How to use Robo-Advisors correctly

In all these years, I have been asked multiple times on my opinions about Robo-Advisors like Betterment and Wealthfront. In general, I think they are great options for people who just get started without a lot of money to invest. They can also be used by experienced people or even professionals to manage a portion of their portfolio. After all, a Robo-Advisor is just a portfolio management tool to help us invest. The question comes down to if you are using it correctly or not. From what I know, many people are probably not. 

A little background first. As a fee-only financial planner, I am consistently looking for new things that may benefit my clients, including Robo-Advisors. The best way to figure out something new is to try it out by yourself. A few years ago, I opened an account with the two largest Robo-Advisors at that time and invested a small amount of money in each of them. I decided to move my money out last year, but I'm still following the new features they are adding to their platforms.

Based on my knowledge and personal experience, I recommend you to consider the following things when using Robo-Advisors. 

1. Consider your complete risk profile. 

Your complete risk profile should take into consideration your willingness to take risks, your ability to take risks, and your need to take risks to achieve your financial goal. 

The risk questionnaire from most Robo-Advisors only assesses your willingness and your ability to take risks but not your need to take risks. 

Why it matters? Let's see two examples.

Example 1, Tom has a stable job earning way more than he spends, and he has saved enough to cover all his future needs, including his retirement. He understands the trade-off between risk and returns and would like to chase for higher returns by taking more risks. The risk score from a Robo-Advisor's questionnaire is very high, based on his willingness and ability to take risks. However, in my opinion, he probably shouldn't take more risks when he already won the game. 

Example 2, Kate also has a stable job, but she spends most of her earnings. She is very conservative when it comes to investing, and she keeps all the money in her savings account. The questionnaire gives her a very low score for her risk profile. To achieve her retirement goal, she probably needs to cut some spending, try to make more, invest a little more aggressively or do a combination of these things. In other words, she will definitely not be able to achieve her retirement goal by only investing in the way recommended by the Robo-Advisor. 

2. Consider all of your assets.

In my opinion, investment decisions should always be made based on everything you have, or at least everything you have for a specific goal. For example, it doesn't make sense to me that if I do not consider the money in my 401(k) when determining how to invest my money in my IRAs and other taxable accounts saved for retirement.  

Most Robo-Advisors cannot adjust their portfolios based on how you invest your outside money. In other words, if you think the portfolio recommended by the Robo-Advisor is the best, you should adjust your outside money accordingly. For example, many people invest their 401(k) money in a default target-date fund. The target-date fund may be totally off compared to the portfolio you get from a Robo-Advisor in terms of investment philosophy, asset allocation, internal cost, etc. You need to adjust your investment options in your 401k and make it consistent with your overall investment plan for retirement. Also, it doesn't mean that you need to find exact or even similar investment for each asset class in your 401(k). There may be a better and easier way, which we will talk about in the tax section below.  

Another common example here is your home equity. In my opinion, the equity of your home should be considered as your investment in real estate. Some Robo-Advisors includes Real Estate Investment Trusts (REITs) as one of their recommended asset class in their portfolio. You may not be able to make adjustments since most Robo-Advisors don't let you customize their portfolio. In that case, you may want to change to a different Robo-Advisor. Just watch out the tax consequences when switching, which we will talk about in the tax section below as well. 

3. Consider your taxes.

Robo-Advisors are trying their best to improve the tax-efficiency of their model portfolios by using some general strategies like Tax-Loss Harvesting (TLH), asset location coordination, etc. However, everyone's tax situation is different, period. I really don't like the word used by most of them in their marketing - "Optimize." It's very misleading since they are trying to optimize the tax-efficiency of their portfolio in general rather than optimizing your tax situation based on your specific situation. The limitations on handling different tax situations are also the main reason I decided not to partner with one of the biggest Robo-Advisor for my clients. I can offer it at a lower cost than a retail consumer would have paid, but it's not in the best interest of my clients.  

Here are some examples. 

Example 1, many Robo-Advisors use Federal municipal bond funds in their portfolio for taxable accounts and use corporate bond funds for tax-advantaged accounts like IRAs. Their reason behind it is they think the after-tax return of the Federal municipal bond funds is always higher than the corporate bond bonds in a taxable account for everyone.  This is not always true. It not only depends on the specific type of bond fund they are using but also depends on your individual income tax brackets. Let's focus on the tax part here. If you are under the highest federal income tax bracket, it may be true. On the other hand, it may not be the case if your Federal marginal income tax rate is lower than 32%. Also, if you live in one of the states with high state income tax like CA and NY, you may want to consider only investing in municipal bonds issued by your own state rather than all states since the interests are exempt from state income tax as well. Since most Robo-Advisors do not let you customize their portfolio, the way around it is only to let them manage the equity portfolio, and you manage the fixed-income part separately by yourself. 

