We believe robo-advisers will be paradigm-changing, but that doesn’t mean they have a free pass to success. They must overcome six significant challenges if they are to evolve into profitable financial services businesses:
1. Changing perceptions of financial advice
For a large group of consumers, investment advisers are self-interested and greedy, financial markets are rigged and corrupt and their money is better off being self-invested into real estate, gold and other real assets. This widely-held perception of the finance industry is deserved.
There have been far too many financial services scandals that prove these theories, from an outright fraud like Bernie Madoff through to a local adviser churning an unsophisticated client through a procession of high brokerage-fee products. Meanwhile, the global markets collapse of 2008 left many investors wary and untrusting of the entire financial market framework. They would rather buy real estate that they can see and touch.
The financial advice industry has failed to make a convincing argument to justify its value to consumers. The industry has struggled with the intangibility of advice, the potential uncertainties of outcomes should markets crash and perceptions of greed among the people running the ‘system’. The impact is that most people don’t want to pay for financial advice.
2. Establishing trust
In financial planning, human interaction has traditionally been vitally important. As many a salesperson knows, selling something that is intangible requires the establishment of trust. This is problematic, because trust in the planning industry is low.
Trust is defined as “a psychological state comprising the intention to accept vulnerability based upon positive expectations of the intentions or behaviours of another” (Rousseau, Sitkin, Burt, & Camerer, 1998).
Repeated surveys around the world show financial advisers sit towards the bottom of the trust ladder. How do robo-advisers show they are trustworthy? To show you are trustworthy, you must display the behaviours that will lead people to trust you.
Three important requirements are:
- Competence in the matters in which competence is claimed and required
- Reliability, by doing the things as expected and promised, and
- Honesty and transparency in dealings with customers.
To convince the broad public that it can be trusted, a robo-adviser will be required to invest in processes and marketing to tell the story of how and why they are trustworthy.
Established brands and the large end of town already have customer bases into which to market to achieve scale while also having the marketing budgets and communication channels needed to attract new business to a robo-adviser.
3. Advice and guidance gaps
‘Advice gaps’ arise when people who could benefit from financial advice do not receive it because:
- Their level of assets is too low to viably warrant the attention of a financial adviser, or
- They are not prepared to pay a fee to receive advice.
In the US, the desire to maximise planner profits makes accessing a financial planner high compared with the rest of the world. US advisers focus almost exclusively on what would be regarded as high wealth clients in the rest of the world.
In the UK, financial advice is generally more readily available to the middle classes – what might be termed the ‘mass affluent’. The dollar figure required to access a basic service is driven significantly by the regulatory framework. Ironically, rules that were introduced to protect consumers now deny many of those people any service at all as the costs of regulatory compliance are too high to make them financially viable clients.
It is, perhaps, a logical conclusion to see robo-advisers as the solution to the advice gap as they have scalability and can service customers at low cost. Some people see robo-advisers ‘democratising’ financial advice, making it available to all.
By definition, those in advice gaps have lower investable asset balances, which means, per customer, lower income for the robo operator. Robo-advisers need profitable clients, but to acquire them as clients they need to invest serious marketing money, which is why existing big players have advantages over new entrant start-ups no matter how well funded. The exception is perhaps those providing a B2B robo white-label platform for existing distributors.
4. Economic influences
Around the world, wealth is being squeezed into upper economic groups, with corresponding falls in income and wealth for the middle and lower economic groups.
The loss of the middle range investor means that an increasing number of service providers are marketing to a shrinking pool of affluent investors, albeit that each of those customers comes bearing a larger pool of assets.
At the same time, there might be increased demand for robo-advisers that focus on providing budgeting tools and cash-flow forecasting, as these issues are of more significance to lower economic groups than questions of investment.
5. Cost of acquiring clients
Robo-advisers need clients to operate and the cost of acquiring (CAC) clients in financial services is high.
To us, this is the elephant in the robo-adviser room that is seldom discussed – which we believe is a strategic failure of the highest order.
Acquisition costs include the costs of initially finding a prospect and then converting those prospects into clients, with the inevitable attrition rate that those conversions incur. When total costs are compared to clients gained the results can be surprisingly high. Lucian Camp calculates the cost of acquiring a client in the UK to be around £200 (US$312).
This cost is beyond the means of many advisory firms, which is why they grow slowly – largely through word-of-mouth referral. In the past, they might have relied on product manufacturers and distributors to provide them with marketing support. Under new regulations in the UK, such supports are now largely no longer possible. But they continue to thrive in the US marketplace. In a world where former specialties have become commoditised, being able to make a financial product or service no longer makes you special as it once did.
Where, in the past, you may have been able to extract an economic rent because you occupied a position of advantage, market forces have now equalised you. Today, the ability (knowledge) and capacity (cash-flow) to quickly market financial products to scale is what separates successful financial services businesses from the ‘also-rans’.
It does not matter if you arrive at the marketplace with a better mousetrap if that trap is hidden where the mice cannot find it. Cheese – in the form of marketing, advertising and promotion – will help to attract them. But cheese isn’t cheap. Robo-advisers are very good at servicing customers, but do nothing to attract customers.
6. Behavioural biases
It is human nature to want it now. But it is also human nature to make plans for the future, including saving money. Of course, the two natures quickly come into conflict. You want a holiday now – but spending the money will reduce your pension in 30 years’ time.
More often than not your ‘present’ self will defeat your ‘future’ self. The future loss is so far away that it is diminished, but the present benefit is NOW! “Pack your swimsuit, honey, we are going to the beach.”
There is good reason to believe that robo-advice systems might do a much better job than human systems at helping people confront and manage this ‘present-day’ bias, by allowing them to visualise the impact of financial decisions made now projected into the future.
As ever when there are challenges, those who are successful will find new solutions and build the scale critical for success, while many others will fall by the side.
Paul Resnik is a co-founder of FinaMetrica, which provides psychometric risk tolerance testing tools and investment suitability methodologies to financial advisers in 23 countries.