Robo-Advisors Part 2: Pros and Cons + Pitfalls to Watch Out For
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm tackling part two of our two-part series on robo-advisors. And this week in part two, I'm sharing three things with you. Number one, the pros and cons of using a robo-advisor. Number two, pitfalls to watch out for. And number three, how to choose the right one if you think it's fitting for your needs.

So if you currently use a robo-advisor or you're considering using one in the near future, this episode will help you better understand if it's a good fit and how to avoid costly mistakes. For the links and resources mentioned, head over to youstaywealthy.com forward slash 104.

At the top of last week's show, I mentioned that I think the more appropriate title for these digital investment solutions is Robo Manager, not Robo Advisor. And that's not a knock on these services. I just think it's maybe more accurate.

A robo-advisor's primary job, just like a target date mutual fund, is to manage your investments. In other words, they're more like an investment manager or a robo-manager. Now, as I'll share in more detail today, these robo-managers have realized that most people want advice and at least some level of human interaction. And for that reason, many of them have rolled out additional services on top of basic portfolio construction and investment management.

So perhaps we'll let them continue using the title RoboAdvisor, but it is really important to understand what you're getting in return for a low fee service and what's really under the hood of some of these additional services that they're offering. And that's what I'm going to dive into today with the primary goal of helping our audience understand exactly what RoboAdvisors are and to give you the information you need to determine if they're a good fit for your situation.

Now, you might be thinking, wait a second, Taylor, you're a financial planner. Don't you feel threatened by these automated solutions? Aren't they your competitor? How can you really be objective here? To which I would say, look, there is no one size fits all solution when it comes to financial planning and financial advice. Robo advisors, they fill a much needed gap in this industry and they can be a great fit for the right person.

I shared the legal Zoom analogy during the last episode in part one, but I can also point to other professions, pretty much every profession. For example, tax preparation. Did TurboTax remove the need for human CPAs? Did H&R Block put all the local mom and pop accountants out of business? Not even close. In fact,

I would argue that the world needs more CPAs, that the best ones that I know reach capacity quickly and have had to close their doors to new clients. In other words, it seems like there's more demand than supply. And we're seeing the same problem in the financial planning world. And that problem is probably going to get worse too, given that there are more certified financial planners over 70 than under 30.

So I'm actually a fan of robo-advisors and I hope that they continue to thrive. I would much rather someone invest with Betterment or Wealthfront than get swindled into making monthly contributions to a high cost cash value life insurance policy that they don't really need. I would also prefer that someone find the best fit for them and their needs rather than be convinced that they need to buy something or work with someone that they don't need.

If robo-advisors don't check all the boxes and a retirement saver is in need of more customized solutions and more technical financial planning and tax planning, well, there are thousands of great firms just like mine all over the country who are available to help. So with that, let's start by jumping into the pros and cons of using a robo-advisor. Here are the five pros that I've identified for today.

Number one, they are low cost. I've mentioned this a few times now. The average robo-advisor charges an annual fee of around 0.3% per year or a little bit less maybe. And that's an incredibly honest and appropriate fee for the services that they render. There are mutual funds and heck, there are financial advisors charging five times that amount and providing half as much value.

As mentioned a few minutes ago, I think they're filling a much needed gap by providing a great service at a fair price. The second pro is behavioral protection. And it's very likely that you've heard me say on this podcast and other places that are our biggest threat to investment success is ourselves.

Investors, decade after decade, the data tells the same story that investors continue year after year to sell low and buy high. They get emotional and irrationally react to short-term events or comments from their neighbor or coworker.

By putting someone between you and your investments, you gain this extra layer of protection. And while you can't necessarily call your robo-advisor and have them talk you off the ledge, many of these platforms have worked behavioral science into their app development. And they contain important prompts and reminders to help you avoid making some of these costly and irrational decisions.

For example, if you click the sell everything button in a taxable portfolio, some of these robo-advisors in real time will calculate the tax consequence of that pending sale and remind you that taxes are an important consideration and even link to an article for more information. So trying to help maybe talk you off the ledge a little bit before you just push a button and trigger a giant tax consequence.

