Enough with Robo-Advisors Already

In college I was a finance major before switching to computer science. Marry finance and technology together and you get something called fintech, which means I should love robo-advisors, that golden child of fintech, right?

The sites like Betterment and Wealthfront that invest your money using sophisticated computer algorithms that last I checked every personal finance blogger was promoting. I don’t use them, and here’s why.

Let’s say you’re 25 and you have $3,000 you want to invest. You start asking around what you should do and people say, “Invest? Dude, you could die tomorrow…go to Vegas for the weekend.”

You’re smart so you don’t listen to that person and instead decide to use Betterment. You sign up and deposit your $3,000, and while you’re at it you set up an additional $300 investment every month because you know automatic investing is what makes you rich.

Okay, let’s fast forward 10 years.

Your investments are worth $70,893. (For simplicity, let’s assume a 10% return.)

But hold on, Betterment isn’t free. At the cheapest tier they charge you a 0.25% fee — to invest your money in Vanguard index funds. Yes, did you know that’s what they’re mostly doing behind the scenes?

Here, I want to show you a really easy way to think about fees that you can use for any investment. Subtract the fee from the return to get the return you’re making. In this case it becomes 9.75%.

At 9.75% your investments are worth $69,825 meaning you lose $1,000 to fees. Not bad. But Betterment isn’t paying any of the index fund fees for you either — now you have to pay those.

How much? On average they’re another 0.16% making the all-in fee 0.41%. Now you’re making a 9.59% return.

Your investments are worth $69,150, and you might be thinking that paying a couple thousand dollars in fees isn’t a huge deal because robo-advisors are make investing easy for you — it’s worth the cost.

Let me show you a different way to think about this.

Let’s say you have some big hairy goal like saving $1 million because you know having $1 million will generate $40,000 in passive income every year and you’ll finally have the freedom to do whatever you want in life.

To get to $1 million you have to be investing more — a lot more.

You start out investing the same $3,000 but now you’re going to invest an additional $3,000 every month. Yes, it’s a lot of money, but this is where things get interesting.

In 15 years you’re going to end up with $1.2 million, and you can finally quit your soul-crushing job.

Okay, but how much are you paying Betterment in fees on that $1.2 million? They’re skimming off $3,720 a year, and if you’re thinking, “So what, I’m a millionaire,” then I’m going to tell you it matters.

Here’s why. If you had your $1.2 million invested directly with Vanguard you might have a couple index funds: a stock index fund like VTSAX with a fee of 0.04%, and a bond index fund like VBTLX with a fee of 0.05%.

Vanguard would be skimming off about $600, which puts an extra $3,120 in your pocket.

To say that another way, when you’re living on $40,000 a year and you’re paying an additional $3,120 in fees that additional $3,120 in fees is a whopping 7.8% chunk of your $40,000. Make sense?

Of course, robo-advisors will say you’re getting more value by paying them higher fees. Let’s talk about the benefits they tout, and you can decide for yourself.

Earning more per year

The whole idea of robo-advisors is to invest in low-cost index funds. You know, the ones that don’t try to beat the market like active funds, but simply match it. So, why can’t Betterment match the market?

Their all-stock portfolio is underperforming the market by 0.8%. What’s going on? They aren’t matching the market because they’re investing outside the U.S.

And you can make the case for having some of your money invested outside the U.S., but people like Jack Bogle — the founder of Vanguard — doesn’t think it’s necessary.

He says, “I wouldn’t invest outside the U.S. If someone wants to invest 20 percent or less of their portfolio outside the U.S., that’s fine. I wouldn’t do it, but if you want to, that’s fine.”

Okay, but why wouldn’t Bogle want to invest outside the U.S.? Warren Buffett says it best in his 2016 annual letter to Berkshire Hathaway shareholders:

“American business — and consequently a basket of stocks — is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that.”

If you’re bullish on the U.S. it doesn’t make sense to invest anywhere else.

Lowering taxes

Tax loss harvesting is a really big selling point of robo-advisors because when I answered a question about robo-advisors you sent me emails saying I didn’t talk about TLH so let’s talk about TLH.

Robo-advisors implement TLH by selling an investment that has gone down in price, and then using the cash to buy a similar — but not identical — investment.

You end up with pretty much the same investments but now you have a tax loss, and you can use that tax loss to offset ordinary income by up to $3,000 a year.

If you want to know more how robo-advisors implement TLH read this from Rob at FutureAdvisor (he’s a fellow reader), or this white paper from Betterment where they disclose TLH isn’t perfect:

“Factors which will determine the actual benefit of TLH+ include, but are not limited to, market performance, the size of the portfolio, the stock exposure of the portfolio, the frequency and size of deposits into the portfolio, the availability of capital gains and income which can be offset by losses harvested, the tax rates applicable to the investor in a given tax year and in future years, the extent to which relevant assets in the portfolio are donated to charity or bequeathed to heirs, and the time elapsed before liquidation of any assets that are not disposed of in this manner.”

