I absolutely love what software can do for us, freeing up our time and energy to focus on the less mundane. And when Robo-Advisors first launched, with simple portfolios of low-cost index funds, they were great. Taking away the human emotions, keeping you invested correctly with a massively diversified portfolio - what's not to love?
However, I've recently come across a few problems that stem from both the Robo-Advisors themselves changing and how to handle distributions and tax situations with my clients. This is some first-hand information that I want to pass along.
Robo-Advisors are getting more sophisticated and complex - which is never in the client's interest. You want simple, easy-to-understand investments. Robo-Advisor that used to create portfolios of 5-10 funds are now are holding 15-20 funds. And they are holding more complicated investments such as risk parity funds. You simply don't need this level of complexity to be successful.
But a bigger problem is Tax planning. The Robo-Advisor has no idea of your unique situation. They do not adjust rebalancing based on your outside assets (401k, IRAs, etc), nor your changing tax situation (i.e. wait until you are in a lower tax bracket next year due to a life change). I've had client situations where these are easily over $30k in taxes that could have been avoided.
I haven't researched all the options, so there may be some simple Robo-Advisors that just buy-and-hold for you. Unfortunately, I can no longer recommend those that I have interacted with for my clients.
Mike: [00:00:00] Welcome to financial planning for entrepreneurs and tech professionals. I'm your host, Mike Morton chartered financial counselor and financial advisor. In this episode, I explained why I'm no longer recommending the use of robo advisors while I love technology. These are simply getting too complex for individual investors and can end up costing you money.
Enjoy this on-air radio broadcast with Matt Robeson.
Matt: [00:00:29] I'm Matt Robinson and I'm joined as always by Mike Morton of Morton financial advice. Mike what's new.
Mike: [00:00:36] What's new um, nothing excited to do another episode with you, man.
Matt: [00:00:41] I'm always excited to do another episode because I always learn something new. we all, hopefully have some money. All of us have some money. We all. A little more money. And that gives us this illusion, that we know a little, something about what to do with our money.
Every time we have one of these conversations, I find out that what I think I know I don't really know as well, at least as I should. So always great insights. And here's a topic that I actually know. Absolutely nothing. About you want to talk about robo advisors? This sounds like some Andrew Yang, the robots are coming to take our jobs future we're in the matrix sky, net self-aware type thing.
What in the heck, Mike Morton is a robo advisor
Mike: [00:01:27] Yeah. These are the robots coming to take your money, matt. It's where it all starts.
Matt: [00:01:31] so I'm going to get plugged in and be used as a battery in the future basically is what you're telling.
Mike: [00:01:36] Correct? Yeah. Yeah. That's definitely the path you're headed
Matt: [00:01:39] definitely it. Okay, good. Good. As long as we're clear on that,
Mike: [00:01:42] So robo-advisors many listeners probably have heard of these things, Matt, but I'll do a brief explanation. This is where you put your money into the album. and these advisors automatically the website and the artificial intelligence, the robot automatically invests your money into a massively diversified portfolio. that,
should be super optimized and very efficient, which is, hard for humans To do. And so we put the robots in charge of taking your $10,000. And spreading it across lots of different funds and companies, and automatically investing that for you. So you can put in a hundred dollars a month or a thousand dollars a year or whatever it is, and the robot will automatically invest that money across all these different asset classes and rebalance it for you.
And it'll be super efficient so that you will make the most money possible.
Matt: [00:02:41] To say that despite all those awesome documentaries, I just noted about the robots rising up to kill us. Like in Terminator, I. Think that sounds attractive. I mean, The idea of a robot doing some drudgery. To me, the idea of doing all this work research, figuring out what to invest in, constantly checking my portfolio.
It's a privilege to have a portfolio at all, that sounds not that attractive a robot doing it for me and doing it really well. Sounds kind of good. Is that kind of good?
Mike: [00:03:13] Yeah, it's fantastic. And they've been fantastic. I'm going to get to why I no longer recommend these things. Okay.
But let's start with, where we've come from it and you're exactly right. It sounds perfect. I don't know what to do with my $10,000, how to make it most efficient for me, I'll give it to the robot and it's based on academic research over hundreds of years.
And so it knows how to allocate this money and rebalance it. And depending on what happens, it's going to do cool things to keep it really efficient. And it's true. That's how this started was that it would take that $10,000, put it in five to 15 different funds across us and international and stocks and bonds and big and small companies and keep it allocated very efficiently for you.
And so it sounds like a fantastic tool. And for that, five or 10 different funds and allocating 5% here and 8% there and doing the rebalancing, they work really well.
Matt: [00:04:03] Now just to draw a distinction here. We're not talking about the wall street firms that have literally put in direct lines to the trading markets so that they can take advantage of like femtosecond differences in movements in prices of various assets of stocks. That is a thing where they have this advantage.
