A Little Experiment

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Things can get pretty crazy when it comes to beliefs.

It seems to me that when you’re devoted to a certain philosophy it’s very hard not to develop a series of blind spots.

When a belief system really resonates with you it sort of becomes a part of you, so any challenge to the philosophy, or any idea that is in conflict with the philosophy, can feel like a personal attack or a threat.

And the only thing more fierce than a single person who believes something deeply, is a group of people who believe something deeply.

Groups of like-minded individuals tend to develop a drive towards orthodoxy. There can become an “us versus them” mentality. And often times there can even be a competition amongst the believers themselves to see who is the most devoted to the common philosophy.

And I’m no different. I have plenty of tribal instincts. I usually believe that my way is the best way. And I can’t help but feel that my own emotionally satisfying ideas are somehow rational.

And in a world where people have beliefs and these beliefs come into conflict with other people’s beliefs, be they religious, economic, political, or otherwise, avoiding conflict can be quite difficult.

I recently came across this phenomenon in an unexpected place. The Mr. Money Mustache forum.

Anyone who has read this blog for any period of time knows that I’m huge Mr. Money Mustache fan. His blog literally changed my life and changed it for the better.

So one would think that posting on a topic there, would be a pretty stress-free exercise for me. After all that forum is composed of like-minded individuals who are interested in frugal living, low-cost investing, and early retirement. As you may have noticed these are all subjects dear to my heart.

Be that as it may, in conflict is exactly where I found myself.

You see, I decided to give my two cents as to why I think Betterment is an excellent investment product, particularly for people who don’t want to manage their investments themselves.

And for this I was labeled a “shill,” a “variable annuity salesman,”and a poor and inane writer. And another writer who approved of Betterment, and disapproved of the name-calling was labeled a “complainy pants ” who contributed only “butt hurt” to the conversation.

Hilariously, one veteran poster claimed that the above labels were not ad hominem attacks.

Not so hilariously, when I responded in kind (I’m no angel), I alone was kicked off the forum for a week by a moderator who just one page earlier have been actively engaged in the argument from the “Betterment sucks” perspective.

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Stay classy Mustache Police.

But honestly, this is all water under the bridge.

People of different beliefs will clash, and clash we did. Life goes on.

I think the interesting part is that the question remains. Does Betterment provide value?

The anti-Betterment folks had made the following argument:

  • Even small fees like 0.15% to 0.35% of assets under management are corrosive to eventual portfolio value.  (And in general I agree.)
  • Betterment adds no value to your portfolio above what you could get from a simple fee free portfolio from Vanguard rebalanced once a year.

And the pro Betterment folks had made the argument that the Betterment fee of 0.15%-0.35% provides real value, and possibly even better returns by;

  • Allowing you to purchase fractional shares so that when you invest $100 in the stock market, $100 will in fact be invested.
  • Automatically rebalancing your portfolio each time you receive a dividend payment or an interest payment or make a new contribution.
  • Providing you with a “set it and forget” multi asset class slice and dice portfolio with good international exposure, as well as exposure to the value and small size factors which have shown to increase returns per modern portfolio theory.
  • Providing an extraordinarily user-friendly interface that is transparent and shows your fees as well as the money invested as well as your percentage return. (People routinely pay extra money for ease-of-use with their computers and smart phones, why would they not do the same for investment products? )

So essentially the anti-Betterment cadre argue that Bettement is all sizzle and no steak (flashy marketing as opposed to real value.)

While the pro Betterment posse argue that there is real value in a well-designed user interface, and that it is quite possible that a Betterment investor could outperform a simple vanguard portfolio investor due to the rebalancing dividend, the ability to have every dollar invested, and improved portfolio design.

And in the week that I was exiled from the Mr. Money Mustache forum I came up with an idea.

Instead of continuing the argument, why not just design a prospective experiment that we can all learn from.

Let’s see how much Betterment’s fees eat away at portfolio performance.

Let’s see if continual rebalancing pays real dividends.

Let’s see if being able to invest 100 cents of every dollar improves returns.

So what I propose to do is this:

In taxable accounts I will make the following investments.

