Understanding How a Robo-Advisor Works
May, 21 2018 | Michael
Determining the Risk Profile of the Client
A Robo-Advisor typically asks a series of questions to determine the risk an investor is willing to take, enabling an ideal portfolio to be created. Some will also look further into the investor’s holdings to determine any difference between the client’s ability to take risk versus the calculated risk of the client’s current holdings. Based on the difference, the Robo-Advisor directs the investor to adjust their holdings to better fit their real risk profile.
Enabling an investor to fill out a questionnaire is one way for the financial advisor (human or Robo) to get to know the investor and to create a risk profile appropriate for them. The more information the system or advisor receives, the more accurate the investor profile and the more personalized the investment strategy that can be recommended.
At a minimum, a questionnaire should be able to determine the investor’s ability to take on risk (“risk capacity”) and their willingness to do so (“risk tolerance“). It should ask both objective and subjective questions, as well as track the consistency with which the investor answers those questions. For example, if an investor who chooses the most aggressive answer for one question and then the most conservative for the next, this is an important data point that should lead to a more conservative risk score. A few subjective questions could include:
1) When you hear “risk” related to your finances, how does it make you feel?
2) Does financial news make you worry about your investments and the future?
3) Do you become worried that you will be left with nothing at your retirement?
4) Do you believe that risk is just an essential part of the investment process?
Providing straightforward answers to questions allows a client to obtain a portfolio with the appropriate level of investment risk that should allow the investor the ability to understand and feel more comfortable when the markets inevitably sell off.
What is Risk Tolerance?
Risk tolerance is the amount of market risk an investor can tolerate. It includes the ability to withstand losses both from a monetary standpoint as well as psychologically being able to deal with potential losses. The ability to accurately assess your appetite for risk is not easy and depends on numerous variables. There is no simple way of approaching it. Risk tolerance is about understanding and learning how to live with the fluctuations in the markets and the potential for losses. It is also about recognizing that you cannot predict what lies in the future and understanding that all investments involve some degree of risk.
Behavioral scientists say that “loss aversion,” the fear of loss, can play a much bigger role in decision-making than the expectations of gains. You may not be aware of your risk tolerance or risk appetite until you are faced with a potential loss. Fear is a more powerful motivator than greed. Most people would rather not lose money when faced with an equal chance of losing or gaining the same amount of money.
When determining risk tolerance, it is important to understand your goals. Other factors include your time horizon, or when you plan to withdraw the money; your expected future earnings capacity; and other assets such as homes, pensions, retirement accounts, Social Security income or an inheritance. All of these influence your approach to risk and achieving your goals.
Typically, the longer your investing time horizon, the more risk you can take on since you have more time to recover from any losses. As you near your investment goals or retirement, you may want to reduce your market risk and focus more on preserving capital rather than potentially risking large losses at the worst possible time.
Many investors divide their investments into multiple “buckets,” each with a separate goal. For example, a bucket created strictly for growth and income can be invested more aggressively than a bucket that is going to be needed soon for retirement or for a large purchase.
Risk Tolerance Versus Risk Capacity
Your risk capacity, or how much investment risk you accept as part of your portfolio, depends on your ability to absorb losses without affecting your current or future lifestyle. Risk tolerance typically stays the same over a long period of time.
Risk capacity is the ability to withstand losses as you stay invested so you can meet your future financial goals. Risk capacity is typically more flexible and changes depending on your personal and financial goals as well as your timeline for achieving your goals. If you have a mortgage, large capital needs for your business or have children approaching college age, you may be far less comfortable watching the markets go down than if you are younger and free of obligations.
Converting Risk Tolerance into an Investment Strategy
In most cases, completing an investor profile questionnaire can help you assess your individual risk tolerance. The typical investor questionnaire leads to an appropriate asset allocation based on your answers about your investment experience, objectives, time horizon, and current financial situation.
Smart investors consider both risk and return when considering an investment strategy. The more informed an investor is, the better the chance that the investor’s decisions will not be emotionally driven. Smart investors also understand that investments in stocks typically have higher expected returns corresponding with higher volatility than investments in fixed income products, which tend to offer lower volatility corresponding with lower returns. Keep in mind that all investments can have periods of high volatility.
As an investor approaches the time when they need access to their money for retirement or a specific goal, market setbacks can have a more pronounced effect. Investors must be willing to endure typical market selloffs so they don’t panic and liquidate their portfolios. They must make sure they stay invested. Most investors who don’t stay invested for the long term typically suffer with returns that pale in comparison to returns had they stayed invested long term.
When an investor knows their limits for investment risk and has a portfolio that takes into consideration all their investment criteria, the investor will have far better odds for achieving their financial goals.
Calibrating the Algorithm
Robo-Advisors recommend portfolios based on algorithms that translate the investor’s answers to the profile questionnaire into appropriate investment recommendations. A poorly-designed or poorly-coded algorithm may result in a strategy that is incorrect for the investor’s goals, risk tolerance or time horizon.
To obtain meaningful answers to a risk profile, the questions should not be highly specialized. They can be created specifically for the types of clients you are targeting with clear and easy-to-understand questions. For example, inexperienced investors not familiar with financial terminology are unlikely to be able to give useful answers to questions such as, “How much volatility are you willing to take?”
Determining a client’s risk profile should not be taken lightly. It is the primary step in determining an investment allocation appropriate for the investor that takes accepted risk compensated by reasonable returns.