A Better Savings Account?

 photo: d i a n a*

It’s one of the most common questions on Mint Answers and around water coolers everywhere: “I have a little money to invest. Where should I put it?”

Let’s face it: the average person, no matter how educated, finds the world of stocks, bonds, and mutual funds to be about as easy to understand as the National Electrical Code. “For most people, opening an online trading account and figuring out what to buy and who to listen to, there’s so much noise out there,” says Zack Miller, an expert on web-based investing and author of Tradestream Your Way to Profits.

Confused investors plus new technology equals opportunity, and startups have swarmed into the investing market. Trade mirroring sites, like Covestor, let you mimic the trades of investment professionals. Online brokerages like E*Trade feature investing advisories that walk you through an online survey and then select a package of funds tailored to your needs. And social lending sites like Lending Club put your money directly into the hands of borrowers—no bank required.

But, arguably, no service has made investing simpler than Betterment, a New York-based startup which launched in May. Betterment is betting that simplicity is a feature investors will pay for, and they’ve created a web-based product that makes investing as easy as opening a savings account. In doing so, they’ve earned plenty of fans (the company hit its summer goals in its first week), but also critics who say the site is misleading and overpriced.

Let’s take a look.

Streamlined to the bone

Opening an account with Betterment takes about five minutes. When you make a deposit, your money will be invested in a mix of exchange-traded funds (ETFs), seven in all, with an emphasis on value stocks. The complete list of funds can be found in the Betterment client agreement.

Once you’ve signed up and transferred money from your checking account to your Betterment account, you allocate your money between stocks and treasury bonds on a percentage basis (60% stocks, 40% bonds, for example), and that’s the only investing decision Betterment asks you to make. The dashboard looks like this:

 

Customers fill out a very short survey about their risk tolerance, and the site suggests an allocation between stocks and bonds. Most customers accept the suggestion. “They’re coming in, they’re using our advice tools, and they’re setting their allocation according to that,” says Betterment founder and CEO Jon Stein.

There’s no deciding which stocks or which funds to buy: every Betterment customer owns exactly the same investments. Betterment automatically rebalances your account so that if you select, say, a 50/50 split between stocks and bonds, it will remain at 50/50 even if the stock market goes up and bonds go down.

A “savings” account?

The simplicity of Betterment’s tools isn’t what has the company’s critics exercised, of course: it’s that they’ve been marketing it as an alternative to a bank savings account.

“They took a process that’s inherently scary and overwhelming for people and used technology to simplify it,” says Miller. “I think that’s an honorable thing. But to market it again and again, to talk about a savings account, is just disreputable. It’s scary, actually.”

Dallas Salisbury, President of the Alliance for Investor Education, agrees. “This website appears to confuse the two concepts, appearing to use saving language to describe an investment that carries the risk of principal loss,” he said in an email.

Betterment has responded to that criticism, up to a point. “We announced this as the replacement for your savings account, because that’s how we saw it,” says Stein. “That said, we took that criticism very seriously, and obviously we don’t want to mislead and we want to appropriately market this. So we went through all of the text on the site to make sure that it was clear that this was an investment, and we’ve changed that positioning just slightly.”

Betterment’s site still invites you to “start saving now,” and says it’s “better than a bank.” But they’ve changed some of their text and graphics to make it more clear that your Betterment account can actually lose money. Yet, on one page of their site they promise that “your money is safe and secure with Betterment,” and trumpet their SIPC insurance. SIPC is completely different from FDIC insurance: it protects your money if an investment company commits fraud or goes bankrupt. It’s no help at all if the stock market tanks.

Stein says his customers get it. “The market is up and it’s down since we launched, and those customers who have lost money, not one of them has come back to say, ‘Hey, there’s risk in this product; I had no idea what I was getting into.’ Not one.”

“Most of our customers aren’t first-time investors,” Stein adds. “This is an investment for the medium to long-term.”

Simplicity, at a cost

Betterment makes money by charging a management fee: 0.9% of your average balance per year. (On a balance of $10,000, for example, that’s $90.) There are no per-trade fees or any other fees; you can add or withdraw money at any time.

When you factor in the expenses inherent in the underlying funds, though, things quickly add up – to a total expense ratio of about 1.09%. In comparison, the average moderately aggressive balanced fund, which maintains a constant stock-to-bond ratio (typically 60/40), charges 1.01%, according to Morningstar. Vanguard’s Balanced Index Fund (VBINX) charges 0.25%.

In the world of investing, 0.9% is a high price—no way around it. If you put your money directly into, say, Vanguard’s Total Stock Market ETF (VTI), one of Betterment’s underlying stock market investments, you’d pay 0.07%. Betterment’s underlying bond fund, iShares Barclays TIPS (TIP), charges 0.2%.

Investors who are disciplined enough to buy and hold these or other low-cost funds could save a lot of money compared to investing with Betterment.

Investing on autopilot

The problem is, many investors simply lack that discipline. A 2010 study by DALBAR found that in the last 20 years, the stock market has returned 8.2%, but investors in stock market mutual funds only made 3.17%. Bond investors did even worse. Why? As the report put it, “Investors are impatient and irrational.” They move their money in and out of the market at the wrong time, they fail to rebalance, and they invest in actively managed funds that hardly ever beat the market.

Betterment’s investors might well turn out to be just as dumb. The product is only two months old, and Stein declined to say how much money customers have invested so far (they’ll report this figure publicly to the SEC at year’s end).

But Stein offers a hint that his customers may be smarter than the average bear (or bull). “There are 5% of the customers or so who will come in and change the allocation once a week or something like that. But that’s really a footnote when you consider 95% of people are setting an allocation and are just sticking with it even though the market’s been pretty volatile.”

(For frequent traders, meanwhile, a Betterment account may be cheaper than using a regular brokerage account, which charges commissions for each trade or monthly fees for unlimited ones.)

Putting your investing on autopilot may be one of Betterment’s better features – but it’s one that’s hardly ground-breaking.

Target-date funds, which are funds of mutual funds with an asset allocation that becomes more conservative as the target date approaches, have been around for years and are now the default investing option at most employers’ 401(k) plans. Average expenses are in the 0.53% to 0.63% range depending on the target date, according to Morningstar. (Buying and selling no-load mutual funds does not involve paying a commission, either.)

Most mutual funds, of course, have minimum initial investment requirements of several thousand dollars, which Betterment does not.  If you have very little cash to set aside, Betterment might be a better solution for you – as long as you understand you are investing, not saving that money, and that involves the risk of a potential loss.