The following is a guest post from Kevin at Just Start Investing.
Today we have a title fight between robo-advisors and online brokers.
In one corner, we have the fresh rookie looking to shake up the investing world. Their speciality is automation and giving you an end to end experience to save you time and stress. Put your hands together for… Robo-advisors!
In the other corner, we have a seasoned verteran. They’ve been around a few years and know how to deliver a customizable portfolio for cheap. That is, if you’re willing to put in the work. Give it up for… online brokers!
Stick with us to see who will win this evenly matched fight. But first, a quick backstory on each competitor is below.
What is an Online Broker?
In simple terms, a brokerage account acts as a middle-man between you and the investing market. Online brokerage accounts allow you to buy and sell investment vehicles easily and quickly online with the click of a button.
Traditional online brokerage accounts give you control over your investments – you can select exactly which investment vehicles to purchase. Plus, if you choose an online broker like Charles Schwab or Vanguard, fees will be very low – making it easy to set up a portfolio on your own.
What is a Robo-Advisor?
Robo-advisors are online investing platforms that do 99% of the work for you.
Most robo-advisors start by asking you to complete a series of questions to get a sense for your risk profile, goals, and to gather some basic information. Then, the robo-advisor will automatically open an account and select investment vehicles for you based on your answers.
Behind the scenes, robo-advisors are employing an algorithm that buys and manages investments for you – optimizing and reallocating your portfolio to match your goals.
The Pros of Online Brokers and Robo-Advisors
With backgrounds out of the way, it’s time to start round 1 of 2 of this title fight. Both of these investing options have different advantages that are unique to one another.
Online Broker Pros
- Low Fees: Reputable online brokers such as Charles Schwab, Vanguard, and Fidelity offer rock bottom fees on their index funds and ETFs.
- Customizable: When using an online broker, you have control over the exact investment allocation for your portfolio.
- Variety of Options: Most online brokers have a large variety of investment vehicles. From stocks to bonds to index funds, there is no shortage of options.
Robo-Advisor Pros
- Easy Set Up: Robo-advisors make it extremely easy to get started. You simply answer a few basic questions regarding your personal information and finance goals, and they handle the rest.
- Automation: Obviously, robo-advisors automate your investing for you. From your initial investment to ongoing management, they make sure you’re investment portfolio is always in line with your goals.
- Tax Optimization: Many robo-advisors offer tax optimization services, most commonly in the form of tax loss harvesting. While you can do this on your own as well, it is a complicated and time consuming task, and robo-advisors can do it much more easily.
The Cons of Online Brokers and Robo-Advisors
For round 2, we’ll look at things from another angle - what are the weaknesses of each of these options. Not surprisingly, in a lot of cases, the advantages of one are the disadvantages of the other.
Online Broker Cons
- Oversight Required: Managing your own investments takes time and effort. While it can be simplified by setting up a 3 fund portfolio using index funds, you still have to take the time up front to set it up, in addition to keeping an eye on it ongoing.
- Human Error: People mess up. You could mis-calculate something along the way and end up costing yourself money in the long term, be it from taxes, portfolio allocation, or any number of things.
Robo-Advisor Cons
- Higher Cost: Robo-advisors cost more money than investing on your own. For one, they charge a management fee (usually around 0.25%). Second, their funds are typically more expensive than the ones you could find on your own (they average around 0.05% - 0.25%).
- Restricted Investments: Robo-Advisors often only have a handful of index funds and ETFs that they invest in (usually less than a hundred).
- Lack of Control: You are giving up control of your investments to the robo-advisor. While this does save you time, it also means you have less authority over your portfolio.
So, Who Wins? Robo-Advisors or Online Brokers?
Through two rounds, we have learned that both robo-advisors and online brokers have unique pros and cons. But I’m not sure that we have found a clear cut winner.
If you are someone seeking simplicity and want to take a hands off approach, then robo-advisors are likely right for you.
If you are ‘Type A’ and like to have control of your personal finances, setting up your own portfolio through an online broker will probably work better.
