When it comes to opening an investment account, you now have more options than you think—options that don’t even include an actual person handling your money. That is, investors today can turn to automated investment advice companies, often called “robo-advisors.”
The robo-advisory route has significant advantages over human advisors, such as lower fees, access to investment advice with less up-front money, and less decision-making and monitoring for investors. Disadvantages do exist, however. Robo-advisors are generally not personalized to an investor’s unique situation, and investors usually go without any human advice or guidance. This means that investors need to investigate whether a robo-advisor is right for their situation.
Ultimately, the choice to use a robo-advisor should be made based on thorough research. But if you, as an investor, decide that the robo-advisor route is best, it’s important to be aware of several issues that may arise in setting up your account. This post will identify a few of those issues and how you can try to avoid them.
What is a robo-advisor, and how does it work?
Robo-advisors are essentially computer programs that invest and manage your money. These programs request information from you about your investment goals, and then run that information through a formula (called an algorithm) to decide the best funds for you based on your preferences—just like how Google brings you results based on your search words and phrases. And just like any human investment advisor, the U.S. Securities and Exchange Commission (“SEC”) and state securities authorities regulate how these programs interact with investors.
To create an account with a robo-advisor, you need to research and find your preferred robo-advisor company on the internet—of which there are many options. Then, you follow the steps on that company’s website to build your account. These steps nearly always start by having you fill out a questionnaire, and that questionnaire will often ask you about your risk-tolerance, income, investment expectations, and time-period that you want to invest. The exact content of a questionnaire, however, differs with each company. Nonetheless, each company will use your answers to ultimately determine the portfolio for you: be it an aggressive portfolio; a conservative portfolio; or anything else that your selected company offers in between.
Did you set up your investment portfolio correctly?
For investors that choose a robo-advisor, problems can often arise from the results of the initial questionnaire—that is, whether the robo-advisor’s recommended portfolio matches what the investor thought they were getting. This is an issue, because for most robo-advisor companies no human advisor checks answers to see if an investor correctly stated his/her risk-tolerance, goals, and expectations. The investor alone determines how to answer the profile questions. And as humans, investors may make mistakes or misjudge their investment objectives.
But as explained below, you can take steps to prevent those mistakes.
How can you get started on the right track?
Before starting a robo-advisor’s questionnaire, first create a personal financial roadmap. This step requires you to research your personal investment expectations, and it requires that you honestly evaluate your investment goals by considering: how long you want to leave your money in an investment account; how you expect your account to look in terms of stocks, bonds, and cash; and what parts of your life may change in the short or long-term future (e.g. employment, housing, income). The SEC has some helpful advice on things to think about at https://www.sec.gov/investor/pubs/tenthingstoconsider.htm.
Next, after you’ve draw out your financial roadmap, you should take a break for a few days to consider your options. This step focuses on removing your emotions from investing. A short-term mental state is not ideal for choosing an account that manages your wealth for years or decades, and there is no need to do everything at once. So, it may be helpful to take your time and make sure you’re comfortable with everything.
After you’ve taken a break, look back and carefully review the financial roadmap that you created. But while you go through this review, think about some common mistakes that you may have made. Consider, for example, recent studies that show how investors don’t realize their risk-tolerance until the stock markets fall into a bear market—something that as of today (April 19, 2018) hasn’t happened since October of 2007 to March 2009. Also consider psychological biases that you may have. For instance, think about how your investment choices may be clouded by recent news (“recency bias”), your likelihood to gravitate toward things that just confirm what you already believe rather than challenge your thinking (“confirmation bias”), or your choice to do something just because everyone else is doing it (“bandwagon mentality”). Everyone has these biases, but being cognizant of them may change your answers to a robo-advisor’s questionnaire.
Last, be careful and make sure that your answers to a robo-advisor’s questions accurately capture your true intentions. Keep in mind that your answer to even one question can largely affect the portfolio that you get in the end.
The suggested steps in this post cannot guarantee that your robo-advisor portfolio will be perfect. Nonetheless, it will at least serve as a basis for you to tackle your choice to invest through new, technologically-advanced avenues.