Our approach

We believe Modern Portfolio Theory is the best approach to managing individual portfolios.  By investing in a diverse pool of assets with collectively lower risk than any individual asset, MPT attempts to maximize portfolio returns for a selected amount of risk. We've selected our investments based on decades of research and historical analysis.

Table of Contents:

Invest to Reach Your Goals.

Focus on the Long Term.

Diversify. Diversify. Diversify.

Balance Risk and Reward.

Resources

Invest To Reach Your Goals

The best way to look at savings and investment options is through the lens of risk and reward. Bank savings accounts have basically zero principal risk (because they're backed by FDIC insurance, which, like Treasury bonds, is backed by the US Government). Likewise, the reward is also small, particularly if you do the math to account for inflation. The SEC explains this concept well:

Your "savings" are usually put into the safest places, or products, that allow you access to your money at any time… But there's a tradeoff for security and ready availability. Your money is paid a low wage as it works for you… How "safe" is a savings account if you leave all of your money there for a long time, and the interest it earns doesn't keep up with inflation? What if you save a dollar when it can buy a loaf of bread? But years later when you withdraw that dollar plus the interest you earned on it, it can only buy half a loaf? This is why many people put some of their money in savings, but look to investing so they can earn more over long periods of time, say three years or longer. (page 11)

With a savings account, you might lose spending power over time. So, there is risk to being short-term focused with your savings.

The Short Term vs. the Long Term

If you need to spend your money in a month or a year, a savings account might be the best place for it, because you're guaranteed to get back the the same dollars you put in (known as your principal). When you invest in stocks and bonds, you're not guaranteed to get your principal back. The fact that you are taking more risk correlates with the result that, while your account balance may fall in the short term, you'll likely earn higher returns over the long term:

Chart courtesy of Stocks for the Long Run; savings account estimate is ours, based on savings rates roughly matching inflation

The Relationship Between Investment Risk and Return

Why do risk and returns go together in investing? One school of thought among prominent economists is that the market for investments is "efficient." Let us explain. There's a lot of publicly available information about the securities and investments one might be looking to buy. Investors have the tools available to understand the varying risks of their investment options. Bigger risks don't necessarily mean bigger returns, but there are a lot of people (and institutions) investing in the stock and bond markets, and they bid investment prices up or down so that they reflect the real risk and value associated with each investment option.

Saving money for major life milestones – education, retirement, etc. – means saving for the longer term: three, 10, or even 30-plus years down the line. Over these horizons, if your portfolio of stocks and bonds is diversified and allocated properly, you should see considerably better returns than a savings account, because of the extra risk that you take on by owning stocks and bonds. It's a smart tradeoff to make.

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Invest to Reach Your Goals.

Focus on the Long Term.

Diversify. Diversify. Diversify.

Balance Risk and Reward.

Resources

Focus on the Long Term.

Ever thought you were better than most people at something? Like bargain shopping, driving, or cooking? It turns out that we humans all tend to think we're above average in some situations where we're likely just average (or worse!). This tendency is called the "overconfidence bias," and it's one of the many psychological biases that all we humans share. And Investing is no different from those other skills we inflate – many people think they can earn above-average returns through their superior abilities (despite much evidence to the contrary). The reality is that trading is hazardous to your wealth, and studies have shown that active stock-pickers generally perform worse than passively selected index funds that track market averages. Many people think they can outperform the market, but they rarely do in the long term.

The Problem with Picking a Picker: Active Management is a Losing Game

Now, you may be thinking, what if I find a certifiably brilliant stock picker and put my money with her? While there may be some brilliant stock pickers out there, it's just as hard to pick a good picker as it is to pick a good stock. Past performance is not a good indicator of future returns, so when people look at strings of recent stock-picking performance to choose a money manager, they're likely to be disappointed when it turns out that their manager is just average (or worse!). In fact, after subtracting fees, the average active stock picker under-performs index funds.

And think about this: every individual or professional picking stocks is competing against millions of people in the market, every one of them thinking they can win, as well as against the behemoth stock-picking infrastructures at well-funded hedge funds and investment banks. These wealthy firms have computers and full-time analysts looking at massive amounts of data and seeking to exploit human psychological biases, making it harder now than ever for the average investor to beat the market.