I will invest $1000 in my Betterment account at an expense ratio 0.25%, in an 80% stock/20% bond portfolio.

On the same day I will invest $1000 in a TD Ameritrade account using Free Vanguard ETFs to replicate a modified version of this lazy portfolio from Rick Ferri. (20 % bonds,40 % international stocks, 40 % US stocks)

FerrithreefundUS bond = BND, US stocks=VTI, International Stocks = VT

I will rebalance the Vanguard portfolio once a year at the beginning of January.

And we can just follow the account values going forward to see which strategy outperforms which in various market conditions, how corrosive the fees are, and whether or not the Betterment portfolio does in fact provide increased returns after fees.

I have no idea how this experiment will turn out, but I’m fairly sure it will be interesting, and I can imagine either strategy winning.

But before I make my ETF purchases, I wanted to open up my study design for comments.

Do you think this is a well-designed experiment?

And what’s your best guess about the results of this experiment?

Please leave your comments below.

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19 Responses to “A Little Experiment”

  1. Kat J May 17, 2014 at 4:30 am #

    Fun. Fascinating. I hope you’re still writing and sharing in 13 months and then 25 months from now and that I’m lucky enough to still be reading. (in 13 years your book will have been published.)
    Life is fantastic and what a fun game to play with money. I value your joie de vivire, openness and sense of calling a spade a spade.

    Cheers,
    Kat

    • Miles Dividend MD May 17, 2014 at 11:30 pm #

      Thanks Kat,

      I hope you are right about my writing. No plans to stop now that’s for sure. I enjoy it too much.

      Alexi

  2. Mo May 17, 2014 at 7:09 am #

    I’m interested! I did my own little experiment a while back. I’m curious why you decided on ETF vs an index funds. Maybe you can add 150/mo in order to make it more realistic. This is going to be very exciting to watch.
    thanks for posting. Also your thoughts on the whole herd mentality when it comes to certain view points was very well written. Though I do think that a few moderators make the MMM forum their bullying playground.

    • Miles Dividend MD May 17, 2014 at 11:47 pm #

      Mo,

      I’m very glad that you’re interested in the experiment.

      I chose ETFs because Betterments portfolio is composed entirely ETFs making this an apples to apples comparison. In addition it is possible to trade vanguards ETFs for free on multiple platforms including TD Ameritrade.

      I probably will not do automatic payments into the accounts because I want to keep the experiment simple. I agree that with such an exercise however ,the ability to purchase fractional shares through Betterment would be a big advantage for the Betterment arm.

      Stay tuned!

      Alexi

  3. jstash May 17, 2014 at 5:13 pm #

    I’m the “complainy pants” from the MMM forum. Sounds like an interesting experiment, although I agree with the other comment: if you could add maybe $100 to each fund per month, you could see whether or not the fractional shares and auto-rebalancing at Betterment create a marked difference in performance.

    • Miles Dividend MD May 17, 2014 at 11:55 pm #

      Welcome Jstache,

      My favorite part of the whole “complainy pants” episode was when Mr. Mark claimed that such language was merely jargon for a reasoned critique of your ideas! You’ve got to give the Mustache police points for creativity.

      I agree that your and Mo’s idea of contributing small amounts on a monthly basis would be both more in line with the way that Betterment is meant to be used, and a big advantage for the Betterment farm.

      But I do want to keep it simple, and I don’t want to be accused of creating a home-field advantage by the other guys.

      I’m actually really curious to see how the two portfolios performance relative to each other.

      Alexi

  4. Elaine May 17, 2014 at 8:20 pm #

    Great plan.Do you follow Saverocity.com? He has a similar approach to testing and does similar experiments now and then. Take a peek.

  5. Elaine May 17, 2014 at 8:25 pm #

    PS – http://saverocity.com/products/betterment/

    Matt of Saverocity likes Bettermemt too.

    • Miles Dividend M.D. May 18, 2014 at 12:09 pm #

      Elaine,

      I also enjoy saverocity com.

