Tech Disruption of Financial Services
Technology writers love to write about disruption: When a simpler, less costly product or service disrupts an incumbent one that’s more complex and costly. One industry that’s ripe for disruption is financial services. Any non-finance expert who’s had to deal with a 401K, IRA, or other investment instrument knows that they are often outrageously complicated. And the actively managed mutual funds that tend to make up the bulk of these offerings are quite expensive, with fees of 1-2% on the dollars invested, which occur in addition to the fees of your personal advisor. In recent years, a handful of companies—often given the unfortunate label of robo advisors—have introduced technology-based products that promise to simplify the process for investors, at lower costs than traditional services. (NOTE: I’m not a financial advisor, so don’t construe the following as financial advice.)
Using Tech to Invest
Robo-advisors utilize algorithms to do a long list of things that have traditionally fallen on the investor to do themselves, or for which they’ve typically paid a human advisor to handle. Instead of using actively managed funds, that carry the aforementioned fees, they tend to use low-cost index funds or exchange-traded funds (ETFs). And instead of charging another 1-2% on top of this to manage your account, they tend to charge on average about 0.25% (some even offer to manage up to a certain dollar amount for free). For these companies, it’s it is all about scale. Here are some of the things they can do:
- Pick the initial stocks. The most daunting task for any novice investor happens right up front when they need to pick the stocks into which to invest. Robo advisors do this for you, by asking a series of questions to ascertain your risk tolerance and goals. Most also factor in your existing assets. While many existing financial services offer similar tools, in the end, they typically still force you to choose your stocks based on the automated advice. Conversely, robo advisors handle it all, explaining what they plan to buy and why they plan to buy it. As an investor, you can then choose how much you know about your portfolio, from just a top-line number to high-level asset class descriptions to individual fund names.
Rebalance the portfolio. Most traditional financial services will rebalance a portfolio—moving funds from one bucket to another to stay within prescribed investment targets—on a quarterly basis at best. Because robo advisors are fully automated systems, most rebalance a portfolio any time it gets out of balance, not at a set time or date.
Tax-lost harvesting. High-dollar investors have had access to tax-loss harvesting from traditional financial firms for years, but robo advisors make this complicated process available to the average investor. It is essentially the selling of a stock that has declined in value to offset taxes on other stock gains.
Not for Everyone
Different robo advisors offer other additional features, but the underlying theme is the same: Using technology to replace high-cost, high-human touch services with lower cost, highly automated systems. The result is that more people gain access to good investment services, and potentially they get to take home more of their investment earnings long-term.
Obviously, not everyone will be comfortable turning over their money to a highly-automated system. Many people will always want to know that there is a real-lie person watching over their money, even if that means paying more. At present, robo advisors make up an exceedingly small percentage of the funds under management in the world. But many of the large, existing financial service firms have recently moved to create similar offerings to those from VC-backed startups. Online reviews of these me-too services have been largely lukewarm, as they tend to cost more and offer fewer features, which is what commonly happens when incumbents attempt to address the entrance of disruptors. It will be very interesting to monitor the growth of robo advisors over the next couple of years, to see how much of the market they capture, how they impact the broader financial markets, and how well their customers fare over time.