WealthTech Insights #17 with Paolo Sironi: Financial Psychology and the Winning Model for Robo-Advisors

Vasyl Soloshchuk

As part of our series of interviews with industry influencers, I talked to Paolo Sironi, a FinTech thought leader and author of Wiley’s bestseller FinTech Innovation: from Robo-Advisors to Goal Based Investing and Gamification, as well as literature on portfolio management.

Paolo Sironi
FinTech Thought Leader at IBM Watson Financial Services.

Paolo has a strong background in wealth management. He was a risk manager for Banca Intesa Sanpaolo in Italy. In 2008, Paolo launched the Capitects startup in Germany, which was innovating investment management solutions using the APIs and new ways of describing the added value of investment decision making for long-term planning. Since 2012, Paolo has been a member of the IBM Industry Academy, linking technology and finance for his international audience.

We talked about current trends in investment management, particularly problems and prospects of robo-advising. In addition, Paolo shared his vision of the European, US, and Australian financial markets and announced his upcoming book, which is expected to lead a revolution in financial advice.

Digital Transformation and Robo-Advising

With regard to business and technology, Paolo agrees that digital transformation is the overall trend. But rather than just looking at technology and discussing how it is transforming today, he prefers to observe all the elements of the industry to see why each has gone digital and how this influences the industry as a whole.

Paolo says, “The banking industry is shifting from a model based on transactions to a model based on services. That means moving from making money by placing products in the portfolios of clients to asking clients to pay for financial advice embedded in solutions that generate added value, which they are willing to pay for transparently.” This means that financial advisors need to provide their clients with personalized goal-based investing models that allow clients to understand ongoing reasons for investing and the relationship between risk, uncertainty, and potential returns. Without using technology, this would be difficult to achieve.

Thus, technology can help to institutionalize the wealth-management relationship, yet in a personalized way. This is why Paolo perceives financial technology as an “opportunity for the industry to transform from a product-focused business model into a client-centric business model.

Robo-advisors, one of the hottest topics in wealth management, should move from disruption (race-to-zero prices) to innovation (real, informative added value for investors) if they really want to generate sustainable benefits for clients. Goal-based investing and gamification are keys to their success.

During our discussion, Paolo referred to “robo-advisory 1.0,” which basically comprises automated investment solutions using a very simple onboarding mechanism to classify clients (or to help them classify themselves) and invite them to invest in a portfolio that includes such goals as retirement and education. The robo-advisor then allows the client to delegate responsibility for rebalancing the investments inside of the portfolio, avoiding behavioral biases that would create a tendency to buy high and sell low.

However, Paolo believes that the next generation of robo-advisors will work more efficiently, for the following main reasons:

  • They will take into account the psychology of (at least the majority of) investors, favoring hybrid models;
  • They will capture the essence of digitizing and use artificial intelligence to augment clients’ understanding.

Paolo highlighted that a high percentage of industry costs passed to investors is determined by unnecessary financial research required to support offering products via open architectures. Research is marketing food for financial intermediaries in front of final investors. By shifting to passive investing and transparent financial advisory solutions based on higher fiduciary standards these costs could be optimized, but the language would have to change as well to make sure clients will still have motivation to invest. Nonetheless, according to Paolo, in their current attempt to compete with prices robo-advisors can only access cheap investments; this could give rise to ineffective portfolios in the long term.

When they appeared in the market robo-advisors started to grow rapidly; today, this growth has slow (excluding those owned by investment-management powerhouses). To grow further, robo-advisors have to spend a lot of money on marketing because they need to push their solution in front of clients. Paolo cited that the biggest players, such as Vanguard or Schwab, can grow faster because they already have the means to make marketing effective.

digital transformantion

There’s a simple reason for the abovementioned slowdown—a lot of people are not yet ready to invest online. As Paolo noted, “Being digital only, even though you’re cheaper, might not be suitable for the majority of investors. It doesn’t mean the model is not interesting, but the psychological barrier of entry for many investors will not be overcome by technological advantages of running digital investing without a clear shift in artificial intelligence to create more suitable and trusted conversations. This is the critical element for many people.”