How to Maximize Earnings Potential: Passively Managed Index Funds

Fortunately, there is a way to take human biases out of the equation and capture at least the average of stock and bond returns. The best way to do this is to invest in index funds. They are often referred to as "passive" investing, because they don't rely on "active" trading decisions for their performance. Instead, they are based on purchasing a little bit of every company in an indexed sector (such as all tech stocks, all big US companies, etc.) You win some, you lose some, but because you've spread your investment across lots of companies in a balanced, non-biased way, you're likely to make money over the long term. Betterment invests you in a type of index fund called an Exchange-Traded Fund (ETF). These are index funds with liquidity, tax, and cost advantages over mutual funds.

The SEC notes the historical advantage of index funds: "Historical data shows that index funds have, primarily because of their lower fees, enjoyed higher returns than the average managed mutual fund." That's why we've focused instead on choosing the very best basket of index funds – the ETFs that compose Betterment's stock market portfolio. Our investors still get the value of experts deciding where to put their money – it's just that we're using our expertise where it has real positive impact.

Other Common Investor Pitfalls

Betterment's simple approach is not only a more efficient use of your time–it's also a smarter way to achieve better long-term returns–because it helps you overcome some common behavior biases.

People didn't evolve to make investments, they evolved to do the basic things necessary to survive and procreate. So our instincts sometimes aren't optimized for investing. One example of a behavioral bias is that we tend to go with what's most familiar to us (like a company who's name we know or who we work for), rather than properly diversifying. Massimo Massa and Andrei Simonov, of INSEAD and the Stockholm School of Economics, respectively, write:

"There is a ‘general tendency of people to have concentrated portfolios… [and] hold their own company's stock in their retirement accounts…. Together, these phenomena provide compelling evidence that people invest in the familiar while often ignoring the principles of portfolio theory'."

In many areas of life, the familiar is important to our decision making–but in investing, going with what we know can send us on a path that diverges greatly from the most effective way to manage a portfolio.

There are a host of other ways your investing decisions might be influenced without you realizing, several of which are described by Alistair Byrne and Mike Brooks here. For instance, people have a tendency toward representativeness, meaning they invest based on recent performance rather than fundamentals. And people are prone to conservativism, which in Byrne and Brook's paper means that they cling to their beliefs in the face of new information (like information that a stock might go down, when they were sure it would go up). Even investors who think they are taking a less risky approach by investing in mutual funds are vulnerable to behavioral biases, according to various studies including one from financial research firm Dalbar.

So, how do you avoid falling victim to behavioral biases that can take your portfolio off the road to long-term growth? The answer is fairly simple: take yourself out of the equation. If you remove yourself from the process of choosing assets, you remove the possibility that you'll be influenced by factors like the ones described above. You'll be less tempted to chase winners, because the stock picking is already done for you. And if you set up automatic deposit, which we encourage you to do, you'll be less likely to move money into your account at inopportune times. These safeguards are part of what led us to making the Betterment model as simple as possible – yes, we want to save you time and energy, but we also are protecting our customers from common investing pitfalls.

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Invest to Reach Your Goals.

Focus on the Long Term.

Diversify. Diversify. Diversify.

Balance Risk and Reward.

Resources

Diversify. Diversify. Diversify.

Diversification refers to the practice of allocating your money across many different assets as opposed to just buying the stock of one or two companies. While not all of your stocks will succeed when you diversify, you are increasing the likelihood that you'll hold high performers and reducing the risk that one of your few stocks will be a disaster and bring your whole portfolio down (because the risk is spread out – any individual company can fail and your diverse portfolio will still be fine). The SEC explains diversification using a familiar idiom:

It is often said that the greater the risk, the greater the potential reward in investing, but taking on unnecessary risk is often avoidable. Investors best protect themselves against risk by spreading their money among various investments, hoping that if one investment loses money, the other investments will more than make up for those losses. This strategy, called "diversification," can be neatly summed up as "Don't put all your eggs in one basket." Investors also protect themselves from the risk of investing all their money at the wrong time (think 1929) by following a consistent pattern of adding new money to their investments over long periods of time.

Diversification can't guarantee that your investments won't suffer if the market drops, but it can improve the chances that you won't lose money; or that if you do, it won't be as much as if you weren't diversified.

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Invest to Reach Your Goals.

Focus on the Long Term.

Diversify. Diversify. Diversify.

Balance Risk and Reward.

Resources

Balance Risk and Reward.

