Duke University behavior economics professor Dan Ariely described in his book Predictably Irrational that people give special treatment to zero more than the number itself deserves. If good-tasting chocolate costs $1.25 and bland-tasting chocolate costs $0.25, some will go for the better taste and some will go for the cheaper price. If good-tasting chocolate costs $1.00 and bland-tasting chocolate is free, a lot more people will go for the now free bland-tasting chocolate even though the price difference between the two is still the same.
We see this effect alive and well in the reaction to Schwab’s new automated investing product Schwab Intelligent Portfolios.
In the previous article Schwab Intelligent Portfolios: “Holding Cash Is Good For You” I said I wished Schwab didn’t mess with the cash part, because it was bad optics, giving its competitors something obvious to point to, not necessarily because including cash as part of a diversified portfolio is so bad in and of itself.
Schwab apparently vastly underestimated the special power of zero. It’s taking some irrational beating from both competitors and the general public.
The Power of Zero
Zero plays three roles here:
1. Cash invested in a money market fund has zero fluctuation. It feels not invested, even though a money market account is an investment. Not too many years ago money market fund yields were above 5%. I wrote an article on which money market fund to pick. It was popular enough to attract the attention of now New York Times columnist Ron Lieber (then at Wall Street Journal).
2. Cash has zero yield now. 0.01% or 0.10% is not exactly zero but close enough to zero that people treat it as zero. Yet somehow 0.9% or 1.05% is considered “high yield.” People hate earning zero on their money.
3. Schwab’s product was supposed to be zero fee above normal ETF expenses, but now people see that Schwab is making money from lending out their cash. People feel cheated and violated, as they do when they find out the free chocolate they are gunning for costs $0.25. No matter how good a deal $0.25 is, people only remember it’s not free.
Perceived Opportunity Cost
All of sudden people demand a return on their cash, not just 1% as in a high yield savings account, but 6% or 8% as in a diversified investment portfolio of stocks and bonds, or even 10% or 12% as in all stocks! Here’s a comment on my previous article from a reader:
“The 6% in cash at 12% opportunity cost amounts to an equivalent ER [expense ratio] of 0.72%, at 8% opportunity cost an equivalent ER of 0.48%.”
I can understand this sentiment from the general public. The puzzling thing is that people who should know better also follow the same logic. Wealthfront CEO Adam Nash wrote an article criticizing Schwab for having strayed from its founding values. Mr. Nash wrote (bold as in the original):
A 25-year old investor who is just starting out, making $65,000 per year and saving 10% annually, could end up with over $138,000 less in retirement due to having a 6% cash allocation in Schwab’s Intelligent Portfolios.
This is true only if the 6% cash allocation would otherwise be allocated to stocks and bonds, in other words, comparing a portfolio of 77% in stocks, 11% in bonds, 5% in commodities, and 7% in cash as shown in the image below with a portfolio of say 83% in stocks 12% in bonds and 5% in commodities. More money invested in stocks leads to more money in retirement.
Even I as an amateur investor know the proper comparison should be against 77% in stocks 18% in bonds and 5% in commodities. Cash is just a form of very-short-term bonds. Otherwise the same logic will say one must invest 100% in stocks, because bonds have a lower expected return, or else our 25-year old could end up with hundreds of thousands less in retirement again.
Betterment’s Director of Behavioral Finance and Investments Dan Egan wrote in The Real Cost of Cash Drag:
For illustrative purposes, let’s have a look at Schwab’s recommendation for “Investor 2”, a 40-year old with moderate risk tolerance. The portfolio is 61% stocks, but you’re forced hold 10.5% cash. A Betterment portfolio at 61% stocks, with no cash drag, has an expected annual return of 5.8%. Let’s generously assume that cash returns 1% annually (currently, it’s much less than that). With 10.5% of your assets on the sidelines, the effective cost would be 0.5% in lower expected returns every year.
0.5% is calculated by 10.5% * (5.8% – 1%) = 0.5%. This calculation ignored that the 89.5% non-cash investments at Schwab are invested 68% in stocks (61 / 89.5 = 0.68), which has a higher expected return than a portfolio at 61% stocks. It also ignored that the stock ETFs at Schwab have more in small caps than the ones at Betterment. More in small caps creates a higher expected return and a higher risk, which may very well take the low-risk low-return 10.5% in cash to balance out. If we assign a 6.4% expected return to the 89.5% non-cash investments, we are back to even.
