Software is Better Than People

Software is far better at most jobs than people are. I realize that statement will make a lot of people uncomfortable, but it’s true. In just about every industry I know, software-based solutions provide greater functionality, convenience and speed than their human counterparts. There’s just no way people can keep up. That’s what prompted Marc Andreessen to make his famous assertion that “software is eating the world.”

Ability to Scale Leads to a Better Outcome

The primary advantage of software is it can serve one person, or a million of them, equally well. Today, computing power is so cheap that it’s essentially free. So it doesn’t matter how complex a piece of software is; you just throw more hardware at it as needed. In fact, the more people who use a piece of software, the more useful the software becomes, because it can use the data it accumulates to discover patterns that humans couldn’t possibly spot.

To appreciate software in action, think about Amazon. You may feel nostalgic for the old-fashioned book seller, but you can’t say she was better than Amazon. A bookstore owner might have known the preferences of a few of her best customers. But there is no way she could pick the ideal book for each of them, much less give them a thorough set of reviews, both positive and negative, for a title they are thinking about buying. And no one particularly enjoys jostling in line in a crowded store, as happens on the last day of holiday shopping. At Amazon, though, there is never a wait, and lines are never a problem.

The same goes for ordering a taxi. A dispatcher works reasonably well for a small number of customers and cars. But the task gets way too complex as the scale increases. Not so for services like Uber. Not only can it can handle thousands of simultaneous customers and cars, but it gets better with volume. In other words you get picked up in a fraction of the time of a taxi.

Most people don’t remember, but Yahoo initially focused on providing a directory of websites that had been sorted into categories by Yahoo staffers, who had to keep up with every new Web destination that popped up. Search, in Yahoo’s early days, was of secondary importance. Google destroyed Yahoo because searching is a far better way of finding information than consulting an index of sites. What’s more, as the size of the Web exploded, Yahoo’s human editors couldn’t begin to keep pace with Google’s sophisticated, efficient algorithms.

By now I think you see my point. Humans have severe capacity limits. Software, on the other hand, can be offered to untold millions of people, with each of them guaranteed the same high quality of service.

The Same Applies to Financial Advice

I believe this is especially true in the world of financial advice. Software does a better job than traditional financial advisors because it provides to an unlimited number of customers important services that had previously been available only to the very wealthy. And the services it provides are even better than what can be delivered manually. Allow me to illustrate with three examples.

Intelligent Dividend Reinvestment

One of the most important jobs of an investment advisor involves rebalancing a diversified portfolio. It’s well known that you can improve your risk-adjusted performance by periodically selling off investments in asset classes that have grown larger than their targeted role in your portfolio, and buying more in asset classes whose performance has lagged. Most advisors rebalance quarterly or semiannually, simply because they don’t have the capacity to look at every one of their clients’ portfolios every single day. That’s not the case for software-based investment services like Wealthfront. Our software checks every client’s portfolio every day, to ensure their current allocation for each asset class is within a predetermined threshold.

We also rebalance in a much more tax-efficient manner than traditional advisors, by using software to intelligently re-invest dividends. Assuming your financial advisor uses best practices and invests your portfolio in a diversified set of index funds (or index based ETFs), those index funds are likely to pay dividends monthly. An average investor might own six or seven index funds, meaning 72 to 84 dividends to reinvest every year. Multiply that by 200 clients (the typical advisor capacity) and you’re up to 14,400 to 16,800 dividends per year. That’s an awful lot of work, so most advisors take the easy way out and simply have the dividends reinvested in the index funds that generated them (using what are known as DRIPs or Dividend Reinvestment Plans). But reinvesting dividends into over-performing asset classes only adds to their size, and thus accelerates the need to sell off some of the investments, thereby generating a tax bill. A much more useful strategy, one that keeps taxes as low as possible, would be to instead invest the dividends in under-performing asset classes. But, as you can easily imagine, figuring out how to do that 15,000 times a year is well beyond the capabilities of a human advisor. But it’s a job tailor-made for software.

Daily Tax-Loss Harvesting

Another example of a portfolio-enhancing service that isn’t possible through an advisor is tax-loss harvesting that is done on a daily basis. Tax-loss harvesting is a way of reducing your taxes by taking advantage of investments that have declined in value. These holdings are sold, and replaced with highly correlated, but not identical, investments, allowing you to maintain the risk and return characteristics of your portfolio while generating a loss that can be applied to lower your taxes.

Very high-end financial advisors offer tax-loss harvesting for their clients, but the enormous complexity of the task usually limits them to doing it once a year. In contrast, Wealthfront’s software looks for losses to harvest on a daily basis. We estimate that provides our customers with nearly triple the tax saving they’d obtain if the service was only performed every 12 months.

Financial Planning

A couple of weeks ago we introduced a fully automated financial planning experience called Path. Prior to Path’s availability, the only way to get a financial plan was to hire a financial planner. But that usually required having a net worth of at least $1 million to afford their investment minimums. And even then, what you get isn’t quite as personalized as you might be led to believe. Most financial planners rely on one of a small group of commercially available software packages that were written more than a decade ago. Work with a planner typically starts with an interview, where your planner, prompted by the software, asks you basic questions, like how much you spend or save each month. If you’re like most people, you probably have to guess the answers. The process continues, with more meetings and revisions, with the final plan taking several weeks to produce.