      And even sort of debated Matt in a prior post:

      http://www.milesdividendmd.com/friction/

      Thanks for checking out the site. We portlandians have to stick together.

      Alexi

  6. David May 17, 2014 at 8:53 pm #

    I have just started reading your blog. Graduating dental student here. How does Betterment differ from Wealthfront?
    I’m interested to see the progress of your experiment! Thanks and keep up the great posts!

    • Miles Dividend M.D. May 18, 2014 at 12:20 pm #

      David,

      Congratulations on finishing your training.

      I have no direct experience with wealthfront. But when I looked into them my thoughts were:

      1. That Betterment’s portfolio was better diversified. (Wealthfront had no small value tilt as I recall.)

      2. It was unclear how the wealthfront portfolio was rebalanced.

      3. Wealthfront touted tax loss harvesting, which is interesting for a high income investor like yourself once you have maxed out your retirement accounts/HSA. Bit it was unclear how this was executed.

      4. Wealthfront was cheaper if you invested less than $25,000, but more expensive if you invested more than $100000.

      Finally, have you checked out White Coat Investor? It’s a great resource for someone in your shoes.

      http://whitecoatinvestor.com/quantiamd-series-part-1-live-like-a-resident/

      Hope that helps

      Alexi

  7. Robert May 18, 2014 at 9:55 am #

    Alexis, goodness knows you and I have clashed here on some beliefs! I think what we do is challenge each other and once we realize there is an area of firmly held beliefs that is unlikely to change without some kind of life changing event or perhaps more of a relationship/conversation than can be accomplished in a blog discussion (or that we have time/patience/energy to pursue), we back off and as in any polite company, agree to disagree and move on to conversation where we can impact each other’s thinking more. Not that it keeps you from posting occasional blogs on topics that push my buttons, or keeps me from occasionally responding in ways that push yours! LOL. But seriously, it is nice to make conversation here and that you remain engaged instead of just doing “post and runs” like some blog writers. If this grows to the size of MMM then that will necessarily change, but that will be too bad.


    I am skeptical about your experimental design. Before designing an experiment, one should first state the hypothesis one wishes to test. What is yours, precisely? I haven’t seen it clearly stated, or at least clearly enough stated to determine if the experimental design is adequate, though I think I know enough about what you are proposing for me to believe that the design is inadequate.


    I’m assuming your hypothesis is something like this, “Betterment adds value over just an annually rebalanced Vanguard ETF portfolio.” More specifically, you are testing: “A Betterment 80/20 stock/bond portfolio will outperform an annually rebalanced Vanguard ETF portfolio comprised of 20% bonds, 40% US stocks, and 40% International stocks.” Even more specifically, you are hypothesizing that this will be true with the latter portfolio in a taxable Ameritrade account, with $1000 initial investment and no subsequent additions/withdrawals. But this hypothesis is still too vague. How is outperformance defined: On a risk-adjusted basis? Over what time scale? By what % margin? Using comparable portfolios or different portfolios? (i.e., equal weighting to domestic/international, value/growth, small/big, etc.).


    You say you are doing this in a taxable account. Annual rebalancing lets you optimize ST/LT cap gains for tax purposes. (Hold for 364 vs. 366 days). Ditto on qualified dividends. So, this is not a “simple” comparison as you’ll need to account for your overall taxable income and tax situation/strategy. In your income bracket, for example, results of this experiment will be different than in mine.


    Then there is the more basic issue in any measurement and comparison, and that is the discrimination ability of the test. For example, you can measure the length of a football field with adequate precision for most purposes by using a tape measure marked off in inches and fractions of an inch. However, apply the same measurement tool to measure the thickness of a human hair and it would be entirely inadequate. To be useful for drawing conclusions, the variance or standard deviation of the measurement (test) must be significantly less than the variance of what is being measured. Thus, while you may be able to compare the length of two fields using a tape measure, you won’t be able to compare the thickness of two hairs that way. You need a measuring device with a scale small enough that the uncertainty in the measurement is small relative to the difference between the thickness of the two hairs; only then can you draw a reliable conclusion about which is thicker or how big the difference in thickness is.


