Is Robo Investing Safe for the Average Investor?

Robo-investing—the practice of using algorithmic trading to predict market events and execute trade strategy—has become among the most attractive investment options for everyday investors in the modern market. Robo-traders exist now for nearly every facet of the market, including newer markets like cryptocurrency. With so many options available, many investors naturally have some questions about the efficacy and safety of robo-investors

Note: Specifically, our investigation focuses on the question of “is robo investing safe for the average investor,” which assumes a beginner-level of familiarity with investing practices and a median income. Readers should take note when reading to consider how the subjects covered below will affect their situation personally. 

How Does Robo Investing Work?

The simple answer is “machine learning,” which consists of three general steps: 

  1. Quants input algorithms or rules relating to market trends into a learning bot.
  2. They feed the bot raw data about the market, which it then uses to make predictions. 
  3. They continue adjusting the bot in response to new data. 

More specifically, machine learning is really a shorthand way of saying that quantitative scientists (also known as “quants) develop a learning bot for which they set algorithms—equations or rules for solving a problem—based on existing market trends. The algorithms used by AI get remarkably complex, but a simple example might look like this: 

“Go long on stock X when stock X gaps up” 

Once these rules are established, quants then feed that algorithm as much information about the market as possible. This includes information about stock prices but also relevant information about world events that impact those prices. For example, the knowledge that people might panic buy items such as toilet paper in the face of a natural disaster (e.g., a hurricane or pandemic) might lead an AI to make investment decisions on those items in the face of another triggering event. As they process the raw data, the bot distinguishes between relevant information, which it uses for predictions, and irrelevant information, which it discards.

The calibrations on these algorithms are remarkably minute and the margin for error is incredibly wide since a string of bad investment decisions can lead to a loss of clients who are seeking other options after losing their investments. Similarly, quants are needed to update the algorithm in the face of new criteria and information. The pandemic over the last few years is a perfect example of how new stimuli can generate ripples affecting multiple markets. It is for this reason that quant scientists are in such high demand in the financial sector.

How Does Risk Affect Investment Strategy?

Risk is a critical concept for investors to understand before beginning with any investment platform. The short and simple rule of investing is: don’t invest anything you aren’t ready to lose. Volatile markets can shift at a moment’s notice, resulting in the loss of your initial investment. 

It’s important to understand that losing everything on the market happens rarely and usually comes about as the result of poor investment planning, such as sinking all your money into a single stock. 

It can also happen when investors act too suddenly, such as taking out their initial investment once it’s recovered instead of giving it time to grow. This is what’s known as behavioral risk. 

Knowing which of these actions to take at the right time, however, depends on having a working knowledge of markets and how they work. Traditionally this has been the job of investment consultants, who prep clients for possible eventualities of investment risks before they happen and offer possible strategies. Robo advisors, however, seek to use an emotionless AI to perform the same job.

Generally, risk divides into two categories: 

Systematic Risk

Also known as “undiversifiable risk,” “volatility,” or “market risk.” This is a risk inherent to the entire market or market segment. An example might be a global recession that affects every asset and stock on the market. This type of risk is impossible to avoid altogether, although losses can be mitigated somewhat if the investor’s portfolio is properly diversified.

Unsystematic Risk

Also known as “nonsystematic risk,” “specific risk,” “diversifiable risk,” or “residual risk.” This is risk that is inherent to a specific company or industry. An example could include a corporate merger that would affect the price of that company's stock. While investors can mitigate these losses through diversifying their portfolios, unsystematic risks are still subject to systematic risks, which affect the entire market.

A close reading of these two categories reveals another important touchstone of investing 101: diversify your portfolio. If one of your stocks goes down while three go up, that is still a net gain for you as an investor, despite the individual loss. When considering these options through the lens of a robo-advisor, it’s important to consider what kind of stocks or funds the bot invests in. 

In most instances, they focus on ETFs (exchange traded funds), which put money in several stocks across multiple industries, effectively handling the diversification process for you. 

More fundamentally, however, it is critical that new investors make sure that they understand the risks inherent in robo-investing in addition to the strengths before getting started. If the platform itself doesn’t offer consulting services, it may be a good idea to meet with an in-person consultant before making any initial investments.

So Why Do People Choose Robo Advisors?

Robo investing typically is not considered a high-risk strategy in the wider world of investing. As a general rule, quants are aware of the wider impact that a poorly set algorithm could have on investors (and the market, in general), so rules and equations are typically geared towards a more conservative investment strategy. This usually consists of ETFs and other pre-diversified funds as well as low-risk asset classes like bonds. 

To break it down into the simplest terms, people choose robo advisors because they offer:

Minimal Risk

Robo investing is relatively safe compared with many other more high-risk investment models. By investing in ETFs and other wide-reaching indexes, the vast majority of robo advisors do a good job of hedging their investments through a diversified portfolio. It is important to note, any form of investment has an inherent level of risk, but the investment strategies undertaken by most robo investors tend to play more on the conservative side of market investment.

