Dan Egan is the VP of Behavioral Finance & Investing at Betterment. He has spent his career using behavioral finance to help people make better financial and investment decisions. Dan is a published author of multiple publications related to behavioral economics. He lectures at New York University, London Business School, and the London School of Economics on the topic.
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What Our Investment Philosophy Means for You
Betterment’s investment philosophy plays a major role in how we help you make the most of your ...What Our Investment Philosophy Means for You Betterment’s investment philosophy plays a major role in how we help you make the most of your money. From this philosophy, we can derive five principles that we believe all investors should follow. Betterment has a singular objective: to help you make the most of your money, so that you can live better. Since our start in 2010, we have developed a range of products and services in pursuit of this objective—from advanced investing strategies to new ways of offering financial advice. What unites each of our offerings? What is the underlying philosophy that informs how we make decisions that we hope will lead to better outcomes for our customers? Here, we outline our fundamental investing philosophy—the philosophy that guides our portfolios’ construction, our investment optimization techniques, and our advice to Betterment customers. Defining Betterment’s Investment Philosophy Put simply, we at Betterment hold to the following: Betterment uses real-world evidence and systematic decision-making to help increase the take-home value of our customers’ wealth. When developing new investment products or advancing our current offerings, we start with a body of well-developed, robust research, then use a system of rules to remove bias and preconceptions from our decision-making process. While we’ve formalized our investing philosophy and internal processes over time, Betterment has held to these same tenets since the beginning. We launched in 2010 with an investing strategy based on more than 50 years of advancing research in Modern Portfolio Theory. The result was a portfolio strategy composed of exchange-traded funds (ETFs) with customizable risk management. Over time, we improved the Betterment Portfolio Strategy and developed more personalized advice for each of our customers. Each advancement emerged from identifying more efficient, effective, and robust methods, and each time we’ve made a change, we’ve used a decision-making process less susceptible to bias. In short, we strive never to be dogmatic in our approach, but rather focus on practical, evidence-backed ways of giving investment advice and building services. What Betterment’s Philosophy Means for Investors We believe firmly that every investor should clearly understand the underlying philosophy shaping the investing process they follow. This is true for our role as an investment advisor too. Regardless of how transparently we explain what we do, the truth is that much of your investing success depends on the choices that you, the investor, make. Betterment will always offer the advice we believe is in your best interest, but it’s often up to you to get the most out of our advice. We set forth a set of principles that are the practical essence of Betterment’s philosophy. These principles were formed from Betterment’s review of evidence about investment decision-making and success, but as with all good principles, they’re intuitive and straightforward—steeped in common sense. Most importantly, these principles aren’t just about us. They are tenets that you, the investor, can and should ascribe to if you wish to have a clear, coherent and realistic approach to managing your money. Our principles for investing success are the following: Make a personalized plan. Balance cost and value. Maintain diversification. Manage taxes. Build in discipline. So, what does it look like for you to embrace each of these principles? In the following sections, we’ll explain how any investor can achieve greater investing success by putting each principle into practice. 1. Make a personalized plan. No two people have the same lives, nor do they want to achieve the same things with their lives. Making a personalized plan is about organizing your money to achieve the specific goals you value. Just as a monthly personal budget makes it easy to know what you’re spending and saving, a personalized investing plan is made up of goals aligned to future expenditures—your retirement expenses, a future car purchase, or perhaps a child’s education expenses. A plan helps you clearly make tradeoffs in the present for the future. While a financial advisor can help you put a plan into action, only you can do the hard work of discerning which goals are important to you, setting your expectations for future expenses, and of course, actually depositing your money into an investment account. 