Robo-advisors for Wealth Management? Suitability and Efficacy Being Questioned
Online wealth management platforms like Wealthfront are gaining popularity, but the Financial Industry Regulatory Authority, as well as the financial advisors here at OptiFour Integrated Wealth Management, are questioning whether or not these “robo-advisors” can really determine clients’ risk tolerance.
Robo-advisors are online wealth management services that provide automated portfolio management based on algorithms—often without the direct input of human financial planners. FINRA is trying to establish exactly how these firms record data, how they calculate users’ risk tolerance, and how they respond to changes in users’ investment profiles.
Can Robo-advisors Really Evaluate Your Needs like a Financial Planner?
Robo-advisors determine risk tolerance by feeding users’ questionnaire answers into an algorithm. The algorithm is designed to calculate the investors risk tolerance. Wealthfront, one of the most popular online wealth management platforms, asks just eight questions:
1. What is your primary reason for investing?
2. What are you looking for in a financial advisor?
3. What is your age?
4. What is your annual pretax income?
5. Which of the following describes your household?
6. What is the total value of your liquid investments and cash?
7. What matters to you most: maximizing gains, minimizing losses, or both equally?
8. If your entire investment portfolio lost 10% of its value, would you: sell all, sell some, keep all, or buy more?
The real question is this: whether a questionnaire has eight questions or 100, can it capture a clients’ risk tolerance better than a human financial advisor? And what happens when the algorithm is given contradictory and inconsistent answers?
Wealthfront Test Case
In an article on Forbes, Marc Gerstein shows us how the advanced algorithm used to determine users’ risk score may be less technical than Wealthfront would have you believe. He described himself as:
• A 40 year old
• Living in a dual income household
• With dependents
• Made $70,000 a year
• Had liquid savings of $200,000
• Equally concerned with moderating losses and generating gains
• Would keep all holdings in a one-month 10% decline
With these responses, he was given a risk score of 7.5 (with 0.5 being most conservative and 10 being most aggressive). The interesting thing is that simply by changing the age and keeping all other factors the same, the risk score changes dramatically: a 25 year old gets a score of 8, and a 65 year old gets a score of just 2.5. Despite the renowned economists and Ivy League PhD researchers advising Wealthfront, the algorithm is affected overwhelmingly by the stereotype that older investors are more conservative and younger investors are more aggressive.
The Bottom Line
According to Business Insider, those with large portfolios who are investing $100,000 or more should be working with an experienced, qualified financial planner. FINRA has stated that robo-advisor software is not sophisticated enough to judge an individual’s risk.
Financial Planning with OptiFour Integrated Wealth Management
OptiFour Integrated Wealth Management employs a team of respected Washington, D.C. financial advisors and wealth management experts. For more information on our array of financial services available, visit our homepage or contact us today.
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