This is very different from a platform like Robinhood that encourages trading, which led to one person recently who opened up an account with $30,000 and without understanding wash sale rules, generated a tax bill of $800,000 last year in 2020. This person makes $60,000 a year. They opened an account with $30,000 and they generated $800,000 in taxes.

It's an extreme example, and while you might not make that same mistake, it's possible to make a number of small tax mistakes throughout your investing career that can certainly add up to a very big number. So needless to say, managing behavior when it comes to investing is very important, and robo-advisors do provide a layer of protection that other DIY trading services often do not.

The third pro is modern technology. Unlike custodians such as Vanguard, Fidelity, Schwab, you name it, these custodians are decades old and their platforms reflect that.

The newer robo-advisors have the advantage of using all their venture capital money to build a modern solution from scratch, which is much easier than trying to turn Vanguard upside down and rebuild on top of their archaic and legacy systems.

While the major custodians are certainly starting to catch up and a slick looking app doesn't necessarily mean you'll retire with more money or anything, but it's a nice bonus to have something that's easy and user friendly, especially if you're a Snapchatting millennial who grew up with a computer in your pocket.

So modern technology is pro number three. Number four, rules-based investing. And you've heard me use this term a number of times on the podcast, but in short, a rules-based investment approach helps to eliminate the guesswork that often leads investors to think they're smarter than the markets. For example, rebalancing is an important piece of investment management. I did a whole episode on it.

Where most people fail with rebalancing is by trying to time their portfolio rebalances and they rebalance earlier than planned on some gut feeling or they decide to delay a scheduled rebalance because of something that they read in the news that day.

And while you might get lucky once or twice, repeating this behavior over and over again can lead to some really costly mistakes. So by establishing some rules that are based on academic research and historical data, investors can stay focused on making money and saving money instead of trying to outguess the financial markets, which again, over time, on average, leads to very costly mistakes.

Finally, the last pro diversification number five, most robo advisors follow what's called modern portfolio theory or MPT, which essentially and you can look it up for more information, but essentially leads to a nice, well diversified portfolio that's optimized to match a person's risk tolerance with their expected rate of return.

There are some pitfalls to watch out for here, which I'll cover momentarily. But in general, you're going to get prudent diversification with a robo-advisor, which isn't always the case with asset allocation mutual funds that sometimes when you look under the hood are much riskier than that sales brochure led you to believe or are even highly concentrated in one or two or three asset classes.

So to recap the five pros, we have low costs, behavioral protection, modern technology, rules-based investing approach, and diversification.

Now, with that, let's move into the five cons that I've identified. Number one, limited customization. So given that robo-advisors are using computer algorithms to manage investments and there isn't a human element, you're restricted to the investment choices that they make available to you.

When you're in the wealth accumulation phase of life, this isn't as big of a deal. As I've previously mentioned, making money and saving money is going to have a bigger impact than this perfectly constructed portfolio. However, later in life, your approach may be more nuanced and require more personalization. It's no longer about maximizing returns. It's more about managing risk.

You also might have larger positions later in life, and those large positions might have large taxable gains that need to be carefully handled as part of a diversified portfolio. And as you transition into retirement, they can't necessarily just be traded by a computer algorithm. The second con is little to no human element. More and more robo-advisors are including an option that allows you to access a human financial planner, sometimes at an additional cost.

While some human interaction is probably better than nothing at all for most situations, the challenge I still come across is that these financial planners, although they're great financial planners, are assigned a thousand clients or more in some situations. In other words,

you're not necessarily getting highly customized, personalized advice here. You're getting a point of contact really in a call center who has to make room for all the thousand plus families that he or she is responsible for.

And that, I mean, that, that number is 10 times the number of, of families that research says an individual advisor can serve if they're doing comprehensive financial planning. So, you know, the typical advisor can handle about a hundred clients at a time. So again, yeah, a thousand families is a lot to keep track of. Even if you're the best note taker on earth, it would be nearly impossible to have constructive meetings and intimate relationships with a

a thousand different people from all over the world and from all walks of life. And by the way, this might be a pro. This might be a perfect solution for you. Just like H&R Block sits between TurboTax and a traditional accounting firm. It might be just the amount of contact that you need. But for me, con number two is little to no human element.

