We’ve seen a plethora of “robo-investment” services crop up in the last few years. Betterment, Wealthfront, Schwab Intelligent Portfolios, and others all provide portfolio management services for relatively low cost. All you have to do is transfer your money into one of these accounts, and an algorithm, usually based on your specific risk tolerance, will invest and rebalance your account to form a well-diversified portfolio. These companies bring sophisticated investment strategies to the masses, using an effortless interface. Gone are the days when only those with hundreds of thousands of dollars had access to a portfolio manager, because most of these services have little or no minimum account balance, and the algorithms do all the work of a traditional portfolio manager. Also gone are the 1-2% or higher “management” fees, load costs, and other miscellaneous fees that used to be associated with investing. Costs are now usually a fraction of one percent. These low-cost services are great for the “set it and forget it” investor. But if you’re willing to put in a bit of extra leg work, you can even further reduce your fees, which is great because:
Investing Can Be Expensive!
Investment costs can add up to a huge amount of lost value over time—which means you will take longer to reach financial independence, and/or have less income once you reach FI. For instance, if you started with a $100,000 investment portfolio, contributed $20,000 per year, and paid 1% in fees and costs—actually a fairly low fee for the “old” style of managed investing—you’d wind up paying over $300,000 in fees over 25 years. Lowering that cost to .25%—fairly typical for robo-investing services—would cost you around $80,000 over the same time period. That’s a massive savings!
But here at MFS, we don’t like to settle for lower fees, we want the LOWEST fees possible to squeeze the biggest returns possible from our financial independence portfolio. Perhaps in a few years I’ll be out of the “build” stage, and into the “enjoying FI” stage, and I won’t want to deal with managing my investments. But for now, I don’t mind spending a few minutes each month keeping my investments in order. Plus, it’s interesting and rewarding to more fully understand my investment portfolio.
I definitely think that some investors should still probably use one of the robo-investors. If you want the easiest option possible and don’t want to think about anything, just go with Betterment, Wealthfront, or Schwab Intelligent Portfolios. These are all great options, and for the ease-of-use factor, provide a lot of value for a relatively low cost. But if you’re like me, you want to maximize the investment gains from every dollar that you’re so hard at work saving. We already know we can’t beat the market, so let’s see if we can pursue the same benefits that robo-investment services provide, but with lower costs, resulting in a higher return on our investment.
Robo-investment services provide four primary benefits: (1) diversification, (2) rebalancing, (3) tax-loss harvesting, and (4) ease of use. We already know that the hands-on method will not be quite as user-friendly, but I think you’ll see that it’s not really all that difficult to self manage your portfolio. The other three benefits are fairly easy to achieve on your own, and without too much work, you can match the performance of the robots, while paying less of your hard-earned money in investment fees. (Maybe the robots won’t rule the world after all…)
This is the biggest factor in any portfolio’s ability to generate gains over time and limit volatility. But it’s also one of the easiest to achieve with index-based mutual funds and Exchange Traded Funds (“ETF”). If you’re not familiar with an index fund, it is basically just a collection of stocks from individual companies that fall into a particular category (such as companies in the S&P 500 index). These funds track a huge swath of the market, and because they’re not actively managed, you usually pay very little in costs. So buying a few index funds that track some of the major market categories will give you maximum diversification, high gains over time, and low risk.
I recommend using the “Investment Checkup” tool in Personal Capital to understand what broad asset allocation you should aim for. (I’m planning a review of Personal Capital soon, so stay tuned!) This is a simple, yet powerful tool to help you set an allocation goal and track your progress. The only variable you need to provide to Personal Capital is your risk tolerance. I use the most aggressive allocation, which equates to 60.2% US stocks, 25.8% international stocks, 10.5% alternatives, 2.2% US bonds, .8% international bonds, and .5% cash. Personal Capital analyzes my investments, and summarizes how closely I match the target allocation in a handy chart:
Now all you have to do is buy ETFs that correspond to these broad asset categories. I use Charles Schwab, which allows you to buy and sell a large variety of low-cost ETFs without paying trading commissions. I primarily invest in the following ETFs:
- For US stocks, SCHB, SCHA, and SCHD.
- For international stocks, SCHF, SCHC, and SCHE.
- For alternatives, SCHH, SIVR, and SGOL. (Or check out some other options for alternatives.)
- For bonds, SCHZ and SCHP (although I’d suggest holding bonds in a retirement account if possible in order to minimize taxes).