Example 2, Tax-Loss Harvesting (TLH) is probably one of many Robo-Advisors' biggest selling points when it comes to "Optimize your taxes." I assume you all know how it works. One thing worthing reminding here is that it only defers your taxes, period. So to determine if it benefits you or not, you need to consider your current capital gains tax bracket, what do you do with the amount of taxes saved this year, when are you planning to sell the shares eventually, and your capital gains tax bracket at the time you sell. If you are under 0% federal capital gains tax bracket now, does tax-loss harvesting still make sense to you? Probably not. It is an extreme case, but you get the point. Even though most Robo-Advisors do not let you fully customize their TLH capability, the good news is that some of them at least let you turn it on and off. Consider turning it off when it doesn't make sense to you. 

Example 3, many Robo-Advisors try to minimize your current tax liability when you submit a partial withdrawal request. It sounds good, isn't it? However, it doesn't work that well for people who want to realize more gains and pay more taxes currently. Why would anyone ever want to do that? Because they believe their tax bracket will be higher in the future. To pay fewer taxes overall in the long run, they want to take advantage of their current low tax bracket. In that case, since most Robo-Advisors do not let you choose what specific security and what tax lot to sell when selling, you may want to leave your money with the Robo-Advisor alone and realize gains from your outside accounts first. 

Example 4, in portfolio management, asset location is as important as asset allocation. Different Robo-Advisors may name it differently. The basic concept is to place more tax-efficient investments into the less tax-efficient type of accounts and vice versa. This is another commonly used tax strategy in portfolio management. The problem is the most common type of tax-advantaged accounts is probably the retirement plan at work like a 401k. As I mentioned earlier, most Robo-Advisors do not consider outside accounts when recommending portfolios. So it would be ideal if you could make your investment plan based on all of your assets from both asset allocation and location perspective. For example, based on the asset allocation recommended by the Robo-Advisor, you may want to place fixed-income investments in your 401k and traditional IRAs and put equities in your taxable accounts. This may be better and easier than simply trying to mimic the recommended portfolio in your 401k, which I mentioned earlier above. 

Example 5, many Robo-Advisors try to reduce the tax impact when you transfer your existing investments to them. They try to avoid selling positions with short-term capital gains unless they cannot hold that type of securities. Most of them only hold ETFs. Some of them also hold individual stocks if they offer stock-level TLH. In other words, if you have investments like mutual funds and individual bonds, they will sell it regardless of the tax impact. Also, if you have any embedded long-term capital gains in your existing holdings, they will sell it regardless of the tax impact unless your holding is exactly the same one they use in their portfolio. "Exactly the same" is the key here. Even if you have one ETF tracking the same index, they will still sell it and let you pay taxes unless the ticker symbol is the same. For people who have existing holdings with embedded gains and want to control the tax consequences, you may consider managing those by yourself and transfer the rest to the Robo-Advisor. Don't forget to include the assets not transferred over when constructing your portfolio, as we talked about earlier. It could be hard for many cases, but it's possible. 

As you can tell from above, Robo-Advisors still have some limitations when it comes to customization. I have also made some suggestions to one of the advisor-friendly Robo-Advisors and hope they can add more capabilities to benefit everyone. Having said that, I still think Robo-Advisors can be great options as portfolio managers for people who just start their careers and investing. The dollar value of having a more customized portfolio for them may be limited. On the other hand, with accumulating more and more wealth, the benefit of customizing your portfolio based on your specific situation will become more and more obvious from the dollar amount perspective. Of course, we are only talking about portfolio management here. Financial planning is totally a different story. 

In summary, Robo-Advisors as a whole is just another tool to help us invest. Due to their business model, you probably shouldn't expect a lot of customization or more personalized advice in the first place. Just like everything else, there is no one size fits all. As long as we know what the tool is capable of and what isn't with the right expectations, we can adjust it based on our own needs and make it the best for our own. I hope this blog post can help you have a better understanding of Robo-Advisors. If you are ready to create or adjust your overall investment plan but not sure about the process, one of my previous blog posts, "How to create an investment plan," may give you some general guidance. 

 

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