Investing Services: Betterment vs. Wealthfront

Recently two investment management companies, Betterment and Wealthfront, have gained an impressive amount of popularity. As you might already be aware, I'm quite skeptical of investment management firms as I've seen the dark side of the financial planning industry. Regardless, I wanted to research both offerings and compare the two in a "Betterment vs. Wealthfront" robo-advisor death match. I wanted to do this review mainly because I'm open to selecting one of these for my own personal use. Before we get into the details lets discuss the fundamental concepts that these services are based on.

What is a Robo-Advisor?

Despite what the investment industry will assure you (mutual and hedge fund managers, commission based financial advisers, stock brokers, etc.), investment allocation decisions can be made solely using various mathematical models. Sure, in the investment allocation decision process you will need to identify risk preferences (subjective assessment), but those are quickly quantified for use in portfolio construction. All other required data (such as investment time horizon, retirement needs, age, current income, etc.) is numerical.

With that said, a robo-advisor is a mathematical model that uses your data and individual circumstances to create a "personalized" portfolio. While a robo-advisor can eliminate the need for professional help to construct a long-term retirement portfolio, it will not satisfy the investment needs of everyone. If you require savvy arbitrage or hedging strategies in your portfolio then a robo-advisor is not for you. Additionally, you will not be able to choose what assets (stocks, funds, bonds, etc.) you invest in, the machine will do that for you. Betterment and Wealthfront are both robo-advisors and utilize mathematical models to automate asset allocation.

Passive Management and Modern Portfolio Theory

Both Betterment and Wealthfront are built on Modern Portfolio Theory (MPT) concepts. Harry Markowitz founded this theory with the understanding that portfolios can be constructed to maximize expected return based on a defined level of risk. Modern Portfolio Theory also suggests that efficient portfolios (optimized based on risk and return) can be constructed by varying allocations to asset classes (i.e. stocks and bonds). This leads to an emphasis on choosing the right blend of stocks, bonds and cash verses choosing one stock over the other.

In addition to utilizing Modern Portfolio Theory to drive asset allocation decisions, Betterment and Wealthfront both take a passive approach to portfolio management. Eventhough they take a passive approach to investing, they will step in and rebalanced the portfolio as needed. Taking this approach keeps transaction costs and fees low. It's wise to take advantage of dollar cost averaging when using these service by setting up automatic investments.

Betterment vs. Wealthfront: The Duel

Now that we have a fundamental understanding of Modern Portfolio Theory and robo-advisors, it's time for Betterment vs. Wealthfront!

betterment vs. wealthfront
betterment vs. wealthfront

When comparing these two services it is clear that they are both extremely similar. The only differences that will matter to the majority of main street investors is cost and initial deposit requirements. The advantages of choosing one over the other truly depends on your individual circumstances.

If you are looking to start building a retirement portfolio from scratch, Betterment will allow you to open an account with no initial deposit. This is as long as you agree to automatically deposit $100 per month into your account. This is a huge advantage for those just starting out. However, the downside to starting out with Betterment is that their fees are higher for accounts under $10,000.

I would personally take advantage of Betterment's low deposit requirement if I didn't have the $5,000 Wealthfront requires as an initial deposit. Additionally, I suspect if you have the $5,000 to use as an initial deposit when using Wealthfront, you won't stay in their "free" account status for long.

I'm attracted to these services for the automatic allocation of investment funds. I'm a advocate of paycheck allotments used to contribute to investment accounts, however in practice it can become burdensome to manage. Thus paying a service like Betterment or Wealthfront to execute the transactions for me is a nice option to have.

Protect Your Retirement from Increasing Taxes

As you develop your financial plan and retirement strategy, it’s important to consider the probability that some of the variables, such as tax rates, will change in the future. Many of the assumptions that financial advisors use in financial plans can quickly change based on laws and macroeconomic circumstances.

While it’s impossible to predict future tax rates, we are to the point now where I believe, without a doubt, that tax rates are going to increase. To protect your investments and retirement from increasing taxes, consider the following strategies.