Evil Schwab vs Benevolent Vanguard
Vanguard is highly regarded in the investment world. Mr. Nash at Wealthfront praised Vanguard as the kind of company Wealthfront aspires to be. In a Vanguard Target Retirement fund that invests 80% in stocks, Vanguard allocates the 20% non-stock investments as 16% in US government and corporate bonds and 4% in international bonds (soon to be 14% and 6% respectively). Schwab allocates its 20% non-stock investments as a mix of US high yield corporate bonds, international emerging market bonds, gold, and cash.
We can debate which bond mix will have a higher risk-adjusted return when combined with the 80% in stocks. The answer isn’t that clear to me, especially when Schwab’s 80% in stocks also have more in value stocks and small cap stocks.
For someone retiring in 45 years, Vanguard’s Target Retirement 2060 Fund tops out at 90% in stocks. If you answer Schwab’s questionnaire with the most aggressive risk tolerance, you get a portfolio 94% in stocks 6% in cash. It isn’t that clear to me whether an investor is better off with 10% in bonds or extra 4% in stocks plus 6% in cash. The answer becomes less clear if you throw in more value stocks and more small cap stocks among the other 90%.
One thing is clear to me: I haven’t heard anyone say Vanguard has a hidden cost of 0.6% due to a “bonds drag” because stocks have a higher expected return than bonds. Only cash drags, but bonds don’t. Is that it?
It takes a much more nuanced discussion to say which approach is better. The public of course has no patience for nuance. They only hear the sound bite “cash is not invested” which really translates to “cash is not stocks.”
I like Wealthfront and Betterment. I think arguing against Schwab Intelligent Portfolios with obviously exaggerated numbers actually makes them look bad. I still believe it’s not about Wealthfront vs Betterment vs Schwab vs Vanguard. It’s about all of the above versus not investing, chasing hot stocks, timing the market, high management fees, being sold inappropriate life insurance and the whole nine yards.
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TJ says
Do you think that the increased bid/ask spread on the Schwab product is a meaningful difference in cost vs the primarily Vanguard ETF’s that Betterment & Wealthfront use?
Harry Sit says
TJ – I don’t think it’s a meaningful difference in cost because it’s a one-time cost and it will come down as trading volumes increase.
TJ says
@TFB – I was thinking in terms of rebalancing among the various ETF’s, but I think you’ve pointed out that rebalancing is fairly rare because of the way the market tends to move.
Harry Sit says
TJ – Someone reported that Schwab said they are using a +/- 2 percentage points band for rebalancing each asset class. If that’s accurate, given that many asset classes, it will take a very large swing for an asset class to go from 14% to 16% or 12%. It’ll be more difficult for a 4% asset class to reach 6% or 2%.
TJ says
For me, since I only want a robo to deal with the equity portion – Schwab doesn’t make sense because of the forced cash holding. If it was Schwab’s allocation with no cash and a 15 bps fee vs Betterment, I’d probably pick Schwab, but as it is set up currently, I’d go with Betterment if I had to choose between the two. I’ll probably end up going with neither. 🙂
Andy says
Actually, it is a two-time cost: at buy AND sell time. Depending on your holding horizon, it could be significant.
If you have a .30% Bid/Ask spread on a Schwab fund (an amount I have seen quite frequently), then you pay .30% extra going in, and lose .3% going out. If you’re talking about a fund with a .20% annual cost ratio, then, you’re essentially paying 3 years of extra fees to hold it. It’s not huge, but if you only hold it for a few years (4, let’s say), it doubles the cost of the fund.
Grant says
Excellent point. Refreshing to see a bit of common sense on the matter.
Sam Seattle says
Another excellent post, Harry.
jan says
My problem with the cash would just be that, I already hold cash in an emergency account. Whatever I invest should be invested in anything but cash. Else it just creates overlap.
Andy says
The problem with thinking about Schwab’s enforced cash holding as being the same as your “emergency cash” holding is that if you need cash, you can’t really use the Intelligent Porftolios cash without consequences. If I have 6% cash balance, and I suddenly need a downpayment for a medical bill or a house, then what happens when I remove the 6% cash? Presumably Schwab then rebalances to restore 6% of the slightly reduced portfolio. Most of this will come from stocks and bonds, so you are essentially selling stocks and bonds to fund your emergency cash needs. This can force you to sell at an unfavorable time. It isn’t really an emergency stash. It is a failure to fully invest your investment funds.