2. Balance cost and value. Most financial decisions involve comparing costs with potential value. But it’s easy to focus on only one side— costs—instead of the potential value one can earn. When deciding on investments or choosing a financial advisor, it’s important to consider both cost and value. As concepts, value and cost are multi-dimensional. Value includes the expected after-tax growth of money, as well as the certainty of a financial plan’s success and lack of stress surrounding that outcome. We believe investors should follow a simple maxim: maximize expected take-home value. As an example, two funds may have a similar return profile, but one fund company charges more. Compare the Rydex S&P 500 Index Fund at 0.75% fees, with the Vanguard Index 500 ETF at 0.04% fees. These funds contain the exact same investment holdings, at very different prices. Costs—when taken holistically—not only include how much you pay out of pocket, but also the income you could be earning with your own time, the value of the time you give up living life, and the stress you bear in executing the actual work. Always reduce your costs when doing so will not reduce value. By balancing all of the types of the costs of an investment with the overall value you expect to receive, you can maximize that take-home value. 3. Maintain diversification. Diversification, at its core, involves not being overly exposed to any single specific risk. Maintaining diversification reduces overall risk but also requires more maintenance and oversight. It also usually means giving up on extreme outcomes, both positive and negative. The benefit of diversification is a lower risk of ruinous outcomes. While the success of any individual investment will wax and wane in unpredictable ways, diversifying across many asset classes generates a more consistent upside without the chance of any single terrible outcome ruining you by itself. It’s a way of protecting against extreme downside risk. For example, emerging markets stocks can have very high returns, but also have a risk of large losses. If you mix emerging markets with lower risk holdings like U.S. stocks, you can enjoy some of the upside, while limiting your downside. In essence, diversification is about ensuring steady moderate outcomes rather than risking an all-or-nothing outcome that could ruin you. A diversified portfolio will never out-perform all of the different asset classes that it includes; it will always be the average of them. Over time, the lower risk but equal average benefit from diversification is a powerful engine for wealth growth. 4. Manage taxes. Just as the income you earn is taxed by the IRS, so are the capital gains you earn by investing in securities like stocks and bonds. Taxes can change the take-home value investors earn from their investments, just as costs and market performance can. For instance, if you and another investor had the same exact investments with the same timing of your transactions, you could expect the same market returns, but, if you manage your taxes differently, you could very well keep significantly different amounts of money after taxes. The personalized nature of taxes means that there is no one-size-fits-all solution. Investors have a wide array of tools to use: tax-advantaged accounts like IRAs, tax loss harvesting, asset location, and even selecting specific tax lots upon sale (e.g., selling the shares with the lowest gain first). But an individual’s tax situation nearly always changes (at least a little) over time. Your expected tax rate in retirement can influence the optimal tax strategy today, especially if you are using traditional IRA and 401(k)s to save. If you are charitable, donating your appreciated shares rather than giving cash can offer an increased tax benefit. Intelligently managing taxes can—without risk—increase the value of your wealth over time, and should be a focus for all investors. 5. Build in discipline. Investors can be more successful when they actively build discipline into their plan: i.e., when they don’t really have to think about it or exert willpower in order to execute it. We believe that many small, consistent, steady actions compound into surprisingly impressive outcomes. The result of steady discipline over time is greater than most people expect. And yet, it’s how most people actually become wealthy. In contrast with “get-rich-quick” schemes, like speculating on lotteries, hot stocks, or options trading, steady discipline does not garner media attention or notoriety, but it is the engine of growth that purrs along quietly. However, the more effort it takes to be disciplined, the less likely we are to succeed. Think about it: it is far harder to maintain a diet when surrounded by unhealthy food. It’s the same with our money. We must minimize the burden we impose on ourselves when trying to maintain discipline. We believe in outsourcing some self-control and execution of our strategies to systematic implementations whenever possible. Automating savings and investment strategies like rebalancing and dividend re-investment are good examples of disciplined investing. From Principles to Outcomes Our investment philosophy and the principles we derive from it are meant to help you become a more successful investor. We encourage you to ascribe to these principles and take them on as your own. While no two investors’ situations are the same, you can improve your investing outcomes by following these principles that stand the test of time. Investing is not a skill; it’s a practice. Remember that. As we, at Betterment, look to the future, we aim to be transparent and consistent about how our principles define our service. If you ever feel we are acting against our declared principles, please let us know.
