5 Reasons Why Investing Small Sums of Money Into the Stock Market is Irrelevant and Risky
Micro-investing is all the rage. But does the average user of Acorns, Stash, Digit, etc. actually understand what is happening with their accounts? Are these efforts really seen as long-term solutions for retirement? Or are they fads, created to take advantage of an unsophisticated user base?
Rounding up doesn’t work. Most users that love the concept argue that the benefit of rounding up is they begin to save money that they would have spent elsewhere. Somehow this is validation. Sadly, if a user believes rounding up will fund their retirement they will be greatly disappointed. For market research, I began to use one of the aforementioned apps to see the round up concept in action. Five months in I have $252.04 saved. My market return is 3.89% and I have made $9.63. My total gain (performance minus fees) is $4.63 or a 1.87% return. I will leave thoughts on cost for my last point and instead focus on the rounding up experience. Like other users, I started with $0 and now have over $250. That is an infinite increase in absolute value since inception! So that sounds pretty good. I choose the most aggressive portfolio which is made up of five equity ETFs in U.S. large and small companies, non-U.S. large companies, emerging markets and real estate. Pretty aggressive, all equities! So why is my portfolio only up 3.89% before fees, when the S&P 500 and MSCI EAFE are up 6.0% and 4.9% respectively over the same time period? Well, for one I didn’t have the $250 invested from the start, remember I started with $0 and have slowly amassed my $250 over five months, buying small fractional shares every few days. Dollar cost averaging. Over the long-term, dollar cost averaging proponents will tell you it is a great way to buy the market over extended periods of time. Unfortunately, in a constantly rising market you would want all of your assets exposed from the beginning, not dollar cost averaged, because you will miss out on the performance because you aren’t fully invested. Beyond the performance slippage, I founded my firm Divvy during this time period, and I have spent way more money than the average user of these apps in getting my company going, yet I have only amassed a little over $250 in five months. With average spending habits of tens of thousands spent per month, I only amassed $250! Let’s explore that a bit further. Say I spent $10,000 per month the past five months. Ignoring market action, I have basically rounded up $50 per month. Extending this out would result in accumulating $600 in a year. If I was 22, which I am not, and wished to retire at 65, I would accumulate approximately $112,000 in 43 years assuming a 6% annual return. Adding the additional assumption that the 6% return is a real return (takes into account inflation) I am pretty certain I wouldn’t be able to retire on $112,000 in today’s dollars. Sure the apps all encourage you to add multipliers to your round ups, or do one time contributions to accelerate your growth, but bottom line the concept everyone raves about, rounding up, doesn’t accomplish anything. It is a brilliant from a marketing perspective, a feel good way to move some money from your checking account into an investment account. Perhaps you would have just spent the money elsewhere, so its better than nothing, but these companies are misleading users to believe they have uncovered a solution to meet your retirement needs. Be careful!
Contributions greatly exceed returns. Early in a users experience with a micro-investing app many companies will use visual dashboards to showcase the amazing growth of your portfolio.
Wow, my account just keeps going straight up!
This skews perception tremendously. The figure above shows a positive 45 degree steady climbing of my account balance. Notice anything missing? I think from the earliest introduction to graphs in elementary school, we all were instructed to label the x-axis and y-axis. Where is the y-axis? The total amount is listed at the top, but without proper labels this could represent a dollar or a million dollars. But if it was a million dollars you wouldn’t see the little stairs steps which indicate another round up contribution by me. If I had a more sizable account, even say $1,000, a $5 contribution wouldn’t visually make a step up like we see here. The point is, when accounts are small, a contribution of $5 is meaningful and will graphically appear to a user like they are really seeing growth in their account. At $100, a $5 contribution represents 5%. Recall from the first point, after 5 months I only gained $9.63, so in a matter of days I contribute $10 exceeding all of the performance I have experienced from the market. This mentally manipulates the user into believing they are really accomplishing something. Now take the same example, but use $1,000. A $5 contribution represents 0.5% of the total amount. Now that contribution doesn’t impact the assets nearly as much. A user wouldn’t be able to tell visually that a contribution occurred. This is important to note, because at this point, performance actually matters. For simplicity, if the return on the $1,000 portfolio was 5%, it would be up $50, ten times the $5 contribution. If this seems like a lot of number manipulation, it is. Understanding this example is incredibly important, but most users today aren’t even near $1,000, so their contributions continue to make them feel good. Today, the average Acorns user has an average account size of $400.
Bull markets and time horizons. The micro-investing phenomenon is still in its infancy. Some of the oldest participants have been around about 4 years or less. Today’s bull market started in March 2009. The bull market is twice as old as the advent of the micro-investing concept. Is there any significance to this? Well, Millennials have been notoriously risk averse and some speculate they were young and impressionable during the Global Financial Crisis. Maybe that is the case, but why then are they also poor at saving? Saving rates continue to be at all time lows. If Millennials remember the financial collapse and are reticent to invest in the markets, then you would think they would have increasing saving rates and been accumulating cash balances. Maybe they can’t because everything has gotten so expensive, maybe they just like to live for today and work to live, not the other way around. But at least these micro-investing companies are getting users engaged and thinking about their longer-term future. The problem is the companies have their own agendas, they aren’t really trying to educate their users, they will project out growth rates, share success stories, give general guidance, but they won’t unmask the real issues. We are eight plus years into a bull market and while I don’t believe in market timing, we will eventually have some catalyst that will spook the market and result in tremendous loss of wealth. These young Millennials, finally starting to trust investing in the market will be crushed. Everything has gone up since the explosion in the FinTech space. Nobody has experienced a significant drawdown in their portfolios. Individual investor behavior is not rational. What will the millions of users reaction be when their accounts suffer 10% declines. Young, market novices, will likely react like prior generations and begin to sell at the most inopportune times. Institutional investors thrive off retail investors fears. It will happen again, it always does. Consider the human behavior of gains and losses. You invest $100 and I return 20% or $120. Nice gain, you’re probably pretty happy. Now the markets are distributed normally, so if I can make you 20% I can lose you 20%. So, how do you feel if the $100 goes down 20% and I return to you $80. Unhappy, I am certain, but would you say equally as unhappy as you were happy in the first example? Most people aren’t, most people take the loss much harder than the win. It’s actually the behavior that drives most coaches into retirement.
