Betterment CEO: Robo Advisors Prevent Errors

July 14, 2014

Jon Stein also says retirees want and like automation as much as millennials.

It turns out that automated financial advisories are not just for the younger crowd. There’s no question that these service providers, such as Betterment and Wealthfront, have a clear following among the younger generation of investors who, having been through two market downturns already, embrace low-cost passive automated ETF portfolios as a long-term solution.

But it’s increasingly evident that retirement-age and near-retirement investors are also jumping onto this bandwagon, Jon Stein, CEO of Betterment, told us in an interview. According to him, they too want low-cost simple solutions to ensuring that they will have enough money through retirement. And why shouldn’t they? As Stein points out, automation helps protect investors from giving in to their emotions and making mistakes that can cost them serious money.

Betterment should know it. A pioneer in the space, having launched in 2010, it now boasts north of $700 million in assets under management. The firm, which has been expanding by roughly fivefold a year, only sees the pace of this growth picking up steam ahead. How did Betterment come to be?

Jon Stein: My background is in economics and human behavior, and I was always fascinated, on the one hand, with how valuable rational economic decisions can be for us. I became interested in investing, and thinking about the long term, etc. On the other hand, I was fascinated with how crazily irrational we often are as humans—how many bad decisions we make, and how we get in our own way.

I found in my own investing that even though I studied economics, earned my CFA, and was consulting banks about their investing practices, I was making some of the same common mistakes that I should have been smart enough to avoid.

One of my first investments was Enron, and, of course, it went to zero. I should have known better than to be buying individual stocks, but there I was making these same common mistakes. I had about seven different brokerage accounts. I had tried everything else out on the market. I had read every book on investing.

None of the accounts did everything right for me in a sensible way. I was looking for the simple elegance of an “ING Direct” and the investing efficiency and savvy of a Vanguard. I just found that nobody put it all together in a well-packaged, well-aligned-with-the-customer kind of a way.

So, I sought out to build it and brought the early team together. We started out with a very simple portfolio of just stocks and bonds. It was fewer ETFs than we have today. Over time, we’ve become more and more sophisticated, and we now have a full investment team, and we have external advisors who advise on our portfolio allocations and the advice we give customers.

But that core mission is still to be aligned with our customers; be transparent; and help them achieve the best returns possible. If you’re an investor and you come to Betterment to sign up, how does the process work? How do you find the right portfolio?

Stein: Typically investors come to us at the recommendation of a friend or family member, and they tell us about their goals. These goals can be things like saving for retirement or saving for a kid’s college, or it could be simply, “I want to build wealth” or “I want to set up a safety net fund”; things like that.

Based on those goals and the time horizons to their goals, we recommend an optimized portfolio for each goal. So, you can have multiple different subaccounts or goals, as we call them, in your Betterment account, each properly allocated.

Over time, we will manage that portfolio, which is all ETFs, for tax efficiency. We’ll rebalance it for you; we’ll make sure that the lowest-cost ETFs are in there and that every transaction is tax optimized and so on. How do you reassess that portfolio allocation given that investors’ sentiment toward risk can change overtime?

Stein: Think about it like a personalized target-date fund. Target-date funds are the most popular option in 401(k)s these days, and they’re often bucketed at around five years. If you’re going to retire any time between 2045 and 2050, there is one target-date fund for you and a million of your closest-aged peers.

Our approach is much more personalized. We’ll have a recommendation that’s based on when you want to retire and how old you are today, but also based on your other goals. That recommendation will change over time.

As you get closer to retirement, we’ll start recommending a more conservative allocation. We’ll show you in the app exactly what you have to do; not only how to allocate, but how much you should contribute.

Once you’re in retirement, we have a product that tells you how much you can safely withdraw each month from your portfolio, and we’ll automatically withdraw that amount for you such that you’ll never run out of money. It’s a pretty sophisticated, full-life, end-to-end investment management system. Some say that investors who turn to automated advisories are really looking for long-term, low-cost investing as opposed to outperformance. Do you see that in the Betterment client?