Using Investment Goals At Betterment
Goal-based investing. The idea is prized among financial advisors—and our team at ...Using Investment Goals At Betterment Goal-based investing. The idea is prized among financial advisors—and our team at Betterment—but to the everyday investor, it’s often difficult to put into practice. TABLE OF CONTENTS What is goal-based investing? Goals and Investment Accounts at Betterment Retirement Savings Retirement Income Safety Net Major Purchase General Investing How to Set Effective Goals Using Betterment Mapping Out Your Financial Picture Goal-based investing. The idea is prized among financial advisors—and our team at Betterment—but to the everyday investor, it’s often difficult to put into practice. After all, being clear about the purpose of one’s savings can be a challenge. You might start saving for one reason, then decide halfway through your progress that the money is really for something else. Or, you might have so many goals you want to save for, you don’t know where to start. Often, people are stuck in a single-savings-account mentality, where your figurative pot of gold is for any and all savings goals—with no distinct purposes articulated. For many investors, goal-based investing takes a lot of discipline and even more introspection. Without the right tools in place, it can be difficult to keep your goals on track. At Betterment, we’re working to make setting and attaining your financial goals a natural and straightforward experience. In this article, we’ll guide you through how goal-based investing works at Betterment and how we’ve designed Betterment accounts to put your goals into action. What is goal-based investing again? Goal-based investing is the best way we know to help you set a personalized financial plan with investments that are aligned to help you fulfill that plan over the long-term. You can think of goals as the building blocks of a plan. When you set goals for your investments, you’re identifying what personal purpose you have for your money, and what you want to achieve. As your advisor, Betterment uses this information to recommend the right level of savings and proper mix of investments to help you reach your goals. The best investment plans consist of a prioritized set of personal goals, so you decide on which goals to focus on first to inform your investment behavior. Goal-based investing is based on a technique used by institutional investors called “asset-liability management,” which aims to match future assets with future expenditures. In other words, goal-based investing seeks to ensure that you have enough money when you plan to spend it in the future. The trouble with this notion of goal-based investing is that you may not think of your money in terms of goals, and even if you do, it’s likely that your goals aren’t always clearly defined. A goal like, “I want to buy a boat or house sometime in the future” isn’t specific enough to inform good numerical planning. If you were an advisor, imagine how challenging it would be to help somebody plan when he or she isn’t quite sure what they want or when they want it. It’s not unlike helping a friend or family member stick to a budget: If they never set a clear cap for their budget, it’s hard to say how much spending is too much spending. From our perspective as your advisor, the best way to help you set a good plan is to help you give your goals as much definition and detail as possible, then determine how they stack up together. What does an investing goal look like at Betterment? When you really think about it, the essence of a goal is your intention to make a future expenditure. For example, you want $50,000 for a future down payment on a house. Or, $300,000 for future payments on your child’s college tuition. Or $100,000 of annual retirement income for 30-40 years. Any future expenditure can be an investment goal. Our Investing Goals At Betterment, we aspire to help you build a personalized financial plan built on goals that reflects what it really feels like to save and spend money. Within your Betterment account, every investment goal you set has a target amount and target date(s) for which you desire to meet your goal. Within each goal is at least one investment account, depending on the type of goal you set. Investment accounts at Betterment include a variety of legally-defined account types, like taxable accounts (what other investment companies might call brokerage accounts), individual retirement accounts (both Roth and traditional), SEP IRAs, joint taxable accounts, and trusts. Different goal types may contain different investment account types. Currently, we have five types of goals: Retirement Savings – for those saving for retirement Retirement Income – for retirees making withdrawals Safety Net – for growing an emergency fund Major Purchase – for making a future expenditure General Investing – for investing when you’re not sure of the specific future expenditure When you sign up with Betterment, you can set up one or more of these goals for your investments. For any existing goal, you can change your goal type in the Plan tab of your Betterment account. You will see an option on the right that reads “Advice type: Edit” that leads you to the option to update your goal type. What we try to do—and we’re constantly working to improve—is to help you set your goals well while also advising you on the right accounts and investments you’ll use to help reach your goals. We recommend customizing the names of each of your goals to set your personal purpose for each. Here’s a breakdown of the default range of stock allocation advice, by goal type: Type of investing goal Most Aggressive Recommended Allocation (typical start of term, depending on age) Most Conservative Recommended Allocation (typical end of term, depending on age) Anticipated term Cash-out assumptions Retirement 90% Stocks, 10% Bonds 56% Stocks, 44% Bonds Up to 50 years Shift to a Retirement Income goal at the target date