Who would have predicted that the robot invasion would start with our personal finances?

Yet here we are, witnessing a shift from your average suit-wearing financial adviser to algorithmic trading and software-based portfolio management. And so-called robo-advisers are now taking over as the most trusted source of personal financial management for millennials.

The Millennial generation grew up as digital natives and are probably the most tech-savvy adults living today. Many of them even openly admit to trusting robots much more than humans, so it makes sense that they would trust robots with their finances.

However, robo-advisers haven’t been around for very long. Some of the most popular players in this market, such as Betterment, Covestor, Future Advisor, Motif Investing and Wealthfront, were founded less than a decade ago.

What exactly do these “advisers of the future” do? Well, they pretty much do the same thing your average registered financial advisor is trained to do, only much more quickly and cheaply.

How Does It Work?

The investment process for average Americans starts with an assessment for risk-tolerance. Basically, you are asked to fill out a survey that asks you questions about your income, ability to save and ability to stay calm when your stocks lose value. The survey also delves into your personality traits and your future goals.

The objective here is to see how much risk you can bear and want to bear. Then the adviser takes the data home and determines how your money should be spread. If you are less of a risk-taker, you may be put you in bonds and if you like taking risks, you get put into stocks. Usually it is split between the two in a certain percentage and your real estate holdings factor in somewhere as well.

What robo-advisers do is automate the whole process. You fill out the form online yourself, the software spits out a plan that’s suited to you, which you can adjust it a bit here and there, and then you leave it to run on autopilot.

The advantage with robo-advisers is you pay less since you don’t have to compensate an actual human being, and the software rebalances for you at regular intervals. It is fast, easy, cheap and incredibly popular. So, it should come as no surprise that more and more young people are going to be managing their money this way in the future.

All good news here, right? Well, the SEC doesn’t think so.

The SEC’s Take On Robots

The Securities and Exchange Commission issued an investor alert on what they called “Automated Investment Tools” back in May, 2015. The regulator isn’t entirely against these tools - they understand that people have been using computers to help with investments for decades.

They also acknowledge the fact that automated tools can reduce costs and increase the access of sophisticated financial tools. It’s a great way to take high-level finance to the masses and democratize the system, something the internet is exceptionally good at.

But the SEC does have some concerns. In their alert to investors they pointed out four key risks investors face when using automated investment services:

1.  Terms & Conditions

Investors are encouraged to read and understand the terms and conditions of using software that has potential access to all their finances. Furthermore, investors need to know if the tool they select is run by a company that gets compensation for certain investment recommendations or trading with a certain broker.

2.  Limitations of Technology

Many of the tools available now are clearly meant to help you make a smart, calculated decision about your finances. But the technology is limited to the information you give it. The systems won’t be able to calculate the risks you can bear if you lie on the survey or give false information.

These tools are entirely dependent on the input data and rely on the principle of “Garbage in, garbage out.” Investors should read through the details and figure out the sort of assumptions the software is making. The interest rates, stock volatility, asset risk and income assumptions must all be understood. 

3.  Suitability

Investment risk surveys are designed to be as thorough as possible, but they may not uncover everything. For example, some systems may recommend a highly risky investment strategy based on your high income and young age, but may not factor in the heavy medical bills you have to pay on short notice for an illness you’ve suffered from for a while.

This is why it is important for automated investment tools to have manual features as well. For example, you should be able to reduce your exposure to biotech stocks and increase your exposure to government bonds if you feel uncomfortable with the proposed strategy.

4.  Data Security

Finally, the SEC advises investors to be careful of unregulated companies that try to get bank details, passwords or credit card information. Phishing and fraud are fairly common online and using investment tools such as these are likely to make you a target.

There’s no doubt that robo-investors are gaining popularity as systems become more sophisticated and users become savvier. But before you either dismiss them out of hand or embrace them unquestioningly, it’s important to understand the benefits and risks they bring to the average investor.