Robo Advice – The risk of overreliance on risk questionnaires
Robo advice could be the “white knight” riding to the aid of the small investor abandoned because the commission subsidy from wealthier investors is no longer available. Without the cross subsidy advice delivered in the conventional way (i.e. face to face) is no longer economical for the mass market - hence, the “advice gap”. And enter Robos.
All Robo advice involves the use of a risk questionnaire to identify an appropriate investment solution. In some cases a risk questionnaire is the central part of the process. However, as will be discussed below, overreliance on a risk questionnaire in a Robo advice process could actually accentuate financially harmful investor behaviours – encouraging investors to increase risk at the top of the market and de-risk at the bottom i.e. maximising losses and reducing gains over investment market cycles.
Quite rightly attitude to risk questionnaires are firmly established as an important part to ensuring that an adviser’s recommendations meet the Financial Conduct Authority’s suitability requirement. A well designed and statistically validated psychometric questionnaire can yield good insight into investors’ feelings about risk and their reactions to investment market volatility. However any good adviser will tell you this is not enough on its own and that the advice process needs to go beyond simply the output from a risk questionnaire, however good it is. For example:
- A client’s reaction to investment market volatility needs to be placed in the context of the client’s investment objectives. As an example, for young clients investing for retirement, market volatility is largely irrelevant. Indeed, downward movements in the market can be an investment opportunity. Market volatility is a convenient shorthand risk measure for fund managers enabling them to produce “off the shelf” risk rated products but short term volatility is irrelevant for all investors other than those with very short term goals, i.e. those worried about capital loss because they anticipate needing to disinvest in the near future. Advisers help investors understand the nature of risk and its potential impact on their goals.
- As is well known, retail investors have an unfortunate tendency to chase rising markets and panic and sell when they fall. In effect doing exactly the wrong thing and as a result achieving poor long term returns. The adviser’s job is to help investors take a balanced view and, in particular, to put market falls in context.
- A major influence on investors’ appetite for risk is market volatility. Lurid headlines such as “billions wiped off pension funds” during a day can cause panic sales. The next day’s recovery is seldom given the same attention. Again without any input from an adviser, investors completing a risk questionnaire may be led systematically to take too little risk with the result that they fail to meet their long term goals.
- A critical element in the advice process is to ensure that investors have realistic expectations of achieving their goals. If a risk questionnaire leads an investor to reduce his or her risk exposure without at the same time pointing out the consequentially reduced chances of achieving a cherished goal, there could be grounds for complaint. Equally it is important that investors understand that even with a lower risk exposure there is still a chance of capital loss. Again an experienced adviser can help investors understand the risks and quantify the loss or potential shortfall in achieving their goals.
Clearly what is potentially missing with Robo advice is the input of a human adviser who can spend time putting the output from a risk questionnaire into the context of an investor’s financial goals. Robo advice processes which rely heavily on the output from a risk questionnaire can therefore be potentially dangerous.
Making Robo come alive
So does this mean that since true Robo advice doesn’t include input from a human adviser, it cannot provide reliable, “fit for purpose” advice. No – the issue is that Robo advice has to be much more than a risk questionnaire. Apart from making sure that there are no other priorities that the investor should be considering e.g. paying off expensive short term debt, the most important requirement of any advice process (Robo included) is to manage investors’ expectations. To put it simply, if the result from answering a risk questionnaire means that the investor stands almost no chance of achieving his or her goal, the advice needs to make this clear and perhaps recommend alternatives for the investor to consider.
It is critically important to “go the extra mile” with Robo advice because there is no “expensive” human adviser sitting with the investor to explain what the potential outcomes from an investment might be – in particular, the trade-off between risk and achieving an investment goal. Stochastic forecasts produced by a robust economic scenario generator (ESG) producing thousands of potential investment journeys from current market conditions into the future, can be enormously helpful. The outcomes from the different scenarios can be summarised and presented in a powerful way to help investors make informed decisions. Investors can see the likelihood of achieving their goals, the size of potential losses along the way and be presented with alternative recommendations. These could include:
- Changing their goal so that it is more likely to be achieved
- Investing more money to improve the chances of success
- Making a considered decision to take a little more risk with their investments.
The algorithms driving the Robo advice can mimic closely what a human adviser would deliver. Telephone support can be provided to explain concepts and help investors understand the recommendations.
The output from risk a questionnaire is an important element in an investment journey but placing too great a reliance on it is not helpful. At present risk questionnaires provide the cornerstone to much Robo advice. This is an unfortunate and needs to change. Using a risk questionnaire to set off on an investment journey is rather like knowing how fast you like to drive your car but not understanding the purpose of your journey, where you are going or how long it is going take to get there!
For information on EValue's Robo Advice solutions, please visit - https://www.ev.uk/products/investment-robo-advice/