Retirement Income 56% Stocks, 44% Bonds 30% Stocks, 70% Bonds Up to 30 years Steady drawdown with dynamic withdrawal rate until target date Safety Net 30% Stocks, 70% Bonds 30% Stocks, 70% Bonds Targets date of achieving desired balance Up to full liquidation at any time General Investing 90% Stocks, 10% Bonds 55% Stocks, 45% Bonds Recommendation is based on investor age No liquidation Major Purchase (House, Education, Other) 90% Stocks, 10% Bonds 0% Stocks, 100% Bonds Between 1 and 35 years Full liquidation at target date Each of these investment goals requires a different strategy—that is the quintessence of smarter investing. Betterment’s automated advice and technology builds a unique investment portfolio for each type of goal. Underpinning each type of goal is a customized stock-to-bond allocation recommendation, which is designed to automatically adjust (in most cases) to help you reach your goal without taking on unnecessary risk. For each of these goal types, we provide a recommended maximum and minimum stock allocation, based on your term, while making certain cash-out assumptions. But we also give you the tools to adjust the dial, if desired, for a more aggressive or more conservative allocation in any goal type. You can also select additional portfolio strategies that are not generally recommended but may be more personalized to your views. Retirement Savings Goals For retirement savings goals, our methodology enables investors to work toward their goal using multiple accounts—including those held outside of Betterment (such as your spouse’s accounts) but synced into the goal. The reality is almost every future retiree will have multiple accounts—IRAs, 401(k)s, 403(b)s, HSAs, and/or taxable investment accounts—that help them achieve their retirement savings goal. So, we developed our methodology to match reality as closely as possible. In addition, retirement savings goals can utilize Tax Coordination™, Betterment’s approach to asset location, which aims to lower your taxes on retirement savings by keeping the highest-tax assets in tax-advantaged account types and the lower-tax assets in taxable accounts. When you have 20 or more years until you retire, we recommend 90% stocks. Our advice reduces your recommended risk level over time until your retirement date, where it shifts to a 56% stock allocation. Then, when you have arrived at your retirement age, you can make the shift to the next goal type, Retirement Income, which we developed to serve your needs in retirement. Example of Allocation Advice for Customer Retiring at Age 65 Figure above shows an example that assumes the customer is planning to live until age 90. Retirement Income Investing Goals Once you reach retirement and start making withdrawals, Betterment’s smart retirement withdrawal process recommends an appropriate allocation for where you are in retirement and recommends a regular withdrawal amount from your goal. Our methodology considers a number of factors to suggest a safe liquidation target or withdrawal amount: Current balance Desired monthly income amount Minimum acceptable income level Desired certainty about not falling beneath minimum income level Conditional life expectancy For example, a 65-year-old male has a remaining life expectancy of nearly 18 years, according to projections used by the Social Security Administration.1 That is 18 years over which he will be both liquidating his portfolio but also growing his assets to support future years of consumption. With regards to the stock allocation, we seek to: Continue to grow your portfolio while in retirement Lower portfolio risk as you are further into retirement Safety Net Investing Goals A Safety Net goal is one of the highest priority goals we recommend for investors. It’s slightly different from other goals because we assume the money may never be needed—but when it is, we assume a substantial portion of the balance will be liquidated all at once. Currently, a goal for your “safety net” or “emergency” fund contains just one account at Betterment. Your account in a Safety Net goal will be taxable, as there are no tax-advantaged accounts for general personal savings. Juxtaposed to this goal, you may also sync an external savings account if you would like to see this account included in your balance. Betterment’s allocation advice for Safety Net goals is conservative and does not adjust automatically over time, holding at 15% stocks, 85% bonds continuously. We recommend you add a 15% buffer to the balance to help preserve the minimum balance you need to have available. Allocation Advice For A Safety Net Goal Major Purchase Investing Goals For a major purchase—such as saving for a car, a house, or even your child’s education—Betterment enables one account for each goal. With any major purchase, an investor usually anticipates liquidating all at once when they reach their goal, usually for a short- or medium-term period of investing. Transaction Timeline Table Thus, Betterment’s allocation advice is more conservative for these goals than that of retirement goals. Since we expect you to fully liquidate your investment at your intended goal date, Betterment automatically shifts your allocation to low stock percentages as you near your goal date in line with our advice, unless you set your own allocation or turn off automatic allocation adjustment. Allocation Advice For A Major Purchase Goal General Investing While Betterment is designed to help you execute goal-based investing, we understand that there are plenty of investors who aren’t sure about their goals, and might have part of their savings invested with no clear purpose. Many investors have a clear understanding for some of their goals, but haven't yet sorted through the precise purposes for all other investments. For these investors, Betterment offers goals that are classified as “general investing” and contain just a single account. Since you can still personalize the name, allocation, and portfolio strategy