One key question helps investors determine risk tolerance. And folks, it’s a tough one…
How willing are you to sacrifice potential rewards to reduce potential losses?
These days, investment firms assume they can marshal their extensive brainpower and financial muscle to automate the process for answering this question.
They want you to trust their computers, rather than yourself or a human adviser.
It’s a compelling narrative. After all, “robot” advisers have a mountain of data on their side.
All you need to do is log into a website. Then, you fill out an online questionnaire designed to assess your risk tolerance.
After that, the robot adviser’s computer gets to work. Before long, you’re looking at a recommended investment portfolio. From there, it’s as easy as pie…
You fund the account. Then, the firm invests in the portfolio it designed for you. The robot adviser will even periodically update the allocations.
Automated risk assessment seems like a natural fit in our lives today…
After all, we’re living in the era of robot manufacturing and artificial-intelligence customer support. And we’ll likely have self-driving vehicles in the near future.
But as I’ll detail today, robot advisers aren’t all they’re cracked up to be…
For starters, the robot adviser often winds up using the same allocations for a gazillion others. A lot of folks apparently have the same risk tolerance as you – at least in the eyes of the robot.
That could be a problem… If the robot adviser says to sell an investment, its price could fall off a cliff. And you and the other humans would be stuck with the losses, not the robot.
Plus, the U.S. Securities and Exchange Commission (“SEC”) has been skeptical about robot advisers in the past. As far back as May 2015, the SEC said…
For example, an automated investment tool may be programmed to use economic assumptions that will not react to shifts in the market. If the automated tool assumes that interest rates will remain low but, instead, interest rates rise, the tool’s output will be flawed.
Here’s another SEC concern from that May 2015 report…
Be aware that a tool may ask questions that are over-generalized, ambiguous, misleading, or designed to fit you into the tool’s predetermined options.
We discussed the problem with these risk-tolerance questionnaires earlier this week. And here are two questions from the website of one well-known firm with robot advisers…
What would you do if your portfolio lost 10% of its value in a month?
__ Sell all of your investments
__ Sell some
__ Keep all
__ Buy more
What are you most focused on when investing?
__ Maximizing gains
__ Minimizing losses
__ Both equally
Other investment firms phrase the questions a bit differently, but they follow this theme.
The questions seem to be straightforward. But the problem is… they’re too straightforward.
How can you or the investment firm trust that your answers are thoughtful and sincere? Heck, the questions are so broad that you can’t even be sure you answered them correctly.
The SEC raised another issue, too…
An automated investment tool may not assess all of your particular circumstances… In addition, automated tools typically do not take into account that your financial goals may change.
To be fair, all the questionnaires I’ve seen ask about age and total assets. But they don’t always cover other key components of an investor’s profile. I’m talking about things like…
- Number of dependents
- Spousal income
- Perceived income security and longevity
- Living expenses
All of these factors help determine your specific risk-tolerance level. They help you figure out how willing you are to sacrifice potential rewards to reduce potential losses.
Do you really think a computer can manage your portfolio without knowing these things?
The robot advisers want you to think they can. But I hope you know better…
It’s your money. Don’t just click a mouse. Get it right.