An aside about expense ratios:
The great thing about these ETFs is that they have extremely low expense ratios, and as you’ve already seen, lowering investment expenses has a huge impact on your bottom line, and is really the main reason to not use a robot-managed portfolio. An expense ratio is basically the amount you’re charged each year to own a particular ETF or mutual fund. For example, if a you own a fund that charges a .5% expense ratio, you would pay approximately $50 per year per $10,000 that you have invested in the fund (10,000 x .005). If a fund charges a .1% expense ratio, you would pay approximately $10 per year, per $10,000 to own that fund. As a point of reference, the broad market ETF from Schwab (SCHB) charges an expense ratio of only .03%. Self-managing these types of low-cost investments will result in a substantial savings over time because Betterment and Wealthfront charge a small (but significant!) management fee of anywhere from .15% to .35% in addition to the expenses charged by the underlying holdings.
OK, back to diversification:
So these funds all have very low expense ratios, and also will expose you to a huge segment of the world’s companies—diversification at its best! You can take diversification a step further by using different methods to index the underlying companies (such as market capitalization, equal weighting, sector weighting, and fundamental analysis), but that’s a slightly more advanced topic for a future post. You’ll get massive amounts of diversification just from using the ETFs I lay out above. Simply transfer some money into your brokerage account, and buy the above funds in about the proportion that Personal Capital tells you to use based on your risk tolerance. If you run the Investment Checkup tool and find out that you’re a little low on international equity, just buy some more SCHF, SCHC, and SCHE. That’s all there is to it! Whenever you have more money to put in, just run the Investment Checkup tool again to see what you should buy.
The reason we diversify is that, in any given year, some investments will do better than others. For example, this year, the S&P 500 has gone up nearly 10.5% (as of the time I wrote this post). The S&P 500 tracks a variety of different “sectors” of the market, so considering all of the sectors, the market performed very well this year. When you take a closer look at the underlying market sectors, you’ll see that the energy sector went up by 26.84%, while the healthcare sector actually fell by 3.4%. There’s no real way to predict which sector will do well in an upcoming year, so we diversify and buy them all to balance our gains and risk over time. The same is true with US stocks versus international stocks. Some years the international stocks will soar, while some years the US market will outperform.
The robo-investors automatically rebalance your portfolio based on how different markets are performing. Keeping within a few percentage points of your target allocation is the best way to ensure that your portfolio performs well, so this is a valuable service. However, the easiest way to “rebalance” a portfolio is simply to add money to it, and buy whichever classes are underperforming. This takes discipline, because the natural tendency is to buy whatever is doing well at the time, but it is vital to track your target allocation. I actually prefer this method to classic “rebalancing,” because you don’t have to sell any securities, and thus you don’t incur any capital gains taxes. As most of us are probably still in the building phase—actively shoveling as much money into our investment portfolio as possible every month—it should be easy to keep your portfolio balanced simply buy buying whatever asset class is underperforming at the time. When it comes time to live off your portfolio earnings, you can maintain the balance by selling shares of overachieving investments, and keeping the underperforming shares to give them time to rebound in later years. Rebalancing = done.
Tax Loss Harvesting
Stocks (and mutual funds/ETFs) generally make you money in two ways: (1) by paying dividends, and (2) through a gradually increasing share price. You usually have to pay taxes on both of those earnings. Dividends are paid out periodically throughout the year, and you pay taxes on dividends in the year they were distributed. You pay taxes when a share price increases as well, but only when you sell that share and realize a “capital gain.” If you don’t sell that share, it is considered an “unrealized” gain, and you can continue to defer paying taxes on it. The opposite is also true. If you sell a share for less than what you bought it for, you can realize a capital loss, which can be used to offset some other capital gain.
The robo-investors generally automatically harvest your tax losses by selling securities that drop in value, and buying other similar securities. The good news is that you can do the same thing relatively easily. I generally look for tax loss harvesting opportunities once per quarter, and I’m planning to write another post soon detailing the very easy process I use to harvest tax losses through Charles Schwab. Stay tuned for a more in-depth discussion of tax loss harvesting.
The process of managing your own portfolio takes a little while to explain, but it really doesn’t take that long to implement. Simply set up some automatic transfers into your brokerage account to occur after every payday (or even once per month), and then run the Investment Checkup function on Personal Capital, and buy anything that needs a boost. The whole process probably takes me about 10 minutes per month (and half an hour or so every quarter for tax-loss harvesting). By doing it this way, you can avoid paying the management fees charged by the robots, which add up to tens of thousands of dollars over time (and more if you have a large portfolio!). These savings are now yours to keep, and can continue to earn you additional income every year using the 4% rule. You make money and learn about investing at the same time! That’s a win in my book.