in these situations, we still call them goals within your account, but our allocation advice on these goals has fewer assumptions than the advice for the distinct goal types above. You can consider general investing goals to be the utility players within your account, where the priority is wealth creation because you have no specific plans for a liquidation event in the future. This makes goals of the “general investing” type generally appropriate for objectives like long-term savings where you might plan to transfer wealth to the next generation or convert your assets into a trust account at a later date. While you can have multiple general investing goals, we often find that Betterment customers who might be using general investing goals could decrease unnecessary risks by using a more precise goal type. In general investing goals, our automated advice recommends a range of allocations from a maximum of 90% stocks to a minimum stock allocation of 55% stocks, depending on your age and how close you are to age 65. Allocation Advice For General Investing How To Set Effective Investing Goals Using Betterment As explained above, Betterment works hard to help you set goals in realistic ways that match your actual savings habits. To align with our research on goal-based investing, it’s important to understand what makes for an effective goal. One framework to thoughtfully determine a prioritized set of goals is called the S.M.A.R.T. approach. S.M.A.R.T. stands for: Specific Measurable Attainable Realistic Time-limited Make your goal specific. A specific goal is one with a clear description and a well-articulated set of circumstances. For example, if you’re saving for a child’s college education, a goal that is specific might look like the following on paper: “My goal is to pay for my child’s total higher education costs (including graduate school if chosen, room and board, social events/clubs, and any other fees).” By stating how many of the possible education costs you’re planning to pay for (i.e. “total”), the goal statement above provides much more information about the size and shape of the future expenditure. Make your goal measurable. Making a goal measurable means that you can tell how close you are to achieving the goal using numbers. Generally, this means quantifying the specific information you know about—setting an accurate estimate of the total of the expenditure you expect to make. Here’s what a measurable goal looks like using our example: “My goal is to save a total of $800,000 to pay for all three of my children’s total higher education costs.” The total expenditure should account for all the factors that went into making your goal specific, but it should turn the various social and philosophical decisions you’ve made about your goal into a numerical sum. You should also account for taxes in setting a precise, measurable goal. Ensure your goal is attainable. As you define a specific and measurable goal, you should make sure it’s actually attainable. Attainable goals are future expenditures you actually have the capability to achieve. For instance, if you make $80,000 in a year, saving $800,000 over five years is not attainable because even if you could save 100% of your income, you’d still come up short of your goal amount. However, if you have more time to save or if you make more money each year, then perhaps the goal could be attained. Consider whether your goal is realistic A goal is realistic if you have the time, resources, and discipline to achieve it. Generally, your goals will only be realistic if you take into account the other goals you have in your life. For example, when saving for college education, you probably will also need to invest for your retirement. If you don’t align and prioritize your goals, you may end up being less able to save as regularly or as much as you’d like—which lowers your chances of achieving either goal. Any goal should be time-limited. The last step in developing a S.M.A.R.T. goal is to make sure the goal is time-limited—i.e. Every goal needs a deadline or target date. Just as measurable goals quantify the total expenditure you expect to make, time-limited goals quantify the time you have to reach that expenditure amount. In most cases, you should try to set goals as far in advance as possible. For instance, rather than waiting until you have three children that will be going to college, it’s a good idea to start saving as soon as you start planning a family. A time-limited goal should also consider how frequently you can plan to contribute to the goal. Will you save a portion of every paycheck? Or will you save just once a year? An effective time-limited goal might read like the following: “My goal is to save a total of $800,000 over 18 years (by [due date]) to pay for all three of my children’s total higher education costs by putting aside at least $1,500 per paycheck per month.” Use Investing Goals to Map Out Your Financial Picture By using a framework like the S.M.A.R.T. approach to set each of your investment goals, you’ll push yourself to think broadly about all the factors of life that affect your financial future while ensuring each and every goal is quantifiable and feasible. Remember that it’s okay to use estimates or set educated guesses when creating goals you’re not quite sure of. In many cases, such as retirement or college savings, you might need additional research and external resources to predict how much money you’ll actually need to reach all the specific criteria of your goal. In getting started saving for a goal, it’s always better to be approximately right than to have no goal at all. If you set reasonable, customizable goals using the goal types available to you in your Betterment account, you’ll get savings and investment advice on each of the building blocks of a solid financial plan. Additional assistance with identifying your goals is available to Betterment Premium customers.
How Does Betterment Calculate Investment Returns?