Diversify Tax Advantaged Retirement Accounts

Roth IRAs (Individual Retirement Accounts) provide investors with the ability to withdraw funds tax-free. This means that during retirement you can utilize these funds without having to pay income taxes. However keep in mind that Roth IRAs differ from their Traditional counterpart in that you cannot deduct your contributions, only withdraws.

In an environment of increasing income taxes it can become advantageous to pay taxes today at a lower rate, than at an higher rate in the future. In-order to protect your retirement from increasing taxes you should utilize a Roth IRA. However, if taxes stay the same or even decrease in the future placing all of your retirement funds in a Roth IRA would not be the best idea.

Due to the uncertainty of future tax rates, it would best serve investors to diversify their tax advantaged retirement accounts. Depending on your income situation, you can decide to split your investments into both a Traditional and Roth IRA.

This strategy will help you decrease you current tax rate by deducting contributions to the Traditional IRA, while hedging against future tax rate increases by contributing to an Roth IRA on a after-tax basis.

Invest in Municipal Bonds

Buying municipal bonds is a second strategy that you can use to protect your retirement from increasing taxes. Municipal bonds are issued by government agencies below the state level (cities, counties, districts, utilities, etc.). They can be issued for general purposes or to finance specific projects.

The income generated from investing in municipal bonds are exempt from federal and state taxes (only from the issuing state). This makes municipal bonds a great investment for people looking to reduce their tax liabilities.

The best way to take advantage of the tax-free income of municipal bonds is to allocate a modest percent of your bond holdings to this investment vehicle.

Despite the advantages of investing in municipal bonds, there are some risks that investors should be aware of. municipal bonds are still bonds, thus they are susceptible to interest rate and market risk. In addition, I personally believe that municipal bonds have a higher than average default risk.

The use of tax advantaged investments can help protect your retirement from increasing taxes. However remember to diversify as the future is unknown and anything can happen.

Measuring the Risk and Return of Investments

Every investor, whether a professional fund manager or individual, seeks capital appreciation when buying assets. However, as we have witnessed in the past few years, there are two sides to investing.

Unfortunately many are caught off guard when the markets turn on them. The consequences of not managing investment risk can become severe.

When developing and implementing a financial plan, its critical that you consider the risks in each investment you make. The goal of financial planning is to enable you to live the life you want to live. In-order to accomplish this you must consider the relationship between the risks and returns of investing.

Measuring the Returns of Investing

In light of the fact that all investors seek returns on their capital, it’s obvious that they would also prefer the highest return possible. Due to market forces, the securities with the highest risk usually come with the highest potential return. On the other hand, the securities with the lowest risk, usually have the lowest returns.

The expected returns of assets are usually calculated two ways. For basic analysis the investor will assume that historical trends will continue, thus if a stock has returned an average of 12% annually it can be expected that it will return 12% a year in the future.

Advanced analysis takes many more variables into consideration than simply the historical average return. Equity analysts will take into account expected earnings, valuation, macroeconomic, business and industry related factors in-order to estimate the future returns of an investment.

Measuring the Risks of Investing

As mentioned above, there are a multitude of risks to consider when investing. Some risks are inherent to specific asset classes. Other risks will affect all asset class, if only to varying degrees.

Systemic risk affects all asset classes and can be described as the risk inherent in the financial system as a whole. This type of investment risk includes “market risk” and “political risk”. Think of this in terms of the macro-economy, if the entire country falls into recession all stocks will be affected. On the other hand, non-systemic risk only affects particular securities, businesses or sectors.

The expected risks of investments can be quantitatively measured through the calculation of standard deviation. Calculating the standard deviation of an asset measures it’s historical variation from its average price. This also can be described as the asset’s volatility. Usually, large-cap stocks have the lowest risk and small-cap stocks have the highest.

Before you invest your hard-earned money, ensure that you understand how to measure the risk and returns of different investments. When understanding the risk-reward relationships of your assets, you will be able to create better portfolios.