From a dollar and quantitative standpoint, it can be hard to tell who is the better choice. I ran a couple scenarios below, but as you will see, the “winner” varies depending on how the variables below shake out.
In both of the scenarios below, I looked at a few variables that I held constant:
- Starting Investment: The total amount at the beginning of each scenario. In this case, $10,000.
- Annual Addition Investment: How much money is being added at the end of each year. I used $5,000 across all scenarios.
- Stock Market Returns: The average annual return of the market (7%).
I also looked at a few variables that I manipulated in the examples:
- Management Fee: For online brokers, this is always $0. For Robo-Advisors, I modeled it based off of Betterment, who charges 0.25% for their basic plan and 0.40% for their premium plan.
- Expense Ratio: In theory, it is possible to get to a 0.00% expense ratio (thanks to Fidelity). Though, for these scenarios, I modeled the online brokers based on Schwab and Vanguard funds, which get to roughly a 0.05% expense ratio at best and 0.25% at worse. For Robo-Advisors, I again modeled off Betterment who predicts an average expense ratio of 0.11% (best case) but has ETFs as high as 0.25% (worst case).
- Tax Loss Harvest: While it is possible to tax loss harvest on your own, I assumed a 0.00% benefit across both online broker scenarios. For Robo-Advisors, I once again modeled it based on Betterment who claims this benefit can be as large as 0.77% annually (best case), which I then took a 75% haircut to for the worst case scenario (0.19% benefit).
Example 1: Online Broker Winning
Overall Variables:
- Starting Investment: $10,000
- Annual Additional investment: $5,000
- Stock Market Returns: 7.00%
Online Broker Best Case Variables:
- Management Fees: 0.00%
- Expense Ratio: 0.05%
- Tax Loss Harvest: 0.00%
- Net Annual Gains: 6.95%
Robo-Advisor Worst Case Variables:
- Management Fees: 0.40%
- Expense Ratio: 0.25%
- Tax Loss Harvest: 0.19%
- Net Annual Gains: 6.54%
Outcomes:
- Online Broker Ending 40 Year Value: $1,054,113
- Robo-Advisor Ending 40 Year Value: $946,925
In this scenario, the online broker drastically outperformed robo-advisors. With an ending 40 year balance that is over $100,000 higher than robo-advisors, which is 11.3% more.
The lower costs of online brokers kept the net annual gains higher, with the robo-advisor tax-harvest benefit not enough to offset it’s hefty fees.
Example 2: Robo-Advisor Winning
Overall Variables:
- Starting Investment: $10,000
- Annual Additional investment: $5,000
- Stock Market Returns: 7.00%
Online Broker Worst Case Variables:
- Management Fees: 0.00%
- Expense Ratio: 0.25%
- Tax Loss Harvest: 0.00%
- Net Annual Gains: 6.75%
Robo-Advisor Best Case Variables:
- Management Fees: 0.25%
- Expense Ratio: 0.11%
- Tax Loss Harvest: 0.77%
- Net Annual Gains: 7.41%
Outcomes:
- Online Broker Ending 40 Year Value: $999,939
- Robo-Advisor Ending 40 Year Value: $1,191,198
In this scenario, the robo-advisor drastically outperformed online brokers. With an ending 40 year balance that is over $190,000 higher, which is 19.1% more.
The tax loss harvest benefit made all the difference in this scenario. It more than offset the robo-advisor fees, and the higher online brokerage expenses expanded the gap even further.
Summary: How to Make the Final Decision
So, who’s the true winner? Is there one?
As alluded to earlier, it really depends on your situation. For some people, robo-advisors will be the clear choice. For others, online brokers might work better.
As you can tell from the quantitative analysis - variables that are sometimes out of your control can affect who the winner is. So I’d recommend basing your decision more heavily on qualitative analysis and how badly you want to manage your investments versus let someone else take the reigns.
Guys, looks like this year I'll have to miss FinCon.
Posted by: Sally T | November 05, 2019 at 02:00 PM