Understanding and using time-weighted and money-weighted returns within your Betterment ...How Does Betterment Calculate Investment Returns? Understanding and using time-weighted and money-weighted returns within your Betterment dashboard. Investors often want a simple answer to a seemingly simple question: how is my money doing? While it’s relatively easy to calculate any one performance figure, understanding it and knowing how to use it can be more of a challenge. When you log in to Betterment, we calculate the following return metrics under “Performance” for each of your goals: A time-weighted return Two money-weighted returns: simple return and internal rate of return Here, we try to help you better understand each way of looking at returns, when you should use each measure, how to compare them, and the dangers of misunderstanding them. We even provide an interactive calculator (see below) that you can use to test with the different calculations. Time-Weighted Return Time weighted returns are the most common way investors will see a return communicated. A time-weighted return can be thought of as the return on the initial balance of an investment over a certain period. For example, investing $1 in the S&P 500 for one year. Common indices, such as the S&P 500, are reported in time-weighted returns. Time weighted returns can refer to a price-only return, or a total return (price and income/dividends). Price returns reflect only the change in price of the asset, while total returns reflect both price and reinvested income. By default, Betterment displays total returns. If you have an investment account in which you, the investor, control the cash flows into and out of the portfolio, and you want to judge the performance of the investments without the distortion introduced by your cash flow timing, you should use a time-weighted return. For that reason, it is the only method you should use to compare the performance of different investments or of a single investment against a benchmark, making it the industry standard return methodology for financial advisors. Money-Weighted Returns: Two Measures 1. Internal rate of return If you want to judge the overall performance of an investment including both investment returns and timing of cashflows, then you should use a money-weighted return. This is true if you use an investment manager who controls when cash is invested, or if you are managing cash flows yourself and wanted to check your performance. The math gets more complicated here, but the concept is simple: When there is more money in the account, its performance is given more weight than when there is less. That way, an investment that has a lot of your money invested when your portfolio is appreciating, and then only a little when it is depreciating, will have that good timing (or good luck!) reflected in a money-weighted return. It almost never makes sense to compare internal rates of return across accounts or managers, since it includes differences resulting from both your cashflows and differences in investment performance. 2. Simple Return The return on an investment is most simply defined as the amount you gained as a percentage of the amount you invested. The simple return is a good back-of-the-envelope calculation that can work perfectly when you’ve only made a single investment, but in most common circumstances will not be a good judge of the growth of your portfolio. If you invested $100,000, and after a year you have $110,000, you can safely describe your return as 10%. But, consider what happens if you were to invest an additional $400,000 at the end of that year. Using the same calculation, you’d now find your simple return to be 2%. Did your investment performance suddenly drop by 8%? Thankfully, no. That is the major limitation of a simple return—it treats all of the deposits into an investment account as having happened at the same time as the first deposit. For more information on Betterment's approach to designing how your investment returns appear in our digital advice, read about our principled display approach.
Further writing from Dan Egan
How to Make a Tax-Smart Investment SwitchHow to Make a Tax-Smart Investment Switch Calculate the value of realizing gains to move to a potentially better investment. A customer once called us to discuss moving significant assets from another provider to Betterment. He asked if he would have to pay a one-time tax cost to liquidate, and considering that cost, would the switch still be worth it? We thought we'd share with everyone a way to figure out the cost and benefits of switching. Depending on your particular circumstances, the answer is likely yes to both questions—selling off a long-established portfolio may trigger taxes, but in the long term, it can be worth it. As an example, you might want to move out of an actively managed mutual fund. Research has shown that a portfolio of actively managed funds is expected to underperform by 1.01% a year on average, after fees, compared to an all index-fund portfolio. Or perhaps you're interested in lowering your fees over the long term or diversifying your investments from a single stock to a multi-asset class