And it is made worse if it is in a retirement account, where your lack of cash earnings just wastes years that it could be earning tax-free retirement income. Inflation is eating at it all the time, and you need to earn on it to not fall behind.
dan23 says
Good post. I thought the Wealthfront post was particularly low class and reflected poorly on the CEO. My thoughts on Schwab is the expense ratio is roughly the same as Betterment (somewhat better or worse depending on how you count the cash), with a high percent fundamental weighting ETFs which may have added value, but their motivations in recommending cash are wrong which creates mistrust.
While 6% cash may make perfect sense in a portfolio as a 100% safe non-correlated asset you rebalance to and from, I doubt that is the case for their entire range of cash allocations (vs bonds), and you know their motivation is the spread they earn on the cash, so it is hard to trust them.
Having said that, I am ok evaluating a product on its merits and not on the motivations of the creators and I would still choose Schwab over Wealthfront, at least for aggressive allocations – I like their fees and allocations betters. Less sure with Betterment which I would choose.
I would love to see returns and standard deviations of rebalancing portfolios either monte carlo or historical with some allocation cash vs bonds. I suspect historical is where you might really see some value (some asset classes with low correlations aren’t correlated until they are – cash would not fall to this).
Harry Sit says
dan23 – harikaried on the Bogleheads forum poked out all 12 model portfolios. Cash goes from 6% to 15% in 10 “reasonable” portfolios (94% equity to 28% equity). More cash in the last two most conservative portfolios (21% equity and 12% equity).
http://www.bogleheads.org/forum/viewtopic.php?p=2421047#p2421047
awef says
If 10% of a portfolio is cash and earning 0.9% under what it could be elsewhere for the same risk, that’s a fair price to pay for a service like this, under what Betterment and Wealthfront charge.
The bigger issue to me is the heavy allocation to fundamental index funds with higher ERs around 0.3% and up. I think it’s something like 60% of equities in fundamental indexes? That should be the real deciding factor for someone, how much they believe in these.
There’s long-term uncertainty about potential index changes over time as well. The more funds they have, the more likely it seems they might be changing things around in the future. I’d be afraid of what the portfolio would look like in the future, which would mean that the only place to use this service would be an IRA (so as to not get locked into something you don’t like with some capital gains). But the real draw of robo advisers is the tax loss harvesting, so it kind of defeats the point.
Then again, I doubt I was really the target market for this deal anyway. It can reasonably appeal to a lot of investors, I think.
B says
The only reason I could possibly recommend Schwab accounts for is for conservative investors who would otherwise hold a money market portion in their account. If you were going to hold money market funds anywhere, you might as well give Schwab the benefit and take from them free “robo services”.
But I really think this whole Schwab debacle has left a permanent negative brand perception. Honestly, I was seriously thinking of moving several family accounts over to them from some robos and other brokerage accounts. Now I can’t imagine ever investing in a Schwab product again.
RYAN says
Thanks for the very detailed and balanced evaluation. It seems to me that a lot of folks are seeing the more simplistic responses to the product (i.e. “your cash position should earn you another 6-10%”) and don’t understand the nuances you point out. I have most of my investments at Schwab in IRAs (invested in super-low-cost Schwab ETFs with ER’s in the 0.04-0.1% range), and a Wealthfront account for after-tax investments. I appreciate the more balanced view you present, which has helped to shift the way I think about the comparison.
And at the end of the day, you’re absolutely right- the real comparison should be with a lack of investing and other stewardship of your personal finances, vs arguing about a very slight differential in fees/costs/methodologies.
Matt says
10% cash out of the market during a 10% return year is a 1% loss. That’s a lot! If it was 20% cash it would be a 2% loss! There’s your hidden fee.
Harry Sit says
Are you saying people shouldn’t invest in bonds? If you invest in bonds are you also paying a hidden fee?
David says
I find that I do not save enough cash and am often 100% invested. The Schwab Intelligent Portfolio seems to offer a benefit to one such as myself. If the market corrects, or goes into bear market territory, I know that there is 6-15% cash that can be used to rebalance the portfolio. They will never (as I would do) invest all of the cash on hand when there is blood in the streets, because they are rebalancing to 6-15% cash.
If you use WiseBanyon and give them all of your investable cash, when the market tanks, you have nothing with which to “buy more”. On the other hand, it should not be difficult in theory or practice to maintain a cash reserve that is equal to whatever percentage of your invested assets you like, in which case you may be better off at WiseBanyon as their average operating expenses are somewhat lower than Schwab, given the lack of fundamental investment options.