Betterment makes the claim that TLH will add nearly 1% per year in returns. Forever. I find this hard to believe because what starts happening is you run out of opportunities to take losses. Why? For the simple reason that markets go up over time.

When you’re taking losses right now what you’re really doing is resetting your cost basis lower and lower, but eventually the market goes up and that means there aren’t any losses left to harvest — unless you’re continually investing lots of new money. Make sense?

Of course, robo-advisors say their daily TLH is a huge value, but there’s been a lot of research that suggests otherwise from really smart people like Michael Kitces. I mean, even Rick Ferri suggests lifecycle funds instead.

Now, these people aren’t saying TLH doesn’t make sense, or that it won’t save you money. What they’re saying is the benefits aren’t as clear as most robo-advisors suggest, and there’s a lot of things to keep in mind like avoiding certain funds in your other investment accounts so you don’t get caught up in wash sale rules.

And one more thing. When you’re squeezing a $10 loss from every position it’s going to generate a ridiculous 55 page 1099-B that your tax software chokes on every year. So there’s that.

Lowering fees

Yes, Betterment charges lower fees than a financial adviser because most financial advisers charge 1%, with the all-in fee closer to 1.5%. But you’ve already seen that they charge higher fees than if you simply invested someplace like Vanguard.

In fact, Vanguard operates at-cost — they only charge fees to cover the cost of doing business. That’s why they can have the lowest-cost index funds on the planet, and continually lower fees.

On the other hand, Betterment recently raised fees. They didn’t really tell their customers about this so everyone got really angry and then their CEO had to apologize.

I was reading through the apology and he’s saying he hopes they can drive fees down. But this was buried at the end:

“We’re preparing for the long haul — as always — and we aim to make this a public company.”

Any CEO understands that when you go public you answer to the board and the shareholders. It’s not your company anymore.

And when it’s not your company anymore what you hope doesn’t matter — profit matters. The best way to increase profit? Either lower your expenses or raise your fees. They’ve already set the precedent.

Diversifying your portfolio

Being diversified means not having all your money invested in just one thing, because if you have all your money invested in just one thing you increase your risk.

Just ask the people who had their life savings in Enron stock and ended up with nothing after Enron went bankrupt.

That’s why you spread your money around into different investments — to diversify. Robo-advisors diversify your money by investing in different index funds, but people have been diversifying long before robo-advisors were around.

Just by investing in a couple of index funds you’re diversifying. Like, if you invest in VTSAX and VBTLX what you’re really doing is investing in 10,778 different stocks and bonds. Here, let me show you.

VTSAX holds 3,587 different stocks.

And VBTLX holds 7,191 different bonds.

Enabling better investor behavior

Morgan Housel recently said behavior is the most critical part of investing. I’m not sure how any robo-advisor can claim better behavior. Why not?

Robo-advisors can’t stop you from you.

Here’s the thing. Robo-advisors are simply the latest in an endless supply of investment products. Right this minute the investment industry is dreaming up the “next best thing” for you to move your money to.

I see this all the time when people email me their laundry list of investments and ask me what I think. And it’s kind of fun for me because I get to play an archaeologist and study how they jumped from one thing to the next thing to the next.

That’s not how you make money, and you don’t make money trying to time the market, either.

For example, between 1990 and 2005 if you missed out on just the 10 best days of the market you would have reduced your return from 11.5% to 8.1%. That means if you invested a $3,000 lump sum in 1990 it’s the difference between having $15,000 and $10,000 in 2005.

Of course, it’d be hugely beneficial to miss out on the 10 worst days. But given that it’s impossible to predict those days it’s always best to do nothing, and no one can do that but you.

Automated rebalancing

Most investors build a portfolio around stocks and bonds. A certain percentage of money goes into stocks for gains, and a certain percentage goes into bonds for stability. Over time, these percentages start drifting so you do what’s called rebalancing.

For example, if you’re younger you might want 80% of your money in stocks and 20% in bonds. That means if you’re investing $3,000 you’d put $2,400 in stocks and $600 in bonds.

As the market goes up and down your stocks might grow to $2,700 but your bonds might stay the same. This makes your new balance 75% stocks and 25% bonds, and what you’re supposed to do is rebalance to get back to your 80% and 20%.

You can do this two ways: Invest new money into the one that’s underweight until you bring it up to the right percentage, or sell some of the overweight one putting the proceeds into the underweight one.

Robo-advisors do this for you, but so does any lifecycle fund. Plus, studies show it’s only necessary to rebalance once a year, and only if you’re off by 5%.

In closing

It’s impossible to tell you what the right decision is because there’s never a “right” decision when it comes to personal finance. The right decision is the decision that’s right for you.

What I will tell you is that if you’re someone who’s trying to decide between not investing at all or using a robo-advisor then use a robo-advisor. I think that’s the right decision over doing nothing.