portfolio. While nothing in this piece should be construed as tax advice, since individual circumstances can vary greatly, the following should serve as a general illustration of the cost and benefit of transitioning to a potentially better investment. Informed Trade-Offs The key here is making an informed trade-off—you may trigger a tax bill today by selling your current holdings, but if you're in it for the long haul, moving to a better portfolio consisting of all index ETFs should make up for that tax cost. The real question to ask yourself when looking to move your investments to Betterment is: How long do I intend to hold this investment for? If you’re a short-term investor and plan to hold assets for a couple of years, or less, there's not much to gain from transitioning to a more efficient portfolio (although it should be noted that under this scenario, you'll realize the capital gains very soon in any case.) And as a general rule, you should only consider moving appreciated investments that you've held for more than a year in order to qualify for long-term capital gains on liquidation. If your investments have not appreciated since you bought them, or if they are held in an IRA or 401(k), you can generally transition them tax-free.1 Tax Cost vs. Excessive Fees The process by which we pay tax versus fees on our investments subtly biases us to overestimate the impact of taxes, and underestimate the impact of fees. Fees are generally taken out of returns before they ever hit our accounts—it's money we never even see. Tax on realized capital gains is assessed for an entire year, and results in a clear and visible liability, paid out of funds that are already in your possession. It's no wonder that irrational tax aversion is a well-documented, widespread phenomenon, whereas millions of people unwittingly go on paying unnecessarily high fees year after year. Your key decision boils down to comparing the long-term benefit of switching to a potentially better investment and paying more upfront tax, versus staying put in a portfolio of less optimal investments with higher expenses (that might also be a drain on your time, which is worth something). It's also important to keep in mind that unless you gift or bequeath your portfolio, you will one day pay tax on these built-in gains. Tax deferral is worth something, but how much? The 3 Key Financial Drivers to Consider 1. You could be invested in better assets. Take a hard look at your investor returns in your current investments. Could they be better? If you’re invested in actively managed funds, you may be losing, on average, 1.01% in returns, compared to an all index-fund portfolio, research shows. Betterment’s portfolio is made up entirely of index-tracking ETFs. 2. Automation and good behavior drive returns. We automatically take care of maintaining your investments for you—including rebalancing, dividend reinvestment, diversifying, tax efficiency, free trades and more. If you’re handling your own investments, consider what you're missing (and also how you're spending your time.) We perform automatic, regular rebalancing, which is expected to add 0.4% to returns, on average; a global, diversified portfolio is expected to add 1.44% in returns as compared to a basic two-fund portfolio and the average Betterment customer has enjoyed a behavior gap that's narrower by 1.25% as compared to the average investor. All told, including the demonstrated benefit of index funds—these advantages are expected to contribute to returns over the long run. 3. If you're paying what a typical mutual fund charges, you could be paying much less in fees. The average expense ratio for a hybrid (stock and bond) mutual fund is 0.79%.2. Betterment’s underlying ETF portfolios have an average expense ratio of 0.06% to 0.17%, depending on your allocation. Note that the range is subject to change depending on current fund prices. Our management fee is either .25% or .40%, depending on your plan. Your all-in cost at Betterment is between 0.31% and 0.57%. As smart investors know, every basis point matters.3 Taxes are a cost, but generally a cost you'll eventually pay anyway. Meanwhile, the cost of being in a sub-optimal investment over the years can far outweigh any benefit of tax deferral. Need a second opinion? If you’re still not sure if transferring your taxable portfolio is worth the upfront costs, we can weigh in. If your taxable portfolio holds more than $250,000 in assets, stop stressing and simply reach out to our licensed transfer specialists at firstname.lastname@example.org. The team can review the specifics of your portfolio and provide you with a recommendation on how to best move—or not move—your assets to Betterment. 1 The discussion here only applies to taxable investment accounts. All types of IRAs (traditional and Roth) and 401(k)s don’t typically trigger taxes when rolling over from one provider to another. (An exception is converting from a traditional IRA to a Roth, which will trigger taxes. However, there are smart ways to lower these, too.) 2 2021 Investment Company Fact Book 3 We've updated our pricing structure since this article was published. Learn more at betterment.com/pricing.
