Would You Trust an Algorithm to Manage Your Investments?: Investor Tips on Robo-Adviser Use

By Majda Muhic & Qudsia Shafiq, Spring 2017 IAC Student Interns

With the rapid growth of automated investment tools, in February 2017, the SEC reissued FINRA’s 2015 Investor Alert, bringing into focus potential risks and limitations of these apparently simple tools. The Investor Alert arms investors with tips on how to navigate this new technological landscape.

Before anything else, both FINRA and SEC advise, make sure you review all disclosures for a particular auto-adviser and understand all of its terms and conditions. Pay particular attention to fees and charges that may be involved. Are there any fees and expenses associated with using the tool or with making an investment transaction? Although cheaper on its face, hidden fees of robo-advisers, including fees associated with a purchase or sale, may leave the service a lot less affordable than appears. If you chose to do so, how can you end your relationship with the robo-adviser? How long would it take for you to cash out on your investments? What is the privacy policy of the particular tool?  If anything is unclear, don’t hesitate to contact the automated tool sponsor directly.

Next, consider the tool’s limitations and assumptions. Every robo-adviser uses a specific methodology to generate its recommendations. This methodology should be revealed in the tool’s online disclosures.  Read these carefully.  Some of the assumptions the tool makes may be incorrect or may simply not reflect your needs or economic reality. A robo-adviser may be programmed not to react to market shifts – thus, while interest rates are raising, the robo-adviser may continue assuming that they remain low. The tool’s recommendations will not reflect economic market reality, and this misguided process will directly affect your wallet. Similarly, the robo-adviser may be programmed to only consider investments offered by an affiliated firm, inherently limiting your pool of options. Make sure you understand these limitations.

A robo-adviser’s recommendations may simply not be right for your financial needs and goals. Different tools assess different factors in generating their recommendations – including age, investment experience, tax situation, need for cash, or willingness to risk losing the investment for a higher return. Some of these factors may be more salient for your situation than others.  The more you understand how the tool works, what its limitations and assumptions are, the more likely it is that your choice will reflect, and meet, your needs.

It is equally important to recognize that the information the robo-adviser seeks from you and the information you provide in response directly affect its recommendations. Pay attention to the questions asked by the robo-adviser – the framing of the question will necessarily dictate your answer which in turn affects the generated recommendation. Carefully input your answers – a single mistake or oversight may result in recommendations not right for you.  Be aware that some tools may ask questions that are designed to fit you into its predetermined options. Again, if anything is unclear, ask the tool sponsor.

Finally, make sure you understand the tool’s privacy policy and protect your personal information. Some robo-advisers may use your information for purposes beyond mere investment advice. Watch out for scams designed to trick you into revealing personally identifiable information. For specific tips on how to safeguard your personal information, read the Investor Bulletin.

It is ultimately up to you to decide whether you wish to rely on a particular robo-adviser in making your investment decisions. How much human interaction – with its personalized service, human judgment, and potential oversight – is important to you?