The Advantages and Disadvantages of Mutual Funds

Despite the popularity of mutual funds, they have both advantages and disadvantages. Wise investors take the time to understand their investments before committing their capital. Understanding the advantages and disadvantages of mutual funds will make you a better investor.

Advantages of Mutual Funds

Easy Diversification - Many mutual funds are actively managed portfolios that are well diversified. Funds are diversified with the objective to improve performance through seeking the highest rate of return at the lowest possible risk.

Professional Portfolio Management - When investing in a mutual fund, your money will be managed by a professional investment team. More often that not, these money managers have plenty of experience, education and a dedicated support team.

Liquidity - Mutual funds provide their investors the ability to buy and sell shares whenever they want or need to. This can prove to be a real advantage in times when optimal buying or selling conditions exist in the marketplace.

Reinvested Earnings - Exponential portfolio gains can occur when earnings (realized gains and dividends) are reinvested into new positions. Mutual funds make it easy to reinvest your earnings, many ask you if you would like to reinvest earnings when opening a new account or position.

Disadvantages of Mutual Funds

Fees and Expenses - The advantages of mutual funds, such as professional management, come with a price. Funds with low management requirements like index matching funds have lower fees and expenses, whereas niche funds will require higher maintenance and will come with a higher cost.

Not Insured - Unlike savings accounts, investments in money markets and certificates of deposits, the capital you place in a mutual fund will not be insured by the FDIC against loss. The value of your mutual fund will rise and fall alongside the stock market and losses can be sustained in the short and long-run.

Below Average Performance - Unfortunately most mutual funds underperform common market indices such as the S&P 500 and Dow 30. In light of this fact, its sometimes better just to invest in a variety of different index matching ETFs.

Limited Investing Strategies - Mutual fund managers are limited in the types of investments that they can make, this often limits their ability to take advantage of strategic opportunities such as buying options and shorting stocks. This is one of the main differences between mutual and hedge funds.

Investing in mutual funds comes with a few advantages and disadvantages. However in most circumstances (and financial plans) the pros completely outweigh the cons.

An Introduction to Mutual Funds

Mutual funds are one of the most popular investment vehicles around the world. This is due to ease and convenience of contributing to mutual fund accounts, their broad diversification and reinvested earnings. Allocating a portion of capital to mutual funds is a great idea for beginners and seasoned investors alike.

Mutual Fund Management

Simply stated, a mutual fund is professionally managed portfolio of stocks and or bonds. Mutual fund managers pool all of the capital received from investors and invests it on their behalf. In exchange for the capital mutual fund investors receives shares of the mutual fund.

Mutual funds offer access to the expertise of professional investment managers without the high price tag of hedge funds and other investment managers. Mutual fund managers are usually supported by a team of investment analysts who help research stocks and determine which holdings to buy and sell.

A Few Types of Mutual Funds

There are probably more than a thousand mutual funds available to investors. However, most of these funds can be categorized in a few different themes. When mixed and matched, these themes can provide excellent diversification across stocks, sectors and asset classes.

Mutual fund portfolios can be constructed with value, growth or income as an objective. Funds can also be built using international stocks, domestic equities or a combination of both. Some funds also tailor to smaller niches, like green energy investments or rare earth minerals.

Fees and Expenses of Mutual Funds

Some mutual funds charge a front-end load or back-end load. Mutual fund loads are sales charges that can be compared to a commission. It’s commonly assumed that load mutual funds are not a good investment and that no load funds are superior. As an investor you should consider funds that provide great returns year in and year out regardless of the fee structure.

Mutual funds can also charge it’s investors a management fee. Management fees are reflected in the value of each share of the fund, thus you will never receive a bill for a management fee. Management fees cover the operating expenses of the portfolio management company and individual fund.

Mutual funds provide great opportunities for both beginners and seasoned investors. Like investing in stocks and bonds, its a good idea to do your research before investing in a mutual fund.