You Can Now Skip Individual Recurring DepositsYou Can Now Skip Individual Recurring Deposits Managing your Betterment auto-deposits just got easier. Now you can skip any individual auto-deposit in just a few easy steps. It gives me great joy to announce that you can now skip any individual recurring deposit before it happens. You can now skip any recurring deposit you’ve set up before it happens from a link in the email sent before your recurring deposit occurs. We’ve heard scenarios like this many times: I have an unusually high credit card bill I want to pay off (rather than save). I need to put a deposit down on my kids’ school tuition and need to skip this month. I need to pay taxes but otherwise want to continue saving regularly. Until today, if you had set up a recurring deposit with Betterment and didn’t want it to proceed, you needed to turn off your recurring deposit completely. This not only meant you needed to remember to come back and turn it on later, it also meant your plan would (incorrectly) be off track simply because you don’t want to save for one deposit. One of the cardinal rules of behavioral finance is never make someone make more decisions than necessary. If clients want to skip just one deposit, they should be able to do it. So from now on, you can skip any individual recurring deposit, so long as it is before 4 PM EST on the scheduled deposit date. How To Skip An Individual Deposit There are two places you can go to skip a recurring deposit. First, Betterment sends you an email a day before your scheduled recurring deposit takes place. In this email, you’ll find a link directly taking you to Betterment’s site where you can skip your upcoming deposit. Just click on it, sign in, and confirm. Second, you can see all pending recurring deposits on the “Transfer” tab of your Betterment homepage. So long as it is before 4PM EST on the deposit initiation date, you will have the option to hit the “skip” button on the right. Then, you'll see: Too many skips can knock you off track. For the vast majority of goals, missing one deposit won’t be enough to knock you off track. Our advice will automatically update to consider your new balance and the skipped deposit, and may slightly increase the recommendation for remaining recurring deposits (as you’d expect). But it is possible that skipping many recurring deposits will reduce the confidence that you’ll reach your target balance on the target date. However, you can always defer the goal a bit in order to make up for your current circumstances.
Portfolio Optimization: Our Secret to Driving Better PerformancePortfolio Optimization: Our Secret to Driving Better Performance We optimally blend funds to deliver higher expected investor returns for each asset class and ensure you get the best possible performance from your investments. Many investors use a combination of tactics to get the best performance they can from their portfolios, including asset allocation, diversification and other risk management techniques. But the difference between Betterment and individuals who are trying to navigate this alone, is the complexity and the scale on which we can do this for you. When you invest with Betterment, you’re getting a professional portfolio that has fully integrated these tactics, delivering you an investment vehicle that's already been optimized. We integrate a number of sophisticated strategies that few people can implement on their own as part of our portfolio optimization, including maximizing upside potential and minimizing the downside risk for each of your investment goals. Building the portfolio We know any DIY investor can choose a bunch of funds with enough personal time spent on research, whether it's through Fidelity or Vanguard or some other platform. In fact, DIY investors can and do apply the lessons of many years of research with respect to picking funds, like only sticking with index funds, or favoring a value tilt. But for many people, spending a couple of days a month on investment research and management is either not of interest or a practical use of their time. The alternatives are paying for an advisor, or using a basic target date fund. The former is expensive, while the latter is inflexible to your needs, and can also be unnecessarily pricey. That's where our portfolio and service are ideal. At Betterment, we offer 101 customizable allocations to customers, ranging from 100% stocks to 100% short-term Treasuries. First, it's helpful to understand how we built our overall portfolio and what's inside. We started with a practical foundation based on Nobel prize-winning research from the past seven decades. We began with the concept of diversifying as much as possible (Markowitz, Modern Portfolio Theory, 1950s), and then tilted toward value and small-cap stocks (Fama & French, 1970s). Since we know that most active mutual-fund managers tend to underperform, we then picked low cost, index-tracking, high liquidity ETFs for our portfolio. And because people often worry about potential losses about twice as much as potential gains (Kahneman, Prospect Theory, 2002), we worked on minimizing downside risk. Lastly, we assembled those funds in a way that gives you better performance by adding another level of analysis, or portfolio optimization. To do that, we used some of the most recent quantitative models for asset allocation and downside risk to squeeze even more performance—or diversification alpha—out of these assets. Learn more about the funds in our portfolio. Driving performance The two modern techniques we used are the Black-Litterman model and a downside-risk optimization model. These two models complement each other like yin and yang—one model helps us optimize for the upside, while the other helps us see what the downside might look like. The Black-Litterman Model: This model allows us to generate forward-looking returns estimates —the upside—based on actual data that includes the collective intelligence of all investors around globe. To be sure, this is a general description of this model; there is also an academic view as well. This complex formula has a very basic insight at its core: it looks at how all investors around the world behave, and based on that information, creates a kind of global asset allocation model. This makes it a very good anchor of where all the world’s money is invested in the aggregate at any given time. The model was introduced in 1990 and refined over the next decade, and also helps make up for some of the shortcomings in the classic Modern Portfolio Theory, which can underestimate the diversification benefits of some asset classes. Read more about our diversification strategy. In addition, Black-Litterman is the way to avoid a so-