In contrast, with Path, no interview is required, and you get your plan right away. We use our software to access data from your financial accounts to figure out your spending and saving patterns; no interview, and no guessing, is required. And your plan is produced on the spot. Not only are your results immediate, but they are interactive. You can even work with your plan on your mobile phone while you’re waiting for a train or sitting in a coffee shop. Best of all, Path is free for Wealthfront clients.

Software Improves with Time

And as we refine and improve our software, we will also improve the quality and usefulness of the insights we offer you. That’s probably the most exciting thing about software; that unlike people, it gets better over time. The investment service we offer today is vastly more robust than what we first launched in December 2011 – and every month we add something new. Advances in artificial intelligence, just around the corner, will lead to even better advice.

And you know what? It’s going to keep getting better. Because software is better than people.

Disclosure

To estimate that our daily tax loss harvesting software provided our customers with nearly triple the tax savings they would have obtained if the service was only performed every 12 months, Wealthfront compared a hypothetical backtest with annual tax loss harvesting to our client actual results obtained with our software which seeks to harvests losses daily.  For the hypothetical calculation, we computed the average Tax Alpha over 6 rolling 10 year periods during 2000-2014.  We assumed a long term tax rate of 24.7% and a short term tax rate of 42.7% and an average risk score 7 account. More details can be found here: https://research.wealthfront.com/whitepapers/tax-loss-harvesting/.

Backtested performance is not an indicator of future actual results.  Backtested results are calculated by the retroactive application of a model constructed on the basis of historical data and based on assumptions integral to the model which may or may not be testable and are subject to losses.

Wealthfront assumed we would have been able to purchase the securities recommended by the model and the markets were sufficiently liquid to permit all trading.  Backtested performance is developed with the benefit of hindsight and has inherent limitations.  Specifically, backtested results do not reflect actual trading or the effect of material economic and market factors on the decision-making process.  Actual performance may differ significantly from backtested performance.  There is a potential for loss as well as gain that is not reflected in the hypothetical information portrayed. Investors evaluating this information should carefully consider the processes, data, and assumptions used by Wealthfront in creating its historical simulations.

Backtested results are adjusted to reflect the reinvestment of dividends and other income and, except where otherwise indicated, are presented net of fees.

Client actual data was calculated and averaged for all risk score level accounts, assuming a long term tax rate of 24.7% and a short term tax rate of 42.7% during the time period of 2013 – 2016.  Past performance does not guarantee future results.  Performance information considered was net of all management fees and expenses. Commissions were not considered since Clients on the Wealthfront platform are not charged trading commissions. For all periods the performance information included the reinvestment of dividends and interest.

Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. This blog is not intended as investment advice, and Wealthfront does not represent in any manner that the circumstances described herein will result in any particular outcome. Our financial planning services were designed to aid our clients in preparing for their financial futures and allows them to personalize their assumptions for their portfolios.  We do not intend to represent that our financial planning guidance is based on or meant to replace a comprehensive evaluation of a client’s entire personal portfolio. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront cannot ensure the accuracy or completeness of data provided by clients or third parties. Investment advisory services are only provided to investors who become Wealthfront clients.  For more information please visit www.wealthfront.com or see our Full Disclosure.

This blog is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.

When Wealthfront replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Wealthfront assumes no responsibility to any investor for the tax consequences of any transaction.

Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that Wealthfront trading attributed to tax loss harvesting may create capital gains and wash sales and could be subject to higher transaction costs and market impacts. In addition, tax loss harvesting strategies may produce losses, which may not be offset by sufficient gains in the account and may be limited to a $3,000 deduction against income.  The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.

Wealthfront’s investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors. The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes.

Wealthfront only monitors for tax-loss harvesting for accounts within Wealthfront. The client is responsible for monitoring their and their spouse’s accounts outside of Wealthfront to ensure that transactions in the same security or a substantially similar security do not create a “wash sale.” A wash sale is the sale at a loss and purchase of the same security or substantially similar security within 30 days of each other. If a wash sale transaction occurs, the IRS may disallow or defer the loss for current tax reporting purposes. More specifically, the wash sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale, and the 30 days after the sale. The wash sale rule postpones losses on a sale, if replacement shares are bought around the same time.

The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term). Except as set forth below, Wealthfront will monitor only a client’s (or client’s spouse’s) Wealthfront accounts to determine if there are unrealized losses for purposes of determining whether to harvest such losses. Transactions outside of Wealthfront accounts may affect whether a loss is successfully harvested and, if so, whether that loss is usable by the client in the most efficient manner.

A client may also request that Wealthfront monitor the client’s spouse’s accounts or their IRA accounts at Wealthfront to avoid the wash sale disallowance rule. A client may request spousal monitoring online or by calling Wealthfront at (650) 249-4250. If Wealthfront is monitoring multiple accounts to avoid the wash sale disallowance rule, the first taxable account to trade a security will block the other account(s) from trading in that same security for 30 days.


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