as retirement, to be achieved by a certain future date, with the ratio of equity to debt securities based solely on the time-frame between the investor’s current age and retirement age.
Extended Investment Term
According to Betterment, an analysis of the Standard & Poor’s 500 Stock Index between 1928 and 2014 indicates that the longer people stay invested, the less loss they risk and the greater their possibility of gain. For example, about a quarter of all one-year investment periods between 1928 and 2014 experienced losses in value, while less than a tenth of the 10-year investment periods resulted in a loss. Similarly, the median cumulative return was substantially greater for 10-year holding periods than one-year periods. In other words, the longer you stay fully invested in a broadly diversified portfolio, the greater your chances of gains.
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