Buying low and selling high is the way to profits for investors, but too many people instead do the opposite and hurt their returns because they cannot not stomach market volatility. Riskalyze, a fintech startup, thinks there is a better way. Its technology assesses an individual’s risk tolerance in a more fine-tuned way than simply categorizing them as aggressive or conservative investors and allocates their assets accordingly. The company says it matches folks with an investment portfolio that more accurately fits their risk tolerance so they can hang on for the long run.
In this Knowledge@Wharton interview, Aaron Klein, Riskalyze cofounder and CEO, discusses the startup’s business model that made Fast Company magazine twice name it among the most innovative finance or personal finance companies. He was interviewed by fintech advisor and entrepreneur Vinay Nair, founder and chairman of investment firm 55ip and formerly a visiting professor at Wharton.
An edited transcript of the conversation follows.
Vinay Nair: Could you explain what problem Riskalyze is solving and for whom?
Aaron Klein: Back in 2011, my cofounder and I felt that for the average person, investing was broken. Our psychology tends to sabotage us when we invest. Warren Buffett probably said it best: “Stocks are literally the only things that consumers refuse to buy when they’re at their cheapest and only want to buy when they’re at their most expensive.” We want to get involved in the markets and put more risk on when things are feeling good. And we want to take risk off and get out of the markets at the worst possible time — when things feel bad. So we tend to sabotage ourselves as investors.
The way the industry tries to solve this problem is to deluge the investor with statistics. We concluded that a better way was to build a short-term framework to help the average investor understand and react to risk appropriately, because when you do that you take a fearful investor who makes bad short-term decisions and turn him into a fearless investor who makes great short-term decisions. As we all know, the only way to achieve long-term financial goals is one great short-term decision at a time.
Nair: How did you spot this problem and what motivated you to start the firm around it?
Klein: My career had always been at the intersection of finance and technology. I had worked with a company in the payment space, had done some other things from staff software, and then was running global products through a division of an auctions brokerage firm. It was while I was there that I said to a friend of mine who was a financial advisor, ‘It’s crazy how average investors think about the concept of risk.’ And he said, ‘If you think that’s crazy, you ought to see how their financial advisors think about it.’ That conversation was the impetus for us starting the company. He’s my cofounder and currently our chief investment officer, Mike McDaniel. We both shared a passion for trying to change that reality for the average investor. It’s our belief that when financial advisors aren’t afraid to talk about risk, investors aren’t afraid to make the right decisions.
Nair: Can you give us a sense of what your Risk Number model is and why advisors are attracted to it?
Klein: We built the technology on top of the academic framework that won the Nobel Prize for economics in 2002 — Daniel Kahneman and Amos Tversky’s work on prospect theory. We had a team of academics do a deep dive into the methodology and they said, ‘On the one hand, there are a lot of novel things in what you’ve done. On the other hand, a lot of what you’ve done is taken stuff that we’ve been working on in the labs for 15 years to 20 years and figured out a way to make it commercially viable and understandable by the average human.’
“I felt that for the average person, investing was broken. Our psychology tends to sabotage us when we invest.”
We took that as a high compliment. Our model is very quantitative. It’s very objective. It’s based on dollar amounts that are relevant to the individual. We built a framework to go up and down an investor’s financial spectrum because it’s important that it be relevant to the individual investors and they understand how to answer these questions, because otherwise, it’s garbage in, garbage out.
We go up and down an individual’s financial spectrum, understand where they prefer risk and where they prefer certainty, and build a model of how they will react when their actual investments move up and down within their financial spectrum. We then take that mathematical model and translate it across actual portfolios.
In terms of portfolio analysis, we’ve got nearly a quarter of a million different securities and investment strategies on the platform at present. We build a return and volatility model for each of those securities every night. And then in real time, when we analyze portfolios, we build a cross-correlation matrix to understand the impact of diversification on those portfolios. All of that rolls up into a portfolio-wide Risk Number and probability range. That’s how we bridge those. The outcome of a client is their Risk Number. The outcome of their portfolio is also a Risk Number. This creates a powerful platform for financial advisors to demonstrate the alignment between a client and their portfolio.