Con number three is you can check in anytime you want, but you can never leave. And, you know, never is a strong word there. I'm just having a little bit of fun. But robo advisors do seem to make it much harder for someone to leave and transfer their money out to another custodian. I'm speculating here, but given how tech savvy these platforms are, it's hard not to believe that this is kind of done on purpose.

Along with processing physical checks and not participating in simple electronic transfers in some situations, some robo-advisors won't even transfer the cost basis of your investments to the next firm that you're moving to, which is pretty normal.

A new client recently joined us from a very well-known robo-advisor. I won't mention their name, but it took weeks for us to obtain this data, the cost basis data, and get the client's accounts updated on our end at our custodian. And if we weren't in the picture, it's very possible that an investor that doesn't really know exactly what they're doing wouldn't have noticed that the cost basis was missing from their investments, which could have led to some very large tax consequences in the future.

Now, is this a reason to avoid robo-advisors? No, probably not. Will they eventually be pressured into making some improvements here? My guess is yes, but I think it's important to know what's currently happening in the landscape and it just doesn't get brought to the surface very often. So con number three, you can check in anytime you want, but you can never leave.

Number four is the future is unknown. And this is more of a personal con for me. You may not agree, but to date, Betterment is the largest independent robo-advisor that isn't, when I say independent, it isn't attached to a custodian like Vanguard or Schwab or Fidelity. So Betterment is the largest independent robo-advisor and they currently manage approximately $22 billion. Well, $22 billion might sound like a lot. It is a lot.

To put this into perspective, Vanguard manages just over $7 trillion. Fidelity total client assets sits around $5 trillion and Schwab just over $4 trillion. And let's not forget about all the global brokerage firms like Morgan Stanley, UBS, Credit Suisse, who all manage well over $1 trillion as well.

So one of my personal concerns here or cons is the unknown about what happens to robo-advisors like Betterment in the future. What's their long-term plan? A few years ago, we saw LearnVest, which was an amazing digital financial planning platform. If you don't know much about LearnVest, there's a great How I Built This episode

podcast episode by Guy Raz, who interviews the original founder. Go check it out. I'll definitely link to it in the show notes for you. But LearnVest was an amazing digital financial planning platform, and they got swallowed up by Northwestern Mutual, which is an insurance company.

We also saw United Capital, a successful and reputable wealth management firm, got bought by Goldman Sachs recently. And the list goes on. There's a lot of acquisitions like this. And for those of you that know my story, I left one of those big brokerage firms years ago because I wanted to create a firm that adhered to the fiduciary standard and put my client's interests first. The last thing I would want to see if I'm a real...

robo-advisor client is to all of a sudden find myself back under the control of a large publicly traded corporation whose fiduciary responsibility is to their shareholders. Remember, many of these robo-advisors took on a lot of venture capital funding, a betterment about $275 million last I checked.

And those investors, those venture capital firms are going to want to see a payday at some point. They're going to want to see an exit. And if they don't sell to a large competitor, perhaps they will go public and IPO, which again raises questions about their fiduciary responsibility going forward. It also raises questions about what happens to fees when they have pressure from shareholders to boost profits.

Or perhaps they'll follow in Fidelity's footsteps and remain a private company. I don't know. The future is unknown. And I think it's at least something to take into consideration here before you just go full steam ahead with your life savings with one of these robo-advisors. Lastly, number five, this is probably no surprise to anybody listening, but the lack of advanced financial and tax planning is for sure one of the big cons here.

As I mentioned in part one of this series, like most things in life, you get what you pay for and robo-advisors are no different. You can't expect to pay 30 basis points or 0.25% per year and expect to get full service wealth management services that are perfectly curated for your needs.

We see a number of new clients join our firm from robo-advisors once they're ready to make that big transition into retirement. And not because robo-advisors are bad or they're upset with their services or their portfolio returns, but because they have a new set of needs and more complexities that require more nuanced help. For example, creating a withdrawal strategy from your different investment accounts, which we have an episode coming up, I think in four or six weeks, somewhere in that range,

But creating a withdrawal strategy from your different investment accounts to create tax efficient income in retirement is not an easy task for a computer algorithm. Heck, it's not an easy task for a seasoned financial planner. There are a lot of moving parts to take into consideration.