Losses start weighing more heavily than victories
They start taking the losses much worse than the joys from winning. When the markets go down, how will all these new users react? They are not being educated to understand the patience required to be good investors. They do not get good guidance on understanding the more complicated risk side of the equation. Everyone can grasp if their portfolio is up or down, but if I told you the risk, as defined by standard deviation, is 20% would that mean anything to you? For most, I probably would have already lost you.
Guidance. What is next for the micro-investing landscape? If account sizes actually become meaningful investment accounts the firms will have no choice but to offer more client service. Today, you are lucky if you can get a phone number to speak to someone for anything beyond a technical issue. In fact, the firms actually make it very clear they aren’t here to help you. Some actually rely on an exemption to avoid providing advice outside of the internet. It is not that you can’t run proper portfolios without advice, it is more of a question of whether you as a consumer that has entrusted a company to manage your hard earned dollars doesn’t want to have the ability to have your questions answered, or have the ability to customize solutions for your needs. Do you think it is suitable to be categorized into five strategies with a million of your closest friends? At values as low as many of these companies will accept it probably doesn’t matter much, but what if you actually have success growing your account? Once you have a meaningful amount to you, do you still want to be generalized, or do you think you are important enough to warrant some personal touch and customization. My guess is this is where each of the businesses will evolve. They will have to offer more solutions or risk losing their most meaningful accounts to others providing more traditional financial services.
Costs. We save the best for last! Fees for micro-investing are an absolute joke. In fact, the pricing schemes are fraudulent. How the SEC and regulatory bodies have allowed it is unfathomable. Back to the general theme throughout, the laws of small numbers manipulate the realities and skew the users’ perceptions. Some might argue it is a brilliant pricing scheme because the users don’t have large accounts, they are amassing larger accounts monthly based upon contributions they make themselves and in absolute terms the cost to manage the portfolio gets lost in the contributions and opportunities to grow your account through rewards. To be fair, it is very expensive to develop an infrastructure to manage a massive amount of small accounts. Someone has to pay for it, unless we choose to live in the alternative reality common in the VC space. But in an EBITDA driven world, you actually have to make profits to find investors. But back to infrastructure, it is costly to create pooled vehicles to accommodate many small investors, ‘40-Act funds have heavy regulation and require boards, assets need to have a custodian, operation teams have to reconcile the strategies performance and corporate actions daily and managers need to get paid. The list goes on. Understanding expenses exist, one must also understand the historical landscape around pricing investment strategies. Hedge funds have historical charged between 1.50% and 2.00% on assets managed plus a 20% carry on the outperformance of the fund. Mostly ridiculed for excessive fees, hedge funds today are under increased pressure to develop alternative, more favorable pricing structures. Traditional long-only strategies historically charged fees around 1.00% for a mutual fund that was managed actively by a firm. The growth in ETFs is a byproduct of underperforming managers and excessive fee structures. ETFs tend to be much more reasonably priced vehicles to get market exposure and tend to be the vehicle of choice by micro-investing firms. So shouldn’t those savings be passed on to the user? Well at values of $5,000 or more they are. At $5,000 most companies charge 0.25% to manage your portfolio, but where it gets interesting is accounts under $5,000. The firm’s proudly state fees of only $1 per month for accounts under $5,000. Wow! That sounds amazing, $12 per year, no big deal, right? Again, back to manipulating the user, sure, $12 is nothing, one bottle of cold-pressed, organic juice. But reconsider the earlier data. The average Acorns client has $400. If you are the average user you are paying Acorns 3% to manage your money. Remember my performance over 5 months, 3.89%, but that was before fees. After fees, I have only returned 1.87%. Quite a big difference if you understand the power of compounding. Without going through all the details, I will make a lot less money over the long-term at these excessive fees. The prior two ADVs from Acorns indicated a growth of the average account size from $250 to $400, so just six months prior, Acorns users were paying an average annual fee of 4.8%. The important figure to note here is the account size growth over a six month period was $150, if you project this figure out, it will take quite some time before the average user’s account will exceed the $5,000 figure where fees are reasonable.
I believe the micro-investing space can be a tremendous opportunity to educate individuals and expose them to the nuances of the markets, but I firmly believe transparency is paramount. The users may be unsophisticated investors, but they aren’t uneducated. They deserve to know the manipulations tools used to engage and take advantage of them.
At Divvy, we to will seek to be a profitable business. We will look to explore ways to capitalize on the significant wealth transfer that will occur over the next 30 plus years. But we will do so with complete transparency. We will be stewards of your capital. Finding ways to change the behavior, first around saving, then applying it to investing. Assets will need to be managed, and money will be made, but it doesn’t have to be at the expense of taking advantage of our users.