Robo-Advisors

In our previous videos, we've talked

about the concept of asset allocation. We learned that we want to create an asset

allocation that accomplishes three things. It minimizes our risk and so

keeps our portfolio as safe as possible. It earns a return that's consistent

with our savings goals, so that we can meet some particular

threshold that we want to achieve. And three,

it's consistent with our risk tolerance. So it's a portfolio that doesn't take on

more risk than we are comfortable with. Financial advisors are professionals

who help us with these tasks, and there's a large industry of these

advisors providing these services to investors throughout the country. These advisors will assess your risk

tolerance, usually through a questionnaire that asks you a number of questions

about your personal financial status and your willingness to assume risk. They'll suggest asset classes to you, and so suggest a particular allocation

that is going to achieve a goal. And potentially also helps you

with tax planning and rebalancing, depending on whether the account

is tax-advantaged or taxable. And also help us with rebalancing, which helps us determine different

allocations both as we age and as different asset classes perform

differently relative to one another. What does a financial advisor

get out of this arrangement? Well, not surprisingly, they charge a fee

in order to provide these services. And a typical number that's usually cited

is that financial advisors charge between 1% to 1.5% of the amount of

money that they're managing. And so if you have $1 million under

management with a financial advisor, they'll charge a fee that is 1% of that,

or about $10,000 per year. In addition, the funds that these managers invest in

typically charge fees on top of this. And so most mutual funds, especially

those that are actively managed, charge some sort of a fee in order to manage

the money that you have invested in them. For an actively managed fund, this fee can

be between three quarters of 1% and 1%. And so as a result, when placing

your money with a financial advisor, you can be paying between 1.75% and about 2.5% in fees for

managing your money. The question that we want to address here, and the reason that we have thought

about robo-advisors as an alternative in the first place, is to think about

how these fees impact our wealth. What I'm showing you on

this particular graph is the accumulation of funds in

an investment account where we have an investor that has 40

years to save, or 480 months. They save $1,000 per month, and earn a return of 10% per

year on their investment. The financial advisor with

whom the investor has placed their money charges a fee of 1%. Now taking a look at this graph,

we can see that starting from 0 wealth, over the course of their investing life, the investor winds up with

just a bit over $4 million. That doesn't seem too bad. Certainly most of us would be

happy to have $4 million when we retire as a result of our

investing performance. The key point, however,

as far as this is concerned is to think about the impact of

the fees on that performance. Again, the blue line is telling us how

much we will have saved at the end of 40 years if the manager charges a 1%

fee on assets under management. And the red line is showing us how

much we would have if there was no fee charged on the assets under management. What you can see here is that we would

have substantially more money at retirement if our financial advisor hadn't

charged us a fee in the first place. In fact, we would have had

about $5.5 million as opposed to $4 million if we had not been

charged a fee for that management. And if we have a manager who charges

a higher fee, or we're invested in assets that charge additional

fees because of management expenses, such that the total fee runs to 2%,

we wind up with only about $3 million. And so you can see that nearly half of

our investment is potentially eaten up by fees on investment management

over our life of saving. Because of these fees, we've witnessed the birth of what

we call automatic or robo-advising. These robo-advisors,

instead of meeting with you in person, have an online questionnaire that

helps them to gauge risk tolerance. They then use index ETFs to minimize fees. We'll talk a little bit more about ETFs

later, but they're low-cost investment vehicles that don't attempt to take active

positions in a particular market, and wind up having much lower management

fees than actively-managed mutual funds. These advisors then automatically

rebalance your portfolio to maintain an asset allocation. So as the value of different

assets in your allocation change, they'll rebalance the portfolio. And they also rebalance the portfolio

as you age and your goals change. There are two main types

of these advisors. What we refer to as hybrid robo-advisors. These are services that

are mostly automated. So by and large you will not come into

contact with a human being when using a hybrid robo-advisor. But there are situations where if you have

enough money or you pay a certain fee, you can speak to a human advisor to get

further advice on your asset allocation. Again, in order to speak to a human being, one usually has to maintain a higher

minimum balance or pay some sort of a fee. And examples of these types of services

are those offered by Charles Schwab and Vanguard, which will provide us

hybrid robo-advising services. The other type of automated advisor

is what we call a pure robo-advisor. Here the asset allocation

is purely automated. There's no human contact,

everything is performed online. These robo-advisors have very

low minimum balances and fees which accomplish two things. First, low fees allow you to keep

as much of your money as possible. And the low-minimum balances allow those

investors without a lot of wealth in the first place to start

investing as early as possible. Two prime examples of these robo-advisors,

the two that have the most assets under management,

are Wealthfront and Betterment. And in what follows, I am going

to use Wealthfront as an example of how a robo-advisor achieves its goals.