There’s no denying robo-advisors are gaining popularity, but FinaMetrica’s Paul Resnik thinks they’re a “robo-bubble” that’s bound to “blow up.”
A study by Corporate Insight shows that robo-advisors in the U.S. directly manage about $19 billion in assets as of December 2014. This is a 21% increase in AUM since July 2014, and a 65% since April 2014, as a recent FinaMetrica report points out.
The problem with robo-advisors, Resnik told ThinkAdvisor during a recent visit to New York, is that they don’t properly calculate a client’s risk tolerance. And without a scientifically accurate risk-tolerance process, robo-advisors are at risk of recommending investments that are not suitable for their clients.
“The reason why this is important to do properly is, if you get the risk tolerance wrong, there’s a great likelihood that the portfolio won’t meet the client’s capacity to cope when the markets go boom and crash,” Resnik said. “What tends to happen, people tend to invest at the wrong time of the market or divest out at the wrong time.”
Most investors buy and sell ineffectively at the wrong times in the investment cycle largely because emotions influence their decision-making so they buy high and sell low, according to Resnik.
Resnik has found, though, that FinaMetrica subscribers who use its risk tolerance assessment say that “investors who invest consistently with their risk tolerance tend to stay with that portfolio through market tribulations.”
By Resnik’s calculations, investing consistently with risk tolerance could add $5,000 a year to performance for every $1 million invested.
A recent report from FinaMetrica, co-written by Resnik, suggests that poor risk tolerance suitability exposes the “robo operator to the risk of expensive legal action or intervention, sanction from regulators and reputation damage.”
Why don’t robo-advisors properly assess investors’ risk tolerance?
“When you’re in the world of the Internet, everything’s about quick,” Resnik said. “If there’s more than one extra step, you’re gone. To do risk tolerance properly, you have to ask a good chunk of questions.”
FinaMetrica’s current risk tolerance and suitability solution uses a 12- or 25-question psychometric risk tolerance test that takes into account investors’ time horizons, capacity for loss, risk tolerance, knowledge of investments and investment experience. “Often times you see the suitability [in robo-advisors] goes, ‘What’s your risk tolerance? Low, average, high.’ There’s no assistance through the process,” Resnik said.
The reason this is, according to Resnik, is that suitability is seen as “a very minor thing” within financial services.
“I don’t think anybody understands that most of our problems are failed suitability,” he told ThinkAdvisor. “I’m using suitability in its general sense, not even the legal definition. Most of financial services history is about product selling, and it’s sort of like saying ‘I’m going to sell you a 6.5-size shoe.’ And you can sort of force your foot into it … that’s not the way it should work.”
Resnik said he is currently working on several projects to see if risk tolerance can be properly assessed with fewer questions to find a “much more accurate way of helping robos.”
“At least in my last umpteen years in the industry around the world, people want to make a sale first, rather than a sale that fits,” he said.
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