Robo-advisors: the Role of AI
In short:
- The role of Artificial Intelligence in financial markets is becoming more prominent.
- For small investors this is in the form of robo-advice.
- However, the development of robo-advice is still lagging to what would be expected.
Technology has always played an important role in the financial market. Developing new technologies to, for example, increase transaction speed has really been beneficial thus far. With the current developed systems, it is hard to imagine how at the beginning of the 20th century, people used to yell their orders on physical exchange markets. Lately Artificial Intelligence (AI), in the form of extensive use of algorithms and flash trading, has had a considerable impact on the market. Up till now the use of AI in financial markets is mostly by bigger players such as hedge and pension funds. However, with so called robo-advising, more and more possibilities are opening up for individual investors.
Currently, there are already some robo-advisors available. Robo-advisors are defined as financial advisors that provide advice or investment management with minimum human intervention. However, the popularity of this service is still quite lagging compared to what would be expected. KPMG predicted that algorithms would manage 1700 billion of capital in 2020, while the actual amount was only 520 billion in 2019.
There are several explanations for this lagging development. One of them is the strict regulations on investment advice. This causes that even with robo-advice, the registration process for new investors can still be quite long. For customers this is often too big of a hurdle. This is quite unfortunate because robo-advice has the potential for a much quicker registration process compared to human brokers and the speed of this process can definitely be of value. As an example we can look back at May 2020, where a lot of investors missed potential returns because brokers could not deal with the flow of new investors, who were trying to benefit from the dip in the market.
The regulatory authorities are also concerned about the dangers of cyber criminality. When a financial advisor is hacked, this also has severe consequences for his clients. However, these dangers are also present for human advisors. Programming errors and malfunctions may be an extra risk in the case of robo-advisors but it is questionable if this is really as big of a risk as argued by the financial regulators. Furthermore, robo-advisors often have some kind of human interference as final check, especially in the case of larger transactions.
The potential of robo-advising is in particular interesting for big commercial banks. Banks with a solid reputation have the potential of selling robo-advice services to a lot of their current customers. Namely, with little returns on their savings account there are a lot of customers interested in investing. Not all of them are necessarily seeking for the best return. Convenience in combination with a fair return can be enough for a lot of consumers. The most logical place to find this kind of service often is the bank where you already are a customer. The potential demand of robo-advice is further illustrated by the fact that 2/3 of the consumers has more confidence in financial advice by a computer than in human advice. An additional benefit which makes robo-advice more attractive is the lower costs compared to the cost of a human financial advisor.
To decide if robo-advising is interesting for you, one should consider the following aspects. First, you should be content with a more passive strategy, since robo-advisors mostly focus on ETF’s. If you are attempting to beat the market and like to trade individual stocks, robo-advice is probably not the right match for you. Secondly, it is essential that you are comfortable with a computer making your investment decisions. Although the chances of cyber-attacks, malfunctions and programming errors are quite low, they should not be neglected completely. Lastly, one should realize that the convenience and low costs of robo-advice often are associated with less choice and control.
It is unlikely that robo-advisors will replace financial advisors completely, since financial advisors offer a kind of personal and detailed advice which cannot be substituted. However, it can be the solution for people who otherwise would not have invested at all. It is therefore likely that it will become even more relevant in the near future.