Nair: That’s great. One of my pet peeves in the space of fintech has been that there’s a lot of tech and very little fin. So far our discussion has been largely focused on the finance part of your business model. Tell us a bit about what makes this a fintech company.
Klein: At the end of the day, technology is at its best when it serves people and what people are trying to do. The goal with any piece of fintech is not to do the tech. It’s to do the fin. We are, in our DNA, a technology company, but we’re at our best when we make the technology recede into the background and create an experience that’s immersive and helps the end user — whether it’s the financial advisor or the investor — get to their end goals.
So, what makes us a technology company? It’s our DNA. The ability to create great user experiences. I felt that was going to be an important piece of the puzzle to building a fintech solution that investors would use, or a risk solution that people would use. And I think that’s been borne out in our success. We started with a strong academic core technology engineer, a physicist by training, a strong user experience-focused engineer, myself — a product person with a vision for where the industry needed to go, and my co-founder, who brought to the table great perspective on risk, investments and the financial advice industry. The four of us helped shape the product in the direction it needed to go. You can trace most of the DNA in the company back to these four people who were there on day one.
Nair: Where are you in the life cycle at present?
Klein: It’s been a wild ride. We spent the first year building our core technology. We spent the second year trying to validate the technology. We felt that financial advisors were not going to road test brand new risk technology on their clients, so we started by validating the technology with small, self-directed investors. We started with a very simple pre-version of the product for your $25,000, E-Trade kind of guys.
In 2012, it was our successful,great failure year. The success part was we got some great PR —The New York Times, Barron’s, NPR. We had users come in and build $2 billion in portfolios on the platform. The failure part was that none of our strategies for monetizing that product were working. We didn’t have the right strategy for making the technology viable. In the fall of 2012, we decided that it was time to change the strategy and go in a different direction. We believed in the technology. We believed in the direction of the company and its core vision and mission, but our strategy wasn’t getting us there.
So we said, ‘Well, we have built about $2 billion worth of validation. Let’s rebuild the product for financial advisors. We’ll make this our last-ditch effort and see if we can’t get something to spark.’ We rolled the financial advisor product out of beta in March of 2013. We had four full-time employees in the company at that point in time and no customers. Today, we serve over 20,000 financial advisors and have over 200 employees — we call them Riskalyzers — serving those financial advisors across the country.
“The goal with any piece of fintech is not to do the tech. It’s to do the fin.”
So, it’s been a wild four years. We’re still very much in growth mode. We feel like we’re just scratching the surface of the innovation that we can bring to the advisor-client engagement experience, particularly around the concepts of risk. It’s exciting days, without a doubt.
Nair: Many fintech entrepreneurs wonder about the right type of partners you should have in your ecosystem that allow you to learn from your failures. What would your advice be to them?
Klein: That’s a great point and I’ll address it in a couple of different ways. There was a partnership that was a huge catalyst for us in terms of jumpstarting our growth. It was a partnership with a guy who is one of my best friends today. His name is Brian McLaughlin. He is the CEO of Redtail, which builds CRM software for financial advisors. We both felt that doing some integration to make Redtail and Riskalyze share data would be helpful to both of our customers. For us [at Riskalyze], it was incredible, because it gave us exposure and put us on the map. Brian was incredibly generous. He wasn’t looking for any kind of revenue-sharing deal or anything like that. He genuinely felt that if I try to expose good solutions and integrate good solutions that my customers are going to need, that’s going to be good for my business and good for retaining Redtail customers. We did that partnership and it was a huge catalyst in our growth. Partnerships executed well can be a great catalyst for a company’s strategy, without a doubt.
On the capital market side, it’s very interesting. We are very non-traditional from that perspective. We had been funded by friends and family, small angel investors. Before we did our first institutional capital raise, we had deployed about $4.5 million of capital in the business and we had revenue exceeding that by a good long shot. We had the discipline that once we got a business going, we could pretty quickly get our revenue number above the capital deployed number. That was definitely very helpful in our growth and helped us to be a capital-efficient company. Throughout 2016, we looked at this and said, “Given our growth trajectory, we have an opportunity to build a long-term independent partner for advisors that can really change the advisor-client engagement experience, put risk at the core of it, and make a huge dent in in terms of turning people into fearless investors.”
