What is behind the rise of robo advisors

Abhishek MathurThe recent launches of robo advisory platforms, both in India and overseas reflect developments in the field of finance and computation that have happened over a period of time. Investment advisory comprises defining market expectations, understanding client risk perception & objectives and matching the two to recommend a plan of action. Simple as it may sound, each of the areas have been fields of intense research.Here are the key developments, from past and present that laid the foundation to robo advisory.1. Modern Portfolio Theory (MPT): MPT, proposed by Economist and Noble Laureate Harry Markowitz, gave a mathematical framework to combine risk and return to give efficient portfolios. In addition, other mathematical frameworks like CAPM (Capital Asset Pricing Model), helped define risk-adjusted returns better. Though these developments happened a few decades back, the impact of risk and diversification becomes clearer as the markets became more efficient. There is an increased understanding even among investors that a good advice is not just about returns, but also the underlying risk that one takes in achieving those returns.2. Behavioral Finance: Behavioral Finance has been an area of interest not just for psychologists but also for economists and financial analysts alike. Research in this area suggests that as humans, our decisions can be laced with biases. Many of these biases can lead to poor choices and decisions while investing. Robo advisory takes away many biases by suggesting actions that are driven by a rational and independent decision making engine. Take for example simple principles of rebalancing and exiting poor investments. It is a well known fact that following an asset allocation strategy and regular re-balancing against a target leads to buying assets at their lows and selling them at their highs. However, it is difficult to implement because investors rarely sell while the markets are doing well and they rarely buy when markets are down. Similarly, investors delay exiting poor investments, which may lead them to capitalize losses.Most robo advisory engines help customers make better investment choices by advising them what is rationally correct for their situation, thus keeping the biases away.3. Computational Power: The American electrical engineer Gordon E. Moore’s law predicted that number of transistors on a chip would double every two years. The hardware industry has kept up with this prediction. Multi core processors, 64 bit processors, parallel computing as well as optimized software have made available enhanced computing power even to a small personal computer. It is common for robo advisors to use millions of simulations and optimization techniques to solve multi variable equations, which are simply not possible to implement without use of these contemporary technologies.4. Changing Preferences: There is an increased preference among individuals to interact and transact online, through an internet-driven environment, which gives flexibility, control and security. This is especially true for products and services that clients have already experienced or have trust upon. At the same time, this environment is a challenge for robo advisors in knowing their clients well enough. It is tempting for robo advisors to collect just basic risk related information and dispense advice. However even from robo advisors clients are looking for bespoke advice. Therefore robo advisors need to discount more variables and evaluate multiple situations for their clients while they prepare their recommendation.These are interesting times and technology paving the path to define the future of advice. The movement is not just about convenience, but also about upgrading the rigor and accuracy of advice. Author is Senior Vice President and Head - Investment Advisory Services for ICICI Securities