    In your proposed experiment, your measurement tool is high variance relative to the factors you want to study. You are not comparing two identical portfolios. I think the question you are trying to address is not whether Portfolio A returns more than Portfolio B (due to different strategy/weighting/etc.–you want them as similar as possible, in fact), but rather, you want to know if Betterment produces a higher return due to the sum of contributions including (a) the negative effect of the small Betterment expense charge, (b) the positive (or negative, depending on tax situation) effect of more frequent rebalancing at Betterment, and (c) the positive effect of being able to remain 100% invested at Betterment regardless of size of investment. These effects are likely to be rather small (e.g., the expense load is a small fraction of 1%, the last effect will be extremely small even on a $1000 portfolio and certainly on a larger one). So, you are trying to measure a relatively small effect. Yet you are intending to do so by comparing the performance of two portfolios which can be expected to differ from factors other than the above, i.e., differences in sector weighting, value/growth, big/small, etc. The variance in returns from Portfolio A and Portfolio B will be large relative to the effect you are trying to measure. i.e., if A returns 15% and B returns 18% in a given year, that difference would likely be attributable to differences in the composition of the portfolios, and not (mostly) from the effects you are trying to study. Compounding this measurement problem is the fact that differences in returns resulting from portfolio composition/design differences can take years or even a decade or more to manifest in some time-averaged way. For instance, value outperforms growth over decades of time, but there have been many years and series of years where this was not true. So, you will be comparing two different portfolios for a relatively short time (I assume your readers won’t be checking back on this experiment 10 years from now), and trying to draw conclusions about factors that are small relative to the variance in those portfolios both in a given year and over a series of years.


    There are other issues, but these are a few of the big ones that come to mind. My suggestion would be to use identical portfolios in both cases. For example, S&P 500 ETFs and 10 year US Treasuries (or the like). The ETFs you use should have the same historical records, in other words, so that the difference in variance of their returns is extremely small (or highly correlated). That way, if there is a difference in wealth in the two accounts after X years, you can attribute it to the factors you are interested in, not to stock/bond selection. Furthermore, I’d suggest defining how long you will run the experiment (it will need to be at least several years, since you are comparing annual vs. frequent rebalancing). I also think you need to consider taxable vs. non-taxable accounts. And maybe more than $1000. And maybe with periodic investments (as others have said).


    Given the need to run for many years, though, I wonder what the real point is in even doing the experiment at all? Why not just backtest the two strategies? That way you can isolate each factor and study it without confounding variables. In fact, you can already find studies that do this, i.e., effect of rebalancing frequency. I think you can do this on paper faster and better than you can do it as a real-time experiment with confounded portfolios/effects.


    Those are my beliefs! :-)

  8. Robert May 18, 2014 at 9:56 am #

    Sorry, I slipped an extra ‘s’ at the end of your name somehow, but can’t edit it.

  9. Miles Dividend MD May 18, 2014 at 12:00 pm #

    Robert.

    Wonderful analysis. I am not worthy! And I agree, I have learned a lot from my interchanges with you and my perspective is subtly changed each time we go back and forth.

    To understand this experiment it would be useful to read the thread that inspired it. Which can be found here. Realize that several of my posts were deleted.

    http://forum.mrmoneymustache.com/investor-alley/betterment-or-vangaurd/

    My hypothesis could be said to be:
    Betterment over a lazy portfolio rebalanced once a year.

    I think its possible that either side will have higher CAGR over time, and that it’s likely Betterment will have a slightly decreased standard deviation due to better diversification.

    I guess that the constant passive rebalancing will be a plus over the long term, but sometimes it will be a negative.

    If my hypothesis sounds wishy washy, it is in stark contrast to the certainty of my opponents in this debate who say such things as

    “Bettermint WILL cost you money and underperform. It frankly will.”

    (Quoted today)

    Which is really to my benefit, because if betterment ever overperforms a lazy vanguard portfolio their certainty is proven wrong. Whereas even if betterment underperforms for 100 years their claim is still unproven.

    Anyone who has studied science is naturally gunshy of such certainty.

