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Advisor ex Machina: The Rise of Algorithm-Based Advice

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On Tuesday, Corporate Insight released a preview of research expected to be published in October that examines the effect of online financial advice startups on the industry.

Corporate Insight studied more than 100 online financial advice startups for almost two years for the report. Tuesday’s release examined algorithm-based advice and what it does for consumers.

“This kind of effort is to understand what’s next,” Grant Easterbrook, senior research analyst for Corporate Insight, told ThinkAdvisor on Thursday. “I’ve done a lot of interviews with the entrepreneurs who lead these firms. The goal is not exactly to pitch ‘Startup X will win, Startup Y will fail.’ It’s more to understand the broader trends here.”

Algorithm-based advice relies on the consumer entering information about their investment accounts. The service then provides advice based on that data. Corporate Insight noted that the best of these firms provides specific recommendations for funds the consumer holds. The report found these automated advisors also typically provide general guidance on the overall asset allocation, risk, diversification and tax efficiency of the consumer’s portfolio.

Easterbrook noted that an automated service “doesn’t really compare” to working with a traditional advisor, but added that they’re not trying to.

“These services are not necessarily trying to replicate the traditional advisor relationship,” Easterbrook said. “In fact, one of the criticisms I’ve heard across the board of some of these firms is that they overemphasize investor questionnaires, or they don’t ask enough questions. The reality is if you ask someone, ‘If the market went down 10% in the next month, what would you do?’ they have no idea. The average person doesn’t understand these things. The entrepreneurs tell me the flip side of that is to find the optimal number of questions that people will actually complete. The more questions you ask, the less likely someone is to finish the questionnaire and sign up.”

The report found various pay models among automated financial services. Some provide all of their services for free. Some use a “freemium” model where basic services are provided at no cost while the service tries to upsell consumers on more advanced services.

The amount of data required and the sophistication of the advice provided was higher among paid services, according to the report, although some have found ways to differentiate themselves. Financial Guard detects whether consumers prefer passive or active investments, and Quovo has developed a PDF statement reader that analyzes consumers’ past statements to study their investing history and behavior.

“Free services tend to grab your attention by pulling out how much you’re paying in fees, versus the paid services, which sort of want to be your advisor,” Easterbrook said. “They’re pulling out ways to trade, but the headline item isn’t going to be ‘You paid this much in fees.’ It’s going to more about what you need to do to bring your portfolio in line with your goals.”

One drawback to these services is that they don’t collect information on consumers’ overall financial situation or their goals, Corporate Insight found. “While there’s value in receiving investment recommendations, it would be better if the analysis were based on a truly comprehensive understanding of the client’s financial situation,” according to the report. Better advice could be provided if the services collected data on “everything from the current value of their spouse’s 401(k) to expected life events, such as sending children off to college.”

The report found some services allowed consumers to assign goals to individual investment accounts, but these features were limited and frequently only available for retirement goals.

Grant Easterbrook, Corporate Insight“To be fair, this is a new technology, but right now the emphasis tends to be on retirement,” Easterbrook (left) said. “The only real goal you can set these up for is retirement. What about saving for college? What about saving for your home? What about your spouse’s 401(k)? It’s pretty limited at this point, but it’s still very useful.”

Another drawback is how comfortable consumers themselves will be with acting on the advice provided. The report noted that consumers who use paid services put themselves at a special disadvantage if they don’t follow through with the recommendations: “Imagine paying for an advisor but only placing a quarter of the trades he or she recommends; eventually, the value of this advice would be called into question.”

Despite the drawbacks, for consumers these services are still better than nothing. “The problem is the average industry planning tool doesn’t give you actual advice,” Easterbrook said. “It may tell you if you have a 60/40 portfolio or if you have to retire a couple of years later. That’s not telling you what to actually invest in. What these services do is they lay it out for you. Using aggregation they tell you, ‘You need to buy these funds, you need to sell these funds, hold these and here’s why.’”

Corporate Insight suggested one way consumers might use algorithm-based advice services is as a “second opinion” to their own financial advisor. Clients who already pay for an advisor can use one of the free services to compare the fees they’ve paid their advisor to what they might pay if they chose different funds. Easterbrook noted that free services were especially useful in that regard.  “For some of the free services, they emphasize fees,” he said. “You can grumble about how much you pay your advisor, but when you can actually see in front of you how much you spent on load fees this year, it’s a whole other ball game. It helps people wrap their head around things.”

Do-it-yourself investors with multiple accounts also stand to benefit from these types of services. Corporate Insight suggested automated services could serve as a way to highlight problems that aren’t obvious in investments spread between various accounts and financial institutions.

“This technology is here to stay, whether or not some of these free services succeed or even paid ones,” Easterbrook said. “I don’t think every one of these firms is going to succeed. Why it’s one of the most interesting groups is a lot of these firms have B2B partnerships, or B2B partnerships are soon to be announced. That makes them a lot more stable in the long term. If there’s a major correction they still have the revenues from their contracts. If it’s just B2C, that’s very hard. If trading goes down, people panic: then what happens to the firm?”

Check out Technology and the Successful Advisory Firm of the Future (and Now) by Michael Kitces on ThinkAdvisor.