Low Fees & Accessibility

Perhaps the biggest draw for the vast majority of new investors is the comparatively low rates at which they can sign on with a robo investor. The majority of robo-advisors charge somewhere between 0.25% and 0.50% of your total investment as an annual fee (with additional minimal fees occasionally applying to individual trades), although these numbers do vary somewhat depending on the provider. These low fees have opened the doors for so many people to begin their investment journey.

Ease of Monitoring

Robo advisors do a lot of the heavy lifting for you. By using the algorithm to predict market events, you can be notified when it is a good time to make a trade (such as buying or selling) or when to hold steady. However, these algorithms are not always universally correct, nonetheless, the automation involved creates a level of ease that appeals to most new investors.

To be certain, accessibility and ease of use are the defining features of most robo advisors. Whereas investing was once a playground for the ultra-wealthy, this new technology gives ordinary people the chance to grow their wealth in such a way for the first time. It’s this reason that even higher levels of investing have taken to the AI approach, such as pure quant hedge funds or middle-of-the-road investment platforms, like RIMAR Capital. These companies see the value inherent in quantitative investing and use it to their advantage.

Is Robo Investing Safe? The Biggest Risks Involved

Perhaps because many newcomers lack familiarity with robo investing as a practice, most beginning investors hear the words low-risk and assume that it’s safe to put all of their money into a respected robo-advisor. Although it is true that robo-advisors as a whole do emphasize low-risk strategies, there are potential issues to keep in mind when considering a robo-advisor. 

They Don't Know You

Robo-advisors have opened the market up to investors from all walks of life. An AI can make market predictions with stunning accuracy, but they might not understand the factors that are holding you back from making investments like age, time horizons, and access to funds.

Lack of Human Interaction

As the name would suggest, robo-advisors consist of quantitative scientists that create the algorithm and business associates who manage the company. Neither of these groups is responsible for consulting with clients, who are instead just left with the AI itself to conduct their investment strategy. The involvement of a financial advisor, however, can work wonders for clients in terms of strategic customization and maximizing profits. More fundamentally, however, these advisors can answer important client questions about how investing works and help them understand the inherent risk associated with investing. Having these relationships at the heart of your financial journey creates happier clients who are more likely to stay for the long term. If the equation says to sell on a downturn, the AI will always sell on a downturn unless another variable gives it a reason not to. In fact, this is the whole reason quants are employed by robo-advisors following the creation of the bot in the first place—they are needed to adjust those equations as necessary to create a stable investment strategy.

Aren’t As Emotionless As They Claim

Any algorithm is only as good as the quant creating it. AI is often considered to be “emotionless,” meaning it doesn’t crack under pressure the way a human investor might. While there is some truth to this, the reality is that an AI’s propensity to “crack” depends entirely on the parameters that the quant sets when creating it. If the equation says to sell on a downturn, the AI will always sell on a downturn unless another variable gives it a reason not to. In fact, this is the whole reason quants are employed by robo-advisors following the creation of the bot in the first place—they are needed to adjust those equations as necessary to create a stable investment strategy.

Limited Strategy Options

Low risk is great, but what about investors looking to maximize profits with a shorter time horizon? There are many investment strategies that can accommodate those goals if the investor is willing to take on a greater level of risk (e.g., shorting a stock when the market goes down), but these options are rarely available with most robo-advisors. Instead, the process often looks much more like putting your money into your chosen firm and watching as they go about their predictive strategy, whatever that might be. Lacking those shorter options imposes a uniform, one-size-fits-all solution where it simply does not fit.

It would be too far to say that robo-advisors prey on new investors who aren’t familiar with concepts like risk. That being said, they don’t do enough to mitigate that lack of understanding. For example, when most clients sign up with a robo-advisor, they are subject to a brief survey (usually consisting of five to 10 questions) about their background and investment preferences. 

This survey is meant to help determine the level of risk the client is willing to undertake, but people are more three-dimensional than a five to 10-question survey can account for. In addition, asking a new investor how much risk they are willing to accept doesn’t accommodate for the fact that they may not know what risk actually means in terms of investing. It’s nuances like this that make having a human advisor (like the ones at RIMAR Capital) so critical when starting your investment journey. 

So, Is Robo Investing Safe? 

Knowing the caveat that all investing involves risk, robo investing is likely a safer way to get started in investing than traditional routes. It’s crucial to understand, however, that while a robo-advisor might be relatively safe, it still might not be what you need. The cookie-cutter approach to investments that they take often results in minimal returns and usually mandates a more long-term investment, which simply doesn’t fit the bill for everyone. 

If you find yourself among those looking for a more personalized investment journey, consider an investment with RIMAR Capital. We tackle investment by using a hybrid approach that combines the best AI platform with human consultants that offer the personal touch your investment journey needs. Best of all, we offer a fee structure that includes no annual fees, meaning we only make money when you do. Let us know if you’d like to speak with one of our (human) consultants.