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.
The Best High-Return Asset and the Best Low-Risk Asset
Of course, diversification must be executed with a careful eye to which stocks to include. At Betterment we do the selection for you, and the basic principles of the value of diversification as well as how to execute it are explained by what economists refer to as “Modern Portfolio Theory.” What we end up with, in our Stock Market portfolio, is a basket that broadly represents the US stock market – and this is the “high risk, high return” portfolio that we recommend to our customers. We could take the diversification even further than US stocks, by including international investments and real estate, but for the moment, we’ve kept this portfolio simple, because you get some foreign and RE exposure via US stocks, and those asset classes are relatively highly correlated.
Not every investor wants a high risk, high return portfolio. Some want a low risk, more short-term investment. And for that, we offer Treasury Bonds, which do carry the risk of a changing price, but don’t carry the risk of default (because the US government backs them). By combining the stock portfolio with the less risky basket of goverment bonds, we can create a balance that’s right for any customer, from low risk to high return. This is a balance that has been heralded by economists. As London Business School professor Raman Uppal writes: “…every investor’s portfolio can be constructed by investing in only two portfolios: the riskless asset and the portfolio T, consisting only of risky assets.” (This kind of dollar-cost-averaging is made possible at Betterment via our automatic savings plan.)
Our Approach to Choosing Stocks
On the stock side, we’ve selected a basket of ETFs designed to represent the broad United States market. We took a multi-step approach to this selection process. First, we defined our target, which is the total US market with a slight tilt towards two subsections: value and small cap. Value and small cap ETFs are appealing because these two factors have been shown to indicate good performance by economists such as Fama and French. Second, we screened for low fees (excluding any ETFs with fees above 50 basis points) and high liquidity. Liquidity is essential because non-liquid ETFs trade with big spreads, and investors pay the price when buying and selling them. Third and finally, we selected the right proportions of the screened funds to match our target.
We review our ETF selections at least quarterly, and expect to change the composition approximately annually. While we actively monitor the portfolios, we passively manage them. That means we’re not chasing hot sectors or fads, rather we’re consistently looking for the best representation of the broad market. So a change will typically mean a minor adjustment – swapping one small-cap value stock fund for another new one that offers lower fees or more liquidity. By monitoring these funds, we avoid getting into funds that might increase fees over time, or become less popular and less actively traded and therefore more expensive for our customers to buy and sell. Before making any changes, we consult our team of advisors, who are top economists, professors and practitioners of finance, and market experts.
Our Approach to Choosing Bonds
When it came to choosing bonds, we selected Treasury Inflated Protected Securities (TIPS) because they are the shortest duration, highest yielding, lowest fee, most liquid inflation protected treasury funds. TIPS provide the dual-pronged benefit of both reducing inflation risk and providing a decent yield in inflationary environments. All bonds have interest rate risk – that is, when rates go up, the price of the bond will fall because investors demand higher rates of return. But short-term (i.e., one to three years to maturity) bonds are appealing because their interest rate risk is lower than longer-term bonds. The TIPS ETF we’ve selected has a current duration of 4 years, and is the most liquid and lowest fee fund out there.