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How does a Robo-Advisor work for the individual investor?

The Robo-Advisor concept is relatively new to the mainstream investment crowd. The product is applicable across many demographics spanning different age, wealth, income, and financial goal categories. In essence, Robo-Advisors are to the advisory business what ETF’s are to the fund business.* In other words, the product is a disruption to the traditional asset management industry and is worthy of consideration for your investment plan.

To begin, a Robo-Advisor is a passive investment management strategy that employs ETF’s to build a portfolio based on Modern Portfolio Theory (MPT). MPT originated from the research of Harry Markowitz. His paper’s premise suggest that investors can tailor a portfolio of investments based on their risk tolerance, therefore implying that assuming some risk is an inevitable part of investing. While risk is inevitable, that risk can be mitigated through diversifying one’s holdings in a portfolio. Markowitz’s work implies that building an efficient portfolio is best achieved through designing the right blend of asset classes based on one’s risk tolerance. A Robo-Advisor utilizes this method in building a portfolio of assets for its clients.

Currently, ETF’s are the most cost-effective vehicle for the general investment public to use when gaining broad asset class exposure. When constructing a portfolio for a client a Robo-Advisor uses a series of questions that will be filtered through an algorithm ultimately placing that client at some point along the efficient frontier which maximizes an investor’s return for accepted risk. For example, according to MPT, clients that are more risk averse will have to accept less expected return. Conversely, those willing to take on more expected risk should be rewarded with more potential return.

Depending on the asset allocation mix from the Robo-Advisor, clients in the former risk profile can expect to have their portfolio allocated to asset classes defined as less-risky, whereas investors fitting the profile in the latter risk category will be invested in asset classes where more risk has been assumed historically.

Generally speaking, one can think of bonds as a less risky asset class than stocks based on past performance. However, within each broad asset class an advisor can target more specific investment niches. For example, Emerging Market Debt is a type of bond or fixed income product but can exhibit more of an equity-like risk and return profile based on the uncertainty assumed with exposure to a less politically and economically stable country. Additionally, an ETF specializing in US Utility stocks can behave more like a bond due to interest rate sensitivity for utility companies and the generally attractive yield from such investments.

Hopefully this information can help shed some light on the Robo-Advisor product and how it can be beneficial to incorporate in your investment planning. As always, please do not hesitate to ask any questions. Thanks for reading.

JD

*Please refer to my post here entitled “What You Should Know About ETF's?” in order to learn about this product if needed.



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