Like literally segments of time that are hard for human beings to even notice they have this advantage over human traders and they're taking advantage of that to make a lot of money. You're not talking about that kind of robot capacity, where you're trying to time things. It's just optimal allocations, constant monitoring, the kind of thing.
That's hard for humans to do.
Mike: [00:04:49] Yeah.
that's exactly right. So we're not talking about the high frequency traders that you mentioned, but we are talking about is the traditional wealth managers. You'd hand them your a hundred thousand dollars portfolio and they would say, oh, I know the smart things to do with this. We'll put 10,000 here and 10,000 there, and 10,000 here, we'll now, with the internet and software, of course, we're solving a lot of these things in different ways and that's what we've done.
They said, oh, we can have a robot take your a hundred thousand dollars, put 10,000 , in a very efficient, super low cost way as all internet and software has driven things these days. And so that's what we're replacing as a traditional wealth manager with a sort of robot wealth manager to efficiently invest your money.
Matt: [00:05:28] You make such a compelling case for why this is good. I'm going to go ahead and dispense with the idea that I'm going to end up, turned into a battery. And Keanu Reeves is going to have to save me, but there's like this massive, but dot.dot lingering at the end of your sentence of, wow. These things are really great.
You say that your view has changed? So what is the, but why has your view begun to change on the value of these robo advisors?
Mike: [00:05:59] so the reason my view has changed is twofold. One. The robo-advisors have been changing a little bit in the last couple of years and specifically more recently. And let me, put some, brand names to what we keep saying. Robo-advisors these are things such as wealth, front, betterment, Schwab, intelligent portfolios.
So people have that in mind when we're saying to you the words, robo advisor, where you put in a hundred thousand dollars and it automatically spreads it out and rebalances it and you can add and subtract money very easily. a portfolio, spread across all these things without even having to think about it.
So one why is my view change one, they've changed a little bit, what they continue to do. And secondly, as I've worked with clients, I see that There's too much activity within the portfolio. And it's hard to for you as a client or me as an advisor to efficiently design the ins and outs, taking money out or putting money in is not really a big deal, but taking money out becomes very.
Tricky in terms of trying to save the most in taxes, capital gains, keeping your portfolio efficient between your 401k and the robo portfolio, things like that. It's becoming a much more of a minefield to tiptoe around and I see them adding lots of complexity and complexity is never good for the club.
Matt: [00:07:22] All right. Let's break that down a little bit. Cause there's a lot of interesting stuff in there. So, First of all you mentioned taxes and costs. what's that all about? what are the sources of some of those? I mean, Both sound to me like categories of, I've got to pay more for this service.
Mike: [00:07:41] Yeah.
so it's an interesting one, Matt, because you think. The marketing materials and how we started off the show. It sounds amazing. You put in $10,000 or you put in a hundred thousand dollars and boom, a couple of clicks of the button. You've got a really nice portfolio. And so it all starts off really well.
So that's great. I love that part. The problem is now that you've got a hundred thousand dollars portfolio across 10, 20 different things, it's getting automatically rebalanced as the market shift. Now, rebalancing is good. You want to keep, if you decide you want 70%. In stocks and stocks really take a dip.
So your portfolio is now 60%. You want to bump that back to 70%. That makes sense. The problem is that these systems end up doing a lot more trading than you would expect. And I'm not saying just like a dozen trades, I'm saying hundreds of trades. So you get your statement at the end of the year. And your eyes will start rolling.
Wait a sec. What are all these trades? And each trade comes with costs. Every trade has costs associated with it. And especially when we get to taxes. Now, taxes are something that we don't think about a lot, except about once a year, because first of all, we hate thinking about it. And it's way too complex.
All right. But these systems, if you think about it, they're , a robo that's constantly tweaking your portfolio potentially. Making lots of trades, all those have tax implications. And so I've seen portfolios having to spend 30,000, 50,000 in taxes alone, at the end of the year, looking back through all that report and saying, oh Yeah.
I've got capital gains of X, Y, or Z.
So there's two problems with that one, all the trading and the costs. And then from the tax perspective, you get capital gains and you really are missing out on tax planning opportunities because the robot knows nothing about you.
Matt: [00:09:27] wow. That's that does sound like quite a lot. And that kind of ties into something you were saying. Earlier, which is that sounds pretty complex. There's just a lot going on. And you said complexity is not good. Tell me more about that. are the problems? Complexity?
Mike: [00:09:48] well in general only chuckling because complexity is never good for the client. All right. If you can't really understand how something is happening, trust me, the person across the table does understand it and it's in their favor. Okay. So you really want to understand exactly how things are happening.