Tax planning and annual Roth conversions to lower your tax bill in retirement is another big pain point for people that have done a great job saving throughout their careers. And it's nearly impossible for a computer to navigate around that stuff.

Now, it's very possible that you or you and your spouse have the knowledge and interest to tackle these advanced planning things on your own. But many retirement savers don't. And relying 100% on a computer algorithm to factor in all the different pieces to your retirement and your tax puzzle would not be advised, at least not yet.

Perhaps AI, artificial intelligence will get so good that it will be possible. But for now, I would just be honest and just recognize that there are limitations when it comes to financial planning and tax planning. And it does depend on your stage of life, your needs and your complexities.

So to recap the five cons, we have limited customization, little to no human element, difficult outbound transfer processes, an unknown future, and lack of advanced financial and tax planning.

Let's now move into three of the biggest pitfalls to be aware of when it comes to you using a robo-advisor, which doesn't often get talked about enough. And so I just want to make sure that if you're using a robo-advisor, if you're considering one, again, they're not bad. I just want you to know what some of the pitfalls are so that you can keep an eye out for them and you know exactly what you're investing in and what you're getting in return for these services.

So the first pitfall is there are some robo-advisor services out there that advertise a free service, there's no fees, and some that require a high cash allocation.

So I hope you're smart enough to see through some of this stuff, right? If it sounds too good to be true, it probably is. There are three primary ways that a robo-advisor might be making money that they aren't telling you if they're advertising no fees or a free service. One of those ways is forcing you to use their own proprietary investment solutions or

or investment solutions that they get a kickback from. And these solutions oftentimes have higher than average underlying expense ratios, or even if they're average or even below average, that money is going directly back into their pocket because they are their own proprietary funds.

Number two, they could require you to hold a large allocation to cash as part of your investment portfolio. Schwab Intelligent Portfolios is one that's caught a lot of heat for this that requires at least a 7% cash allocation last I checked. And it could be higher. It could be into the double digits depending on the model, the investment model that you choose.

which as you know, a giant cash position creates a drag on your portfolio returns, especially in a low interest rate environment like we're in today.

Finally, number three, if there is a cash requirement, just know that they are lending your cash out and making a lot of money by doing that. For example, more than half of Schwab's revenue in 2019 or 2020, and I'm sure it hasn't changed, more than half of Schwab's revenue came from lending out customers' cash.

Many people don't know that that's how a lot of these custodians make money by asking you or finding ways for you to hold more cash on their platform, and then they lend it out. So again, it's not a reason to not use a robo-advisor. It's just important to understand what you're getting in return for no transparent fees and potentially high cash allocation requirements.

The second pitfall to be aware of, and this is one of my bigger pet peeves, is tax lost harvesting. Many of the well-known robo-advisors highlight the value of tax loss harvesting on their website and in their marketing material. It's hard not to see on most of these websites. In fact, one of them, one of these websites, claims front and center that tax loss harvesting will cover your annual fee for

three times over or more. Well, you know, while it's one thing to mention tax loss harvesting as a service that's provided, it's another to claim that it offsets all the fees you're paying by three times or more. I find the statement quite misleading given that tax moves such as tax loss harvesting are far from being appropriate for everybody.

Also, academic research is still mixed on the real value of tax loss harvesting because in reality, you're just pushing out your growing tax liability into the future. It's not a way to permanently save on taxes. It just saves you from a tax bill temporarily right now this year.

Plus, when you engage in tax loss harvesting, you have to swap one investment for another like investment to avoid the wash sale rule. And that presents a new challenge, which is exposure to what's called tracking error.

In summary, this doesn't necessarily mean that nobody should engage in tax loss harvesting, but there are costs and risks to doing it that just aren't brought to the surface. And those costs and those risks could turn your nice low-cost robo-advisor solution into a very high-cost service if you're not careful. Lastly, pitfall number three,

to watch out for low risk, high return solutions. So sticking with the theme of misleading claims, some robo advisors and their very talented marketing departments are figuring out that advertising, boring, low cost investment solutions that are grounded in academic research just aren't cutting it. And now they're coming up with clever product names and automated investing solutions that claim to offer a low risk way to generate higher returns.

Last year, Wealthfront, one of the bigger robo-advisors, was called out publicly for the giant losses that investors experienced in their risk parity fund. That fund fell 43% in 25 days during the COVID crash of 2020.