Stein: I think anyone who reads the same articles you and I read has an understanding of market dynamics and would agree that it’s essentially impossible to outperform the market, unless you have better information. That information can come in the form of deep research. It can come in the form of insider information. It can come in the form of faster execution than other market participants have. But it’s impossible for the average retail investor to beat the market.

From our perspective, we do everything that’s sensible for the average retail investor to get an edge, and a lot of that comes down to tax efficiency, it comes down to automation, and it comes down to controlling human behavior such that we don’t get in to our own way, and make bad decisions that harm our own returns. Do you think automation is the best cure for irrational investing?

Stein: Yes, I do. That’s a good way of saying it. Do you have a preference for a specific ETF provider? How do you go about picking the right ETFs?

Stein: We have no preference for ETF providers. We look at what are the lowest-cost ETFs in each asset class, and rank every ETF that is available based on the expense ratio, based on the trading spread, and based on tracking error. Through that ranking we choose the top as the primary ticker, and then we choose a secondary and tertiary ticker, which we alternate people into when we’re doing tax-loss harvesting or transactional tax optimization. Who is your main competitor in this space? Is it a firm like Wealthfront?

Stein: We clearly have similar missions, but I see this market as being so big that our competition really is the firms from where our clients are coming. We get the most customers from Vanguard, from Schwab and from Fidelity. That’s our real competition. How does Betterment differentiate itself from its competitors?

Stein: This is how we are different from the standard Vanguard, Fidelity, Schwab: We are an advised account, whereas they are not providing advice. They are basically supermarkets where you have thousands of different choices, and it’s up to you—the customer—to figure it all out and then to do it.

Relative to them, we’re a more advised—and automated—solution, which means you’ll get better returns, you’ll have a better customer experience, because you’re advised along the way, and you’re more likely to actually reach your goals than by using a do-it-yourself method.

It’s also lower cost, so it really wins on every count, and that’s because we are built on newer technology and we don’t have to deal with the legacy system and infrastructure that those firms do. Do you focus on millennials as your core client base, much like Wealthfront does? Who is the Betterment client?

Stein: We have a lot of customers in their 30s and 40s, and I think our average age is something like 36. But make no mistake; we have a lot of customers who are older as well. In fact, 20 percent of our assets come from customers over age 50, and that number is increasing because of our retirement product where we’re actually telling customers how much they can safely withdraw, and withdrawing that for them, so that they will never have to worry about running out of their retirement savings. Should this segment of automated financial advice continue to grow as quickly as it has so far? Will automated advisories ever fully replace flesh-and-bone advisors?

Stein: I don’t think the goal is to replace flesh-and-bone advisors. The goal is to give customers a better set of tools to manage their money. We’re not out to put people out of work. Our goal is to make sure that the average American has the best possible tools at their disposal to save and invest for the long term. Historically, these tools have only been available to the extremely wealthy, and we’re making them available to anyone. What are the biggest risks an investor faces when opting for an automated investment service?

Stein: I would look at it the other way: What is the risk of not doing so? The risk is that you’ll continue to have suboptimal returns, and you’ll continue to underperform, and anyone who doesn’t come over quickly is just wasting time. Do you think passive management and ETFs are at the center of the success in automation?

Stein: Definitely. It’s like a smartphone compared to an old flip phone. It’s just so much better, that, once you experience it, you wonder why you didn’t do it sooner. Is there anything in this industry that still surprises you when it comes to investor behavior, or to what solutions resonate with investors?

Stein: One thing that was surprising to me was just how many older customers were interested in our service right away, and because of that, we started building products for them.

It was great to see that it wasn’t just college students who wanted the best tools; it’s everybody who wants them. And I’ve been to rooms full of retirees who say, “We want these kinds of tools as well, and we have just as much to gain from them as anybody, so don’t think you’re just selling them to young people.”



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