Today we have a guest post (the very first here!). Brad Kingsley is a personal finance blogger and certified financial coach. He helps people create a plan for their finances to achieve big goals, like getting out of debt, paying for college and providing for a comfortable retirement. Follow him at MaximizeYourMoney.com.
Robo-advisors can handle all of your investing and investment management needs. For the benefit of this easy-to-use service there is an associated cost. I can’t tell you how many times I’ve heard “I’ll just do it myself and not pay any fees!” In reality not paying fees isn’t an option. Still, DIY investing costs less so it should be better than paying a service, right? Maybe not. Let’s explore the question of whether or not robo-advisor fees are worth the cost.
First, I want to get us all on the same page in understanding what DIY vs. robo-investing looks like. I’ll also point out the top concerns with both options: performance for one and cost for the other. We’ll explore what the last 30 years of investing results would have looked like with and without robo-advisor fees. Then we’ll consider if the robo-advisor fees are worth the cost or not.
What Does DIY Investing Look Like?
If you’re a true do-it-yourselfer, you will open a brokerage account at a firm like Fidelity, TD Ameritrade, Vanguard, or similar.
Then you will research a good portfolio asset class mix that aligns with: 1) your goals, 2) your timeline, and 3) your risk tolerance. This could be anything from two or three funds to hundreds of individual stocks. The key is being diversified while still getting the returns you need and staying within your acceptable level of risk.
Once your portfolio is decided, you need to purchase shares in appropriate amounts to reach your target percentages. If you are following the dollar cost average method of investing, each month you need to split your purchases to keep your target allocations. When your allocations get too far from the target, which does happen over time, you need to rebalance the account. Of course when you rebalance you need to consider losses, gains, and tax impact.
When your allocations get too far from the target, which does happen over time, you need to rebalance the account. Of course when you rebalance you need to consider losses, gains, and tax impact.
What Does Robo-Investing Look Like?
Another option is to work with a robo-advisor platform, like Wealthfront or Betterment.
Going this route you need to open an account with them and complete a questionnaire. These questions are used to understand your investing timeline, goals, and risk tolerance.
With the answers to the questionnaire, the robo-advisor will recommend an asset class portfolio mix personalized for you. Not only will they suggest asset classes but specific low-cost ETF funds to use in fulfilling the portfolio. You can review the model portfolio and either accept it as-is or adjust it before accepting.
With the portfolio decided, you link a bank account and transfer money. The platform will automatically split up the money to match the portfolio model chosen. It will also automatically keep your portfolio balanced over time in a tax-optimized manner.
A DIY Concern: The Behavior Gap
Perhaps you read through the steps of DIY investing and thought “no problem!” Before jumping into that option though, you should understand what some refer to as the behavior gap.
Carl Richard coined the phrase and wrote a book of the same name. Essentially the behavior gap explains why investMENT returns are higher than investOR returns.
That’s right. Study after study shows that investors lag market returns by several percentage points per year on average. In 2016 it was particularly bad with investors lagging the market by a whopping 7%. You might not experience this same underperformance, but the odds are against you for sure.
If you want to better understand why that gap exists, and perhaps how to avoid it, you can check out my article 5 Reasons Your Investments Are Performing Below Average.
A Robo Concern: The Fees
Did you notice how much easier it was when described above to invest with a robo-advisor than doing it yourself? Well, those benefits come with a cost. The robo services need to charge money to cover costs and stay in business.
How much? The most common price point is .25% per year. That’s right, one-quarter of one percent each year, split and paid quarterly.
Wealthfront doesn’t charge any fees on the first $10,000, then .25% above that. But they have a $500 minimum and zero human interaction. I believe Kathryn is a fan of Wealthfront and has been happy with their service. (editor’s note: yes, I talked about this in my post 5 Simple Truths To Help You Get Started Investing in the Stock Market)
Betterment charges .25% up to $2 million, then no fees above that. But they don’t have any minimums, and you can use their secure chat platform to get answers from one of their Certified Financial Advisors. I’m personally a fan of Betterment and you can read my full Betterment Review if you’d like to better understand why.
The Impact Of Fees Over The Last 30 Years
Even though the past is no guarantee of future performance, it’s all we have. So I’m going to look at a sample portfolio to gauge the impact of .25% worth of fees. The timeline being reviewed is the last 30 years – from 1987 to 2017. Someone with such a long timeline is usually young (perhaps 25-55) so I picked a 90/10 portfolio. So 90% US Stocks and 10% US Bonds.
For this example, I’m also making the assumption that the investor is going to start with $100 then max out their IRA contribution limit each year. Currently, that is $5,500 per year, which works out to $458 per month. This data assumes equal monthly contributions (dollar cost averaging) into the previously mentioned allocation.
So, what do the results of that analysis show?
If you aren’t already investing right now, prepare to be jealous (and perhaps have your mind blown).
That’s right. Someone 25 years old in 1987 investing as described above would be within a stone’s throw of a million dollars when they were just 55 years old. The exact amount they’d have is $849,851. Nice!
Plugging some numbers into my financial calculator shows me that is a compound average growth rate (CAGR) of 9.06%.
But wait! Remember that the average investor lags the market by at least 2% per year on average. What type of impact would that have on the ending balance?
If the CAGR dropped to 7.06% the balance after 30 years would be just $566,233. Still a LOT of money, but that’s more than $250k “lost” to bad behavior!
Frankly, even ignoring the ease-of-use for the robo-investing platforms, not cheating myself out of a quarter million dollars is a compelling argument in their favor.
Returns Subtracting Robo-Advisor Fees
What if this person had used a robo-advisor solution? Of course they didn’t exist back then, but let’s say they did. If the person used the robo solution they would avoid the behavior gap problem of self-management. But they’d also pay an annual fee.
What would the ending balance be after 30 years if a .25%/year fee was paid?
The investor would have $804,962 in their investment account.
While that’s obviously less than the potential balance had they been a perfect investor with no fees (unlikely) – it’s WAY better than if they experienced the behavior gap drag that impacts most investors.
I agree that $45k is a decent chunk of change. That’s a pretty nice car!
The question comes down to: do you trust yourself to be a perfect investor on your own? If you can do that, you can have an additional $45k in 30 years. If you’re wrong though, you might have lost the potential of $238k over those same 30 years.
Would you risk $238k to potentially gain $45k? Some people would. I wouldn’t.
I do believe that there are some people who can, and do, practice buy-and-hold. They can stay calm when the market is down 30%. They’ll invest every single month regardless of what is going on “in the world”.
It’s a small percentage of the population. Study after study confirms this reality.
So for someone who either 1) understands they aren’t going to be a perfect investor or 2) accepts the value of the easy-to-use platform – a robo-advisor solution is worth considering.
For someone new to investing who doesn’t want to do a ton of research and manage a portfolio, a robo-advisor is well worth the fees.
Frankly, if we were honest with ourselves, most of us would benefit from an automated platform that kept us following our investment plan consistently. I believe it’s an option that everyone should at least consider.