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.