    Alexi

    • Robert May 18, 2014 at 8:37 pm #

      Alexi,
      I read through that (lengthy) thread. See what you mean about some folks showing attitude! The hypocrisy of the moderator is evident. You kept it pretty classy compared to some of the firebrands there who lobbed insults left and right. Good points were made on both sides, though, and there is enough information there for folks to make an informed decision, IMHO.


      I think the average MMM reader is an independent-minded sort of person who is thus drawn to the DIY approach with Vanguard rather than Betterment, but that isn’t representative of the population at large, where I think Betterment does offer value to a particular segment of the population.


      One thing worth considering is that Betterment seems to me to be competing not against Vanguard but against other asset-based fee-based financial advisors, including those at brokerage firms like Merrill Lynch, Wells Fargo, etc. There are a lot of people being hand-held at these firms for significant costs. Others, such as Ric Edelman’s firm, cost somewhat less and aren’t pushing expensive funds. Compared to these types of firms/services, Betterment offers significantly lower fees. However, they do not offer financial advisory services from a qualified financial advisor. Thus, you aren’t getting advice on taxes, estate planning, overall financial plan, use of trusts, etc. In comparison to these services, you should probably look at cost of Betterment plus pure fee-based financial advisors.


      From reading more, it looks like Betterment’s rebalancing is from allocating new investment money and dividends, not selling and buying (at least not frequently). That may be better for tax reasons (in a taxable acct), but if so that means your experiment, with no periodic added investments, will not be able to take full advantage of Betterment’s rebalancing feature. (I may be wrong on this; I haven’t delved deeply enough into the Betterment website to get a clear answer. Do you know what their rebalance frequency is outside of the allocation of dividends and new deposits?).


      Your May 3 response to foobar said that if he is paying $5k in fees to Betterment he must have a $330,000 account. Actually, that would be a $3,333,333 account. I think you dropped a decimal place in your calculation.


      I do wonder about the supposed advantage of fractional shares at Betterment vs. Vanguard. While you may not be able to get fractional shares of Vanguard ETFs within a Vanguard account, I believe you can within a regular brokerage account (just like you can buy fractional shares of stock). So I think you can buy fractional shares of a Vanguard ETF within an Ameritrade account. That eliminates that disadvantage of Vanguard funds.


      It is amusingly ironic that the moderator who silenced you has a signature tagline that reads: “A silent voice is as powerless as a silenced one.” !!

  10. Richard August 3, 2014 at 8:42 pm #

    Additional point: the core argument here may not be DIY vs advisors, but DIY vs behavioral psychology.

    I think I’m pretty savvy about investments, finance and the hidden fees of large financial services companies. Yet over the years I’ve observed that I sometimes slip in “reallocation” when I should be doing “balancing”, and that reallocation is often more accomodating to what is popular that year than I’d care to admit.

    We know from behavioral finance that those with a strong sense of independence and autonomy are often more vulnerable to herding than they realize. So an automated system for rebalancing, aside from any other benefits, might offer greater control precisely because there is less need to tinker with the allocation.

    • Miles Dividend M.D. August 3, 2014 at 9:07 pm #

      Great point. I Completely agree Richard. Our own irrationality should never be underestimated.

      I am also guilty of finding excuses to tinker. It is a constant struggle, and I am quite sure that the DIYers are guilty of the same. And with betterment this impulse is almost completely absent.

      We who feel we are more rational than the rest are usually the least rational of all.

      Now that bettermment has tax loss harvesting, I think that DIY is almost assured to lose in any head to head with taxable money.

  11. Daniel May 11, 2015 at 10:38 pm #

    I’m guessing it’s being more than a year now. I’m very interested in your results. Did you publish anything about it? Thanks

    • Miles Dividend M.D. May 11, 2015 at 11:45 pm #

      Daniel,

      Sadly I never invested the money to run the test. No good excuse, I was all talk and no action on this one. Last year a more US focused strategy would have won, this year, so far, a more international approach would have. I did harvest almost 2K of Tax losses on 68K of investments last year with Betterment, so that was nice (my expense ratio was negative after taxes.)

      AZ

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