The portfolios are generally recommended between five to 10 different low cost index funds spread across, U S market international market. Bond market, things like that, really big classes. So five or 10 things that might be even a little too complex for people at home two or three is actually. Now these robo-advisors are going 10 to 20 things and they're constantly trading them to keep them in balance. All right. So now we're getting a lot of complexity and trading and balance, but recently what has happened is they're getting more complex. They are trying Matt to beat the market in certain ways.
Hey, here's the most efficient, modern portfolio theory thing that we should be doing. And so they're adding even more trades. And more complexity to the portfolio and marketing it as, Hey, this is the most efficient thing, and that's not really true in the real world when you're a real human being and your portfolio is there to grow and invest and then eventually use it's not always about being most quote unquote efficient based on academic research it's to live your life, and complexity becomes overwhelming.
Let me give you one real world example. Recently there's something called direct indexing. All right. So, you know, Matt, that you can invest in the S and P 500 for pennies on the dollar. Sorry, fractions of pennies, you can invest in all 500 companies, one low cost index fund. You own all 500 companies and they manage just owning those companies for you.
And it costs you almost nothing. Instead, Matt, you could buy all 500 companies. All right, now, imagine there's software that would allow you to do that. You could imagine that pretty easily. Oh, I can click a button and it would take my a hundred thousand dollars and buy all 500, individual companies, all 500 right. software could do that pretty easily. This is called direct indexing. Why would you want to do. Okay. The reason, one reason why you might want to do that is something called tax loss, harvesting, which we talked about before, some of those companies go down in value. So over the year 400 of them go up, but 100 them went down.
So overall you made money, but 100 of your positions went down in value. You could sell those, use it as a loss to offset the gains and pay no taxes. That sounds amazing. Mike, why wouldn't I do that?
Matt: [00:12:14] No, why wouldn't I do that?
Mike: [00:12:16] Yeah, exactly. Now you own 400 companies. You sold off the hundred that?
you saved, Right.
So now you own four, by the way, Matt, you now own 400 different individual positions in your portfolio. When you get your statement, I'm sure that looks pretty and you sold off the a hundred for losses. You didn't pay any taxes this year. Now everything's in 400. So what happens next year? Eventually your losses, you no longer have you sold them off.
So over the years, you no longer have losses, but you still have 400 individual positions, all moving different directions.
So now you have a lot of complexity. How will you eventually sell those? Matt? I want to use some of that money. Which one are you going to sell?
Matt: [00:12:50] I choose to sell Google because
Mike: [00:12:54] Cause it's the one, one. name you can recognize.
Matt: [00:12:56] Availability bias. I think they call it.
Mike: [00:12:58] Exactly. So you're quickly getting a picture, the complexity, which one's gone up where the taxes. Now again, you could say software will solve this. Used to rely on the or human advisor, for helping you to make choices and stuff. Now you're relying on the software program and then being around an in five years and 10 years.
And when you retire, knowing your tax situation, how are your taxes going to be spread out over various time periods? I'm not working for a while. My taxes are very low and then I've got RMDs and my taxes are really high. Does the robot know all that stuff? So now you can see there's a lot of complexibility to financial lives.
You really want to keep your portfolio as simple as possible so that you can manage it based on your life.
Matt: [00:13:39] want to pick. Something else you said in there, which is you use to rely on your financial advisor and something you've really stressed in the past on this show is the importance of having a financial advisor. Who's a fiduciary who has your best interests. That is their legal obligation to follow your best interests.
And I'm wondering, I really have no idea about this. Are the robots fiduciaries for you. And by that, what I mean is if I could easily see the company that owns this robotic system, having an incentive to churn through more trades and it may achieve an optimal portfolio, but as you were suggesting a moment ago, In the course of it in the course of all of that churn and the fees and the tax position that you're putting yourself into, it may not be best actually for you as an individual investor.
So is there any consideration of that with these robo-advisors that the firm that owns them is in a fiduciary position with you?
Mike: [00:14:48] Yeah they would have to be a fiduciary in some stance because they're holding your money now. Human's not making recommendations for you. The robot is so it gets murky. And honestly, Matt, I don't know the answer because there's brokers and dealers have a different standard than financial advisors.
Financial advisors have to be a fiduciary for the client. That's sitting across them. Brokers and dealers have a best interest standard. They have to recommend things that are in your best interest. But not necessarily the fiduciary standards. So there are two different standards that the public really doesn't understand why I don't understand cause I barely understand it. Okay.
So it's super confusing. The robot does, I will say this, it's trying its best to make the most efficient portfolio for you to get the most amount of money. The problem is. That, that can also lead to a lot of money for the company. Like you were saying, the churning and the spreads and all the costs and fees.
And also it can add so much complexity to your life that you will end up shrugging your shoulders, not understanding it and have to hire people or pay lots of taxes or whatever the situation may be. Let me give you an example. before I say that, let me also say I'm not necessarily recommending you need a financial advisor.