There's really only one choice you have to make with your Betterment account, and it's the most important one: your investment allocation. The word "allocation" refers to the way your money is divided among different investments. At Betterment, an investment allocation slider allows you to move between higher-return investments – stock ETFs – and less risky investments – bond ETFs.

So, how do you decide what investment allocation is right for you? We like how the SEC puts it:

The answer depends on when you will need the money, your goals, and if you will be able to sleep at night if you purchase a risky investment where you could lose your principal.

That is, there are three important things to think about. First, when do you need your money? Second, how do you plan to spend the money? And Third, how comfortable are you with the possibility that you might not be able to afford your goal?

Horizon, Goals, and Risk Tolerance

To address the first: are you saving for the long term (e.g., retirement, buying a home in 10-15 years) or the shorter term (e.g., your honeymoon in 2 years, a master's degree in three years)? If you're saving for the longer term, you can likely take a more risky approach to investing, because you'll be able to withstand short-term losses in the interest of a bigger payoff down the road. As the SEC writes:

If you are saving for retirement, and you have 35 years before you retire, you may want to consider riskier investment products, knowing that if you stick to only the "savings" products or to less risky investment products, your money will grow too slowly – or, given inflation and taxes, you may lose the purchasing power of your money. A frequent mistake people make is putting money they will not need for a very long time in investments that pay a low amount of interest.

On the other hand, if you are saving for a short-term goal, five years or less, you don't want to choose risky investments because when it's time to sell, you may have to take a loss. Since investments often move up and down in value rapidly, you want to make sure that you can wait and sell at the best possible time.

Your goals are closely related to your investment horizon. Betterment gives you advice based on your age and expected time to retirement (under the assumption that some of your savings won't be used until retirement), and we're working now to bring you advice for other goals.

The most tricky (and often overlooked) part of asset allocation is the third part: risk tolerance. If there's a chance you'll flip out when you lose 10% of your investment and take all your money off the table before your portfolio has a chance to bounce back, you're setting yourself up for an unsuccessful investing strategy. To make the most of investing, you need to have the wherewithal to stick to your plan – trading in and out is destructive to returns.

So, on the advice tab on Betterment.com, in the Personal section, we assess your risk tolerance, and if you can't stand losing money, we target a conservative allocation for you. Then, for an added sanity check, you can also take a look at how your peers (other Betterment customers like you) are investing.

Set and Forget

Once you've set your allocation, sit back and relax. Being a (well-informed) couch potato in the investing world is actually healthy (rather than messing around with your investment allocation based on short-term market moves). We'll automatically rebalance your account for you. That means that as your investments change in value, we'll reallocate your funds between riskier and less risky assets in order to maintain the allocation percentages you started with. Rebalancing increases returns (taking advantage of mean reversion in prices) and reduces risk (you should not end up with substantially more exposure than you bargained for, years later). We'll even take care of automatically reinvesting the dividends you earn.

If your circumstances change – say you get engaged and need to start saving for that honeymoon, or you have a child and it's time to save for college – our advice and the handy slider tool are always there for you to adjust your allocation when you need to do so.

When left to their own devices, people make investing decisions that work against them due to behavioral bias. That's why the Betterment set-and-forget approach works: once you put your money in with us and choose the level of risk you're comfortable with, we help you stay the course so you aren't in danger of making re-allocations that appear to make sense in the short-term but are likely to reduce your earnings in the long-term.

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Invest to Reach Your Goals.

Focus on the Long Term.

Diversify. Diversify. Diversify.

Balance Risk and Reward.

Resources

Resources

Throughout Betterment Foundations, we  mention a number of articles, papers, and research reports written by other smart people.  Here, we have gathered all of those resources together in one place in case you want to learn more.

Part 1: Invest To Reach Your Goals
Part 2: Focus On The Long Term
Part 3: Diversify, Diversify, Diversify
Part 4: Balance Risk And Reward

Additional Reading

Here we've gathered some content on investing that we find interesting. Feel free to read at your leisure – don't worry, there won't be a quiz.

Asset Allocation
The rule of 120 in Asset Allocation
Behavioral Biases
Why most investors don't make money in the stock market--they do it wrong
Index Investing
Active vs. passive management Issues with active management
Efficiency and indexing, even for small caps
Investments
TIPS, short term bonds, and inflation hedges
Fama and French's value and small cap findings

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