That’s been our vision from day one and was really exciting to us. So we went ahead and raised $20 million in capital from FTV Capital. They used to be known as Financial Technology Ventures. They’re a little bit broader now, but that’s at the core of what their firm was. They’re long-term, patient investors — that was the big thing I was looking for. I said to them, ‘I don’t want pressure in two or three years to do a quick flip of this thing.’ And they said, ‘Look, we were the first institutional investors in financial engines. And that was a 13-year hold before financial engines went public.’ That was what I wanted to hear and the kind of partner that I wanted to fund our company.
Nair: How did you build this impressive network of tens of thousands of advisors?
Klein: At the end of the day, there’s really no silver bullet there. I can’t point to one specific thing. It was a lot of back-breaking work. And that work, by the way, was on the part of an incredible team that we’ve been able to build and I’ve been hugely privileged to be a part of. We have a sales team that is out there having conversations with individual financial advisors. You’ve got to be very disciplined and very effective to be able to make the economics work when you’re dealing with a product at a price point that an individual advisor can’t afford. It’s difficult. It’s not easy. It’s not for everyone. Once we were able to start getting some growth and got our brand going, that became easier and over time we were in a position where we could bring a new customer on board and be profitable on that customer within the space of four to six months. That is a requirement when you’re dealing with the individual advisor market, where you’re dealing with low annual contract values. That’s how we’ve done it. We’ve done it from the bottom up.
“We’re just scratching the surface of the innovation that we can bring to the advisor-client engagement experience.”
One of the positive things about that for our business is that for the longest time our largest customer was like 1% to 1/2% of our revenue. It creates its own set of unique challenges, because you’ve got many customers to support. But on the other hand, you’ve also got a very resilient and diverse revenue base.
Nair: How do you grow from here, given that you already have access to a substantial number of advisors?
Klein: We think we’re just getting started. If you look at the 20,000 plus that we are privileged to serve today, depending on how you want to count, we haven’t even quite crossed 10% market share. From our perspective we’ve got a long way to go to achieve our mission of empowering the world to invest fearlessly. Let’s not forget, the world isn’t just the United States. It’s a great place to start, but there are advisors that we hear from every day in Australia, the U.K., and Canada asking for us to come to those countries. We’re working towards that as well. We’ve still got a lot of opportunity for growth in the core.
At the same time, what we’ve heard from our advisors is, ‘You have revolutionized how I engage with clients. You’ve revolutionized how I make decisions for clients. The next thing that is driving me crazy is how difficult it is for me to implement the decisions that I make for my clients.’ So we rolled out our Autopilot platform to help advisors automate that, with the Risk Number at its core. In other words, an advisor can decide that I’m going to put a client in this portfolio, Autopilot can automate all the trades that need to occur to put that account in that portfolio, and then keep the account on track so when the account’s Risk Number drifts away from where the advisor wants to keep it, Autopilot surfaces the right steps, the right tasks that the advisor needs to take at the right time to get that account back on track. And, as we like to put it, ‘Take the hassles of an advisor’s business, put them on Autopilot so they can focus on their client relationships once again.’
Nair: This leads to the educational aspect of your business. Tell us about Riskalyze Academy. What do you do there and what are your goals with that initiative?
Klein: Right at the beginning we felt that an average support team wouldn’t be able to make this grow, because implementing the Risk Number into an advisor’s business is not as easy as putting a new app on your phone. You’re talking about weaving a whole bunch of concepts about risk into client engagements, client interactions and client meetings. That’s a lot of work. It takes support and coaching for an advisor to get there. So, we invested in having the industry’s best support team. We consistently hear from advisors that we have 95% plus customer satisfaction ratings with our support team. We also invested in a team of coaches that works day in and day out to help advisors be more successful in the work that they do. We do ongoing training every week, both 101 and 201 classes, to help advisors understand, learn, and become more successful.
“There are incredible opportunities to completely change the user experience around banking.”
