Digital investment advisors, also known as roboadvisors, make investing easy by recommending investment portfolios tailored for investors' individual needs.
A major attribute determining which portfolio you'll be pointed toward is the roboadvisor's evaluation of how well you tolerate investment risk. By understanding how roboadvisors determine risk tolerance, you can gain insight into the kind of investor you are and better understand the advice you get.
Roboadvisor risk measurement is based on asking you how you feel about risk.
“Roboadvisors use predefined online questionnaires to assess the risk tolerance of the investor”
- Michael Tertilt
a German researcher whose study of roboadvisor risk tolerance practices appeared The Journal of Wealth Management in 2018
Your responses to one of these questionnaires will let the roboadvisor assign you to a risk category. An investor whose answers indicate a desire to avoid risk would be considered more conservative. Another investor whose answers indicate more willingness to accept risk would be considered an aggressive investor.
Questions That Reveal What Kind of Investor You Are
Questionnaires from roboadvisors that Tertilt studied presented from four to 27 questions. A different research study of roboadvisor risk assessments published in The Journal of Wealth Management found that questions typically covered three topics.
Those topics included:
- Investment objectives. Typical goals include funding retirement, paying for college, or purchasing a home. Different objectives may call for different investment strategies and suggest a different portfolio.
- Risk capacity. This refers to the investor's financial capacity to handle potential losses or declines in the portfolio's value. An investor with more assets would likely be seen as having higher risk capacity.
- Risk tolerance. This looks into the investor's psychology and how he or she feels about putting money at risk.
Within these parameters, every roboadvisor tends to take a somewhat different approach to determine your investor risk tolerance. There are, however, some typical questions roboadvisors are likely to ask. By considering how you would answer them, you can gain insight into your own risk tolerance. Typical questions on a risk assessment include:
- Do you invest for retirement or to generate general savings?
- What is your age?
- What is your net income after taxes?
- What is your savings rate?
- What is the value of your current liquid investments?
- When deciding how to invest your money, do you worry more about maximizing gains, minimizing losses, or both equally?
- If your investment portfolio lost a given percent in a month, would you liquidate your portfolio, sell some investments, do nothing, or increase investments?
The last two questions are the ones that most directly address personal risk tolerance. For instance, if you answered question six by saying you were mostly concerned about maximizing gains, you are probably a more aggressive investor. If you are more concerned about minimizing losses, you are more conservative. An answer indicating equal concern about maximizing gains and minimizing losses suggests a balanced attitude toward risk.
How Risk Tolerance Affects Portfolios
Armed with risk assessments, roboadvisors use computer algorithms to create portfolios of mutual funds and exchange-traded funds. The algorithms tune the portfolios to investor risk tolerance by varying the mix of funds. A riskier portfolio, for instance, would include more funds that invest primarily in stocks. A less risky portfolio would have more funds consisting mostly of fixed-income holdings.
Because they use impartial computer algorithms to make investment recommendations, roboadvisors also avoid biases that may influence human advisors, notes Tertilt, who also contributed to the upcoming book, “Robo-Advisory: Investing in the Digital Age."
Evaluating Roboadvisor Risk Assessments
Freedom from human bias doesn't make all roboadvisors equal.
“Unfortunately, there is no standard, accepted way of evaluating a person's risk tolerance”
- Scott Stratton
a certified financial planner in Dallas
"Investors may find that questionnaires from different companies may vary substantially in terms of their design, content, and depth of questions."
As an investor, you may want to ensure that roboadvisors are accurately assessing your risk. Generally speaking, the more questions the roboadvisor asks in the risk assessment, the more thorough and on-target the assessment is likely to be.
In addition to examining the scope of the assessment, you may want to find out what you can do if you are uncomfortable with the risk level of the portfolio you are offered. To make sure you can do this, Brie Reyes, a certified financial planner in Fort Worth, Texas, says investors should determine who they can contact if they have questions about their portfolio and how to make that contact. “Will it be a phone call? Email?" Reyes asks.
After learning the channel you'll use to communicate about your portfolio, don't be shy about using it. If you are uncomfortable with the amount of risk the portfolio is showing – perhaps if it declines sharply during a volatile market – you may want to reassess your responses to your risk assessment., Reyes says.
A risk-tolerance assessment is an essential part of working with any advisor, whether digital or human. Knowing how one is created can help you understand the kind of investor you are and what to expect from your roboadvisor. “Without a crystal ball, investors need to find a middle ground that is good for growth but won't cause them to lose sleep at the next bear market," says Stratton. “A good risk tolerance evaluation should focus on long-term goals and tune out the short-term noise."