You can get a target date. All right. We've talked about these. This is a one fund that has a mix of stocks and bonds. And it's super simple because it's literally one fund and you can put your money in there and be massively diversified. And there you go very tax efficient. So I'm not saying, oh, you need to run out and get a financial advisor or anything like that.
There are other options for doing this, but let me give you one scenario. I've run into again, back on the tax planning and financial advisors are understanding your situation. If I have a client that's currently in a nice job at Facebook or Google or Amazon, making really good salary. So they're in a high tax bracket, but I know my client's going to leave that job and take a year off, travel the world, or maybe start another company, before coming back, I know their taxes next year will be very low.
They're taking a year off, having almost no income. Since I know that there's lots of planning opportunities I can do the robot, doesn't know anything about that. And I've run into this situation. The robot has sold positions to rebalance, and my clients had to pay tens of thousands of dollars in capital.
Why would you do that? Tens of thousands of dollars. When I know next year you'd pay $0 in capital gains or much, much less to rebalance. So there's a simple example. And then retirement is the other one. Robots don't know you're going to retire next year. So they don't know to stop selling things. Let it get a little bit out of balance.
For a year or two in order to save tens of thousands of dollars, literally tens of thousands in taxes in the following year. So there's just a couple of simple examples where knowing your individual situation can save you tens of thousands of dollars, but only If you don't have this complexity, that's just going to be really difficult to unwind.
Matt: [00:17:42] If I'm not in one of those situations where I'm about to take a year off or I'm about to retire, let's say, I assume that things are going to be pretty much the same for me for let's say the next five years. And I'm looking at a target date fund versus a robo advisor. Can a robo advisor really achieve a better return through a more optimal portfolio?
Versus a target date fund or is the rebalancing that much more efficient that I'm going to see a difference there?
Mike: [00:18:19] All right. That's the simple answer right now, what I would look at is If I'm in this situation, I'm going to be going 10 years, 20 years, I'm working. I'm just adding money to portfolio. That seems like a good use case for robo-advisor let us do it thing.
Keep everything very efficient, invested. What's nice about both target date funds and robo-advisors, they keep everything invested constantly. So it gets you out of your own. So that's a huge win right there. I used to say, Yeah.
go with the robo-advisor. It's fine. They do a really good job.
They keep you 90% into the stock market. They keep it rebalanced and efficient. You can just add money to it's great. I'm now more concerned that in 10 years or 20 years, Your portfolio would be way too complex that you would have to, hire people or do something to unwind it, or what happens with that technology.
If some other company comes along and buys it, I now am Erin more on the side of using target date funds in taxable accounts, just use a target date fund instead. It's going to get you the same return. Okay. Now of course, one of them is going to get you a better return. I don't know which one, but essentially that they're 80% in the stock.
Then you're going to get essentially the same return over the next five, 10 years. The only thing I would now recommend a robo-advisor is within a tax deferred or tax free account. So 401k an individual retirement account there. I don't care as much about the trading because you don't have any capital.
You're not paying taxes. It's all tax deferred and you can easily unwind if it is direct indexing and you own a thousand positions, you could sell all of them and have zero tax implications and just go back to something super simple down the road. So there I'm less concerned because you can always unwind it very easy with no tax implication.
Matt: [00:19:58] So let's say I'm listening to this and I've got a robo advisor right now, and I'm getting a little concerned that maybe this isn't the best thing for me. Plus the robo-advisors started making inquiries about getting the nuclear launch codes over at the Pentagon. So I'm getting a little bit nervous.
What should I do?
Mike: [00:20:14] I would recommend looking at that and probably trying to get out of it at this point. Yeah. Which is sad for me to say, cause I really do like the idea of, so I love software. I love technology. That's my background, but it's now getting too complex. And so I would say I would probably sell out of that and just get an individual target date fund or just the S and P 500 fund.
You know, if you're looking 10, 20 years, you could just invest it a hundred percent in the stock market S and P 500 or us stock market fund one thing set and forget it mutual funds. You can also add too. So if you're in a situation you're adding a hundred dollars a month into that, you can do the same thing with mutual funds set that up.
So it works exactly the same way. And I would go that route.
Matt: [00:20:53] Okay. Definitely call the department of defense and get them to check on what the heck that robot is doing. Mike Morton, this has been very eyeopening. I actually don't feel a sense of terror about robots, but I see what you're saying about some of the concerns. So thank you for illuminating us about some of the changes to robo-advisors and some of the reasons maybe we should all be a little bit more cautious.
Mike: [00:21:15] thanks, man. It's great. Thanks for joining us on financial planning for entrepreneurs. If you like, what you heard, please subscribe to and rate the podcast on Apple iTunes, Google play Spotify, or wherever you get your podcasts. You can connect with me on linkedin or mortonfinancialadvice.com. I'd love to get your feedback. If you have a comment or question, please email me at firstname.lastname@example.org. Until next time thanks for tuning in.