I love robo advisors.
Don’t get me wrong. I love many things. My son, my wife, real estate, blogging, a good cognac and a strong whiskey … but I’ll leave those for another day.
What is a Robo Advisor?
I’ve been surprised how often I get this question from friends (although I shouldn’t be surprised, considering how much time I spend on my finances). These days, there is a lot of coverage on the rise of robo advisors and their impact on the financial services industry. More importantly, the big brokerages like Schwab, TD Ameritrade and Vanguard (among others) have started competing robo advisors.
So, what is a robo advisor? Well, the simple definition is that a robo advisor is a set of algorithms and software that manage your money for you instead of a human.
Get it? Robots & advising.
There is strong research showing that a few index funds are all anyone needs to achieve wealth. Warren Buffett has famously said a standard market index fund (a fund you can buy like a stock that holds thousands of stocks, like VTI) is his recommendation for everyone. Robo advisors give you a well-diversified portfolio, catered to your risk tolerance, and add in benefits like free trades, rebalancing, and tax loss harvesting. Historically, this type of wealth management service was reserved for only the wealthiest of individuals. But now anyone, with any amount of money, can get all of the wealth generating benefits for a fraction of the cost.
Let me be a little more specific.
There are thousands of index funds out there.
Index funds are designed to cater to any person’s specific investment desires. For example, you can buy all the stocks in the United States (VTI), all the bonds in the U.S.(BND), tech companies in China (KWEB), Oil & Natural Gas companies, and even Marijuana companies (HMMJ).
Modern Portfolio Theory, a well-known investment theory on diversification, is at the heart of most robo advisories and most wealth managers. Without getting too detailed, the theory states that you are better off holding a bunch of different stocks, bonds, whatever, as opposed to putting all your money into one.
Basically … don’t put all your eggs in one basket.
What’s more, there are volumes of math backing up this theory. It shows you can lower your risk, but keep the same return, through diversification. Robo advisors take this theory and apply it to your portfolio using algorithms. You can do it yourself without a lot of work. But since most of us are lazy, we often prefer to pay someone (financial planner) or something (robo advisor) to do it for us instead.
The robo advisor will take a bunch of different funds, split your money across them according to your goals, and then balance them to make sure the breakdown is correct. Over time, one fund growing and another losing value can mess up your mix and rebalancing corrects this.
For example, Wealthfront has me in U.S. stocks, foreign stocks, emerging markets, natural resources, dividend stocks, and municipal bonds. They pick a mix across those that work for my risk profile and financial goals and maintain the balance as things shift over time. They charge 0.25% yearly, with the first $15k free. A traditional (read: human) manager would ask for 1%-2% for the same services.
Why I Love Robo Advisors
Good returns, low risk, reasonable fees … What’s there not to like? (several things actually, which I’ll cover later).
A financial manager (think of a guy at Wells Fargo who “buys investments for you”) charges between 1% to 2% to manage your money. Also, if you have less than $100,000 under management you are considered a second tier client. $20,000 might be a lot to you, but not compared to your manager’s $1,000,000 customers. Robo advisors don’t discriminate.
In comparison, robo advisors range from 0% to 0.8% for the management fee. Also, the amount to start can be as small as $500 ($1 in some cases). This fact makes robo advisors up to eight times cheaper than a human manager.
It’s easier to take money out if you need it. You should not steal from yourself by spending investments, but when you get a surprise tax bill, they will sell shares and get you cash in the most tax efficient way without the lecture. All you do is say how much, and the details are handled in the most tax efficient way.
And don’t forget all the cool nerdy financial features.
Tax Loss Harvesting creates an artificial loss for tax purposes by selling and selling and rebuying two similar funds. Regular rebalancing ensures you’re well-diversified as your stock values fluctuate. Finally, free trades are trades that are free (… if that wasn’t clear). If those features seem appealing to you, you’ll be happy to know that they are included with most services.
“Wow, Damien! This is amazing. What’s there not to like!?!?”
What I Don’t Like About Robo Advisors
The single biggest complaint about robo advisors:
I can do it all myself and save the money.
What the robo advisors are doing isn’t that hard if you learn it. You could even put $1,000 in an account, look at what they do, and reproduce it on your own for a 0% management fee. This would save you a couple of percentage points and could add up over the years.
Also, you don’t have someone to talk to when stuff gets weird. Some companies are addressing this by offering a robot and a person, like Betterment. While it’s not their fault, it can be refreshing to yell at your manager when the market drops.
Lastly, they are new. There is a lot of research and math behind these models, along with extensive backtesting (simulating the results of decisions 50 years of historic data), but they are still relatively new.
Which robo advisor do I use?
My advisor of choice is Wealthfront.
Everyone is different, but here are the reasons I choose Wealthfront
- The first $15k is managed for free, forever
- One of the oldest robo advisors
- Competitive 0.25% management fee
- Not owned by a bank or brokerage (I like tech companies more than banks)
- Direct Indexing, where they will buy stocks instead of ETFs for more tax loss harvesting and fewer ETF management fees
I used to be a hardcore Betterment supporter, but then they raised fees for accounts above $100K. Betterment went from 0.15% to 0.25%, and I’m not the only one upset. Since Betterment doesn’t offer any money managed for free, Wealthfront became much more attractive. That said, they do offer a human (at an increased 0.40% rate) for accounts above $100k now and have no account minimums, compared to Wealthfront.
Charles Schwab’s Intelligent Portfolio is a free option from one of the major brokerages. Many are complaining about how much cash they keep in your portfolio (up to 30%) and their $5,000 account minimum, though.
Vanguard, a powerhouse in the cheap ETF space, launched Vanguard Personal Advisor Services recently, and already became the largest robo advisory. At 0.3% you get access to an advisor who will actually consider accounts outside of Vanguard. Unfortunately, Vanguard has a $50,000 account minimum and Tax Loss Harvesting isn’t guaranteed. I’m currently moving my retirement funds to them though. Their lack of tax loss harvesting doesn’t impact a tax-free account (aka an IRA). Also, you gain access to their Admiral Shares, which have incredibly low expense ratios, effectively lowering the cost of Vanguard in relation to others.
Of course, there are many more with various costs and features. Check out NerdWallet’s Best Robo Advisors for 2017 for more options.
Personally, I signed up for both Betterment and Wealthfront in 2014 and used them both for a year. The returns were about the same, with Wealthfront ahead by a little. Betterment had a better user interface, but Wealthfront redesigned theirs and has caught up. Now, I have over six figures in Wealthfront and I’m happy with my decision.
One big benefit of Wealthfront is their referral program. You start with $15,000 managed for free if you are referred by someone. This increases by $5,000 for every friend you refer. This is a lifetime benefit, compared to a month of no fees seen at other companies.
Starting out, this means there is $0 cost to have Wealthfront managing your money vs. doing it yourself! If you have $10k-15k lying around in a bank account, Wealthfront is a great option. Even your emergency fund can go into an account set to the low-risk setting, ensuring it’s there when you need it, but beat the 0.5% you are getting with a savings account.
Are Robo Advisors Right for You?
If your money is just in a savings account, 100% the answer is yes. They are the simplest and easiest ways to start investing and earning a real return.
If you are a seasoned investor, then you can figure out if it makes sense for you. Personally, I love the convenience and tax loss harvesting. I don’t keep all my assets in one, but I do view it as a solid well-diversified base that holds most of my assets outside of real estate.
Have you used a robo advisor? Are you interested in getting started with Wealthfront but have been confused about how to do it? Leave a comment on your thoughts or experiences, or questions about how they have worked for me!