Now, it would be one thing if they highlighted that this is a very risky strategy and you can experience giant losses that far outweigh the broad market indexes. But instead, their website continues to say the following, quote, Historically, risk parity has generated better returns for a given level of portfolio risk than modern portfolio theory, end quote.

Unfortunately, since the launch of this fund, things have gone this way the whole time. Speaking of, the second part to this pitfall, which includes this risk parity fund from Wealthfront, is to be careful of hidden fees. So from August 1st to October 31st, 2018, the actual holdings in the risk parity fund were down 7.3%. However...

the fund itself was down 9.65% during the same time period. So I'll say that again.

From August 1st to October 31st of 2018, so I'm rewinding a couple years because this is an old example, the actual holdings in the risk parity funds, so strip out all the management fees and underlying costs, just the actual holdings were down 7.3%. However, the fund itself, the returns that investors received was a negative 9.65% during that same exact time period.

This indicates the giant hidden cost structure that Wealthfront clients were paying that didn't show up in the expense ratio. Now, Wealthfront has made some fee adjustments since then, but in general, a risk parity strategy still contains higher underlying costs, which inherently are going to drag down returns. And this just isn't in big, bold letters on the website. You have to really dig through the nitty gritty details to see this stuff.

So as you consider a robo-advisor solution, be sure to look under the hood and really understand what you're investing in and try to look past the marketing copy that's written by some of the best marketing copywriters in the world. Just know like there is no such thing as a free lunch.

To recap, the three pitfalls I shared were one, to watch out for no fee solutions and high cash requirements. Number two, be careful with tax loss harvesting and the true long-term benefits. And number three, keep an eye out for investing solutions being packaged up in a way that sounds too good to be true. And just make sure that you know exactly what you're paying as these fees can easily be hidden.

As we wrap up here, I want to be sure to highlight that robo managers, I mean, advisors, robo advisors are outstanding solutions for the right person. They are not the one size fits all solution that's often touted on their websites and in advertisements, just like TurboTax, LegalZoom, Redfin, H&R Block, and tons of other examples that

Robo advisors are filling a much needed gap. And to me, that gap is a service that is in between doing everything yourself and

and hiring a full-service financial planning firm. And if you just need investment management help and the services provided by the robo-advisor are adequate for your needs, the pros outweigh the cons, and you don't have an overly complex situation, they can be a great solution. In my experience, they are a solution that's most fitting for people in the wealth accumulation stage of life.

And that doesn't mean young professionals don't need financial planning help from a human advisor. In fact, they need a lot of help and guidance, but their investments just need time to compound and making money and saving money is going to be the most important factor to their investment success. Not having a professional financial advisor build the perfectly constructed portfolio.

It also doesn't mean that those who are in retirement or transitioning into retirement shouldn't consider a robo-advisor either. A digital online advisor might be the perfect fit for you and your situation, and I really hope that these two episodes will help you make that decision. And if you do determine that a robo-advisor is a good fit, I would find one that matches up with these three criteria.

Number one, the fees and risks are transparent and not covered up by clever marketing material. Number two, fees are competitive with other similar services. Number three, the company is trustworthy, has a long-term positive reputation and a clear vision for the future. And then a bonus number four, you meet their investment minimum and they're able to deal with all of your different account types. We didn't talk about it, but some robo-advisors, even some of the notable ones,

can only deal with certain types of accounts. So be sure to confirm before you go all in and start transferring all your money. Be sure that they can actually handle and deal with all your different account types.

There's obviously a lot to dissect when it comes to robo advisors. I thought this was going to be a short, you know, one part episode. It's turned into two longer episodes. I really hope this two part series was, was balanced. It was objective and helpful. If you think that I missed something or you want to know more about a particular topic or a point that I brought up, just shoot me an email at podcast at you stay wealthy.com. I'd

I love hearing from you guys, our listeners, and your feedback and questions help to make this podcast better. And if you've ever emailed me, and a lot of you have emailed me, you know that I read and respond to every single email. So shoot me an email, podcast at youstaywealthy.com. For all the links and resources mentioned today, head over to youstaywealthy.com forward slash 104.

Thank you, as always, for listening, and I will see you back here next week.