It became clear to us that we had an opportunity to take that to the next level. We did that a couple of ways. We launched our first-ever customer conference — the Fearless Investing Summit — with three packed days of education for our advisors, to help them be more successful in their business and empower their clients to invest fearlessly. We also launched Riskalyze Academy, which is an online learning platform that helps advisors and employees take their knowledge about how to weave the Risk Number into their client needs to the next level. It has multimedia videos and assessments to help them along the Riskalyze journey.
Nair: What are the principal risks that you see, whether it’s in the regulatory, technological, or competitive domains?
Klein: From a regulatory standpoint, regulators seem to love what we do. Sometimes regulatory decisions can seem capricious, but typically what we’ve found is there’s a human being there who has the best interest of investors at heart. Our belief is that more transparency around risk and more understanding of risk are critically important. So far, we have seen risk regulators agree with that assessment.
There’s always competitive risk and technological risk to any business. I just tell the team, ‘At this point, we are about five years ahead from any serious competitor.’ We don’t want to stress about what other companies are doing. We want to stay focused on our vision of where we see the industry going, where we think the industry needs to go, and push towards that vision. The faster we do that, the faster we get six years ahead on somebody now being a serious challenge to us.
Nair: There’s a lot of buzz around the fintech industry. What areas do you think have the highest growth potential?
Klein: I think there are incredible opportunities to completely change the user experience around banking. Simple Bank was one of the early examples of that. They of course ended up selling to BBVA [multinational Spanish banking group]. But recent changes in how the feds are allowing new banking charters for some of the new disruptive companies are interesting. I look at how my wife still uses the paper checkbook to keep track of her budget categories with her debit card and I think, ‘There’s got to be a better way to solve that kind of problem.’ I think that banking and how we do personal finance is an interesting place to do disruption. We’re starting to see it, I would argue, in the debt side of fintech. One of the places that we might see both banking and debt and even wealth management disruption pop up are around how we move money to each other.
I’m intrigued by what Square is doing with Square Cash and by some of the different companies that are starting to get into where you store funds, because that’s ultimately what a bank looks like. They are maybe just a few features away from looking like a bank. If you decide to go down that path, then you’ve got a lot of interesting things you can do. One of them is wealth management. I think there are opportunities for companies that already have distribution and relationships with customers to offer that first tier of wealth management services. I don’t think that’s going to disrupt the financial advisors whom we serve, but I do think it could be highly disruptive to the self-directed kinds of brokerage accounts, which are basically rudimentary buy and sell platforms.
“Amazon has most adults with liquid cash exceeding $300 in their bank account registered on their service.”
The idea that anything from an Amazon to a Square Cash could offer some simple ways to get market exposure on your money is a way more powerful value proposition than businesses [some investment service firms], which start from scratch and have zero distribution and zero access to customers.
It’s very difficult to build distribution from scratch, and you better have some strong revenue streams to be able to support it. It’s hard enough when you’re dealing with businesses like Riskalyze is, but it’s tough with consumers. Some of the robo advice businesses are spending $825 to acquire $63 in annual revenue. That’s not a business model that’s going to work. I find it interesting to look at companies or even startups that already have distribution somewhere else. That’s where I think wealth management businesses at scale might be kind of interesting. And I do believe that there’s space for those kinds of services, but they’re going to largely disrupt self-directed investing.
Nair: Do you think that’s going to bring in entrants from outside finance?
Klein: I think it’s very possible. I would bet on Amazon before any of them. Amazon has most adults with liquid cash exceeding $300 in their bank account registered on their service. Amazon has some of the most interesting reach into consumers, and it’s a global reach.
But even if you just think about the United States, you’d be hard pressed to find an adult that doesn’t have an Amazon account. That’s incredible distribution of reach, and to the extent that they begin to leverage their Amazon payments business into being a place where you store money and then eventually being a place that you could click and get some market exposure on your money — that’s a very interesting business. It doesn’t disrupt the need for real financial advice. It absolutely is wildly disruptive to self-directed investing businesses that want to charge you a transactional fee to place trades that you don’t even understand. I find that to be hugely compelling, but you’ve got to have distribution. Great products are great, but great products without distribution never reach sustainability.