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Balance Risk and Return

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”…

Articles by Betterment Editors
By the Editorial Staff Betterment Resource Center Published Feb. 13, 2012
Published Feb. 13, 2012
3 min read

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 – Treasury 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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