In this post, I discuss the basics of robo advice, its pros and cons for the benefit of the interested layman as a lead up to the launch of the freefincal robo advisory template next week.
What is robo advisory?
Suppose you wish to plan for your daughter's college expenses 10 years from now and wish to know how much has to be invested and where. Let us consider the inputs and outputs of this calculation.
1: The current cost of the education you have in mind (hard to come up with a number as this can change down the line, but we need some input to start with).
2: The rate at which this cost increases year upon year.
3: The return expected from the investment.
These three inputs are enough to provide the basic output: monthly investment necessary.
Even in this simple calculation, notice that input 1 is personal and inputs 2 and 3 are technical. While input 2 is only guesswork, there is a lot more to input 3, the return.
The return expected from the investment is not just a number. We need to decide how much to invest in equity and how much in fixed income. We need to know the kind of return we can expect from these over 10 years. Then we need to decide how to vary the equity allocation and fixed income allocation as the time for college admission nears. We also need to factor in taxes.
All these are possible in the several calculators available here. In a calculator, you the user enters both the personal data and technical data.
A robo-adviser is a calculator or piece of code that accepts only personal information and pre-determines the technical input, depending on the age of the person, investment tenure and risk appetite of the person (if sought).
It then outputs an investment strategy (asset allocation for each year) with product categories and products to invest in. If you invest "via" the robo website, then they also can remind you to rebalance the portfolio periodically and also fund change recommendations.
The trouble is, even if the robo adviser suggests commission free products (eg. direct mutual funds), they often recommend only certain types of products for all needs. For eg. they would recommend only a liquid fund or ultra short term fund for a short term goal and not a bank FD or RD because that will not benefit them in any way. So it is important to recognise that there is a conflict of interest involved in direct robo portals also. This was one of the motivating factors for me to work on robo template.
By offering robo template that is free to use and unattached to any transactions, I can focus on the limitations of robo advice and try to make them better without any fear of favour.
Pros and cons of robo advisory
Consider for a moment what an MBBS degree or a financial planning certificate does. It teaches and trains the student to react in "certain ways" if they notice "certain sets of symptoms". This is pretty much how an algorithm works at a basic level. So there is a robo element present in every profession. In fact, it is a pretty strong element.
A competent professional is not just a well trained professional. She should be able to adapt and modify her recommendation depending on the needs and status of the patient or client.
The common complaint is that a robo or a piece of software will not be able to do this. This criticism is true in many instances, but this only means that the code does not factor in all relevant situations and needs constant modification. More importantly, the alternatives to robo advice are: true DIY (not AIFW-DIY) or working with a competent, conflict free financial planner. Not easy at all!
When it comes to financial planning, robo advice will work extremely well for young earners with uncluttered portfolios. The challenge is to make it work for older investors and especially those who are retired. This has been one of my core objectives. This area needs sustained efforts.
The first job of a robo advice software is to try and capture all the elements imparted to a financial planner during training. The second job is to capture other factors that come to light only when the financial planner interacts with clients and works on real cases.
The first job is more than possible and has been done by many. And in my case, thanks to some awesome beta-testing by friends, I am reasonably satisfied, but will leave the judgement to you. The second job is an ongoing task for everyone.
The biggest advantage of robo algorithm is that the user does not have to worry about the competence of a planner at least with respect to basics.
The competence of a planner with respect to course corrections is an unknown when we engage them. Wrt robots, the mathematics of investing is already coded in. The user should be able to intelligently modify the inputs as per their changing needs. Users who cannot do this, need to work with a "competent: human advisor.
So a DIY element is mandatory when it comes to robo advice. The user must strive to understand the scope of the algorithm from day one in order to use it better.
To conclude: robo advice plays a big role in our lives even if only consult human professionals. Choosing a good robo platform is as hard as choosing a good financial planner. Let's Face It: Everyone Needs Do-it-Yourself Skills!
The challenge for robos is to handle a wide range of inputs and cough out a workable plan (free from conflicts if possible*). This is an ongoing process just as a financial planner cannot afford to stop learning.
- My friend Raghavendra Shenoy is fuming right now 🙂
Should I use robo advice?
You can if you are young with a simple portfolio. If you are not so young with a diverse portfolio, then you must be able to judge the quality of advice given and understand the plan of action proposed. Else, approach a human planner.
If you are one of those guys looking for an explanation every time the market falls, a robo will not help. Certainly not mine.