Human and Robo Relationships

There is a lot of debate about the possibility of completely replacing human financial advisors with robo solutions. Paolo agrees that this is a believable scenario, but he is confident that in the medium term the hybrid model will remain more relevant. From one side, technology empowers both advisors and clients to add value to financial advice:

  • Clients can do more things by themselves;
  • Financial advisors can serve more customers and provide digital advice to them.

On the other side, it is the investment conversation surrounding clients’ onboarding, not only investment inboarding, that allows advisors to become more involved in the client’s everyday financial life. “Digital can be expected to grab a much larger part of the wealth-management industry if people become accustomed to it in their daily financial lives, but this isn’t happening. That is the only element of starting innovation that can effectively turn the economy with digital technology from pull to push, and facilitate the robo-advisor model to go outside and be mainstream.” Paolo added, “If robo-advisors can’t find a way to resolve people’s emotional problems regarding dealing with money, they will be a winning model for fewer people.

The problem is that most robo-advisors today only focus on the investment side. However, in reality their formula should include all aspects of financial planning, including earning, payments, saving, investing, lending, borrowing, donating, insuring, mortgages, retirement, etc. Paolo agreed: “In order to attract new clients, robo-advisors need to be capable of bundling into their solution as many services as possible that are related to the finances of individuals. The offering should not be the same for every person in the world.

There are still respective amounts of wealth that people have. In addition, some clients have more constraints than others. Robo solutions should add a differentiating element so as to provide value-added advice.

Paolo summarized: “The winning model of the robo-advisor is the platform for your whole financial life. It should focus on your goals and be affordable independently of the amount of wealth that you have. If you’re going to use a robo-advisor, make sure that this digital platform is suitable for personal finance and capable of providing sufficient comfort to enable you to make financial decisions via the platform. Even if clients are driven towards human advisors, the problem of digitalization will still loom large because investors are going digital in their daily lives and advisors are striving to provide more added value. Digitalization for them is a way to automate administrative tasks, better showcase their propositions, and have time to focus more on the relationship to justify their advice for clients.

Risk Tolerance and Efficiency of Questionnaires

Before allocating a client’s portfolio, robo-advisors use some kind of questionnaire that helps them to identify the client’s goals, time horizon, and risk tolerance. The efficiency of such questionnaires is often doubtful; however, Paolo is confident that without enriching and extending this dataset, the client profiling cannot be efficient: “The more you understand and know about the client, the better it is for creating personalization; this creates understanding of the whole plan.

The problem is that over time, people may change their preferences, and their answers will therefore differ from their previous ones to fit their new goals. “The point here is not to profile customers, but to create an onboarding mechanism that enables clients to understand the consequences of risk and return. These would be the key elements,” Paolo stated. “The risk profiling tends to pigeonhole clients, but it is imperfect. We see that regulation in Europe is moving ahead in that regard to open up for more requirements. This is actually the essence of my new book, which completes FinTech Innovation and is coming out in November. It is dedicated to the revolution of financial advice. Then, the onboarding and inboarding will be more defined because one generates the input for the other; the onboarding gives the wealth-allocation framework and the client understanding involved in his investment solution during inboarding.

Financial Markets Around The World

During our discussion, the issue of differences between financial markets on different continents arose. Paolo stated that “The US has the technology, Europe the regulation, and China the business models. In particular, European markets are more dominated by banking networks. US markets instead have a longer history of independent personal financial advice and are more fragmented markets for financial advisors. Regulation is standard in both markets.

global finance

Paolo believes that both markets are moving towards services and solutions as a source of revenue in mobile transactions, and also favoring conversations that can be brought into the wealth-management relationship based on price.

With regard to Australia, Paolo suggested that its market is more similar to those of the US and UK than to core European markets, and due to superannuation rules it already generates greater requests for financial advisory linked to retirement problems, which are soon to affect a large population worldwide. Because human financial advisors are unable to provide efficient advice for the mass market, technology, particularly robo-advising, may improve the situation and make retirement planning and investing accessible for many investors.

Again, Paolo highlighted that in order to create an efficient investing platform, not only financial advisors, but technology people who create the platform, should necessarily be informed about financial psychology, and the psychology of investing. This would enable them to foresee clients’ behavior, understand more sensitive aspects of their lives, and exploit technology innovation to provide value-added services that truly work on digital platforms.