'Like A 1950's Black-And-White Fuzzy TV': How One Fintech Startup Completely Changed The Way We Think About Risk

How much should I risk?

There is perhaps no five-word combination in the history of investing that has confounded investors as much as this one.

Finding the answer to that question and others that surround it—like What is my risk tolerance? and When should I sell?—is partly how the financial advisory industry was built. After all, it’s easier to let a professional handle the tough questions.

And handle it they did. The number of financial advisors in the U.S. reached 325,000 at its peak in 2008, but as anyone in the industry knows that number has dropped substantially in recent years—down to about 200,000 in 2017—as the explosion of robo-advisors and ETFs have made self-directed investing easier than ever.

So, while the fundamental question still remains, the trouble is compounded by a new dimension: Who, or what, should I trust to know how much I should risk?

The answer to that question is what a pair of finance veterans set out to find.

Going Against Human Nature

In 2010 Aaron Klein was the director of product for OptionsXpress where, in his own words, he “saw firsthand how poorly average investors think about risk.”

His friend Michael McDaniel was a financial advisor, and the two got to talking.

“I remember saying to him ‘I think it’s crazy how the average investor talks about the concept of risk.’” Klein said. “And he says ‘If you think that’s crazy, you should see how many of their financial advisors think about it.’”

When it comes to assessing risk, financial advisor conventional wisdom starts with age. If you’re young you’re probably aggressive, and if you’re old you’re probably conservative. Or so the logic goes.

“Then we ask a few nonsensical questions like ‘If your portfolio was a car what kind of car would it be?’ and ‘Do you get a thrill out of investing?’

“You can stereotype me until you’re blue in the face, and then nudge that stereotype with my market sentiment. That doesn’t make it my risk tolerance,” Klein said.

In Klein’s view, this logic isn’t just archaic—”like a 1950’s black-and-white fuzzy TV”—it’s against human nature.

“If you look at the approach that financial advisors have taken in recent years, it was a returns focus. That kind of gave way to the second wave. Basically whenever you ask me about short-term returns, I’m going to deflect the question and say ‘Let’s not think about short-term returns, let’s think about your long term goals.’

“The only problem with that advice is that humans are incapable of following it. The challenge is that humans react to risk in the short-term. That approach is all about pushing back against human nature.”

So Klein and McDaniel decided to do something about it.

In 2011 they formed Riskalyze in an attempt to quantify the fundamental question of risk.

“It was all built around the idea that if we could quantify and understand how much risk a client can handle, then we can actually build a short-term framework to help investors understand and react to risk appropriately,” Klein said.

Quantifying Risk

It took two years for the pair to actually launch a product, which they also named Riskalyze, based on two academic frameworks: prospect theory and monetary utility theory.

“These were concepts that were in academia and in the labs for some time, but they had never been commercialized,” Klein said. They had never found a way to make these concepts usable by the average person.”

At the product’s core is something called the Risk Number, a scale from 1-99 that measures how much portfolio downside risk an investor is capable of handling over a given six month window. The higher the number, the higher an investor’s risk tolerance.

They take a six-month perspective because, according to Klein, most clients are not capable of stomaching a downturn for a full year.

Klein said that the majority of investors fall between 20-80 on the risk number scale. More specifically, a portfolio consisting entirely of the S&P 500 would fall somewhere between 78-84.

Ideally, this number forms the basis for investor expectations.

“The only way to achieve long-term financial goals is one great short-term decision at a time,” he said. “So we want to let things like confirmation bias—where we’re inclined to make decisions that support things that we already believe—we want to let confirmation bias work for us by saying ‘This portfolio is a risk 45, and a risk 45 six months from today has a 95 percent chance of being anywhere between down 8 percent and up 12 percent. So if six months from today I’m down 4 percent, that’s normal for my portfolio.”

No Retail Tools...Yet

Riskalyze’s reframing of risk seems to be working. Five years after its launch over 20,000 financial advisors have incorporated the tool into their services, and the company has launched other products aimed at helping them better serve their clients.

At the 2018 Benzinga Global Fintech Awards Riskalyze won the Best Financial Advice category, as well as the first ever Likefolio Customer Love Award, awarded to the fintech company with the most enthusiastic customer base on social media.

Klein said that the company has no concrete plans to launch a retail product, but it’s on their radar.

“There will always be people who don’t have access to financial advice, and there may be ways we can bring the risk number to them in the future,” he said. “But one step at a time. As we say, the mission is to empower the world to invest fearlessly. If we can help people understand or react to risk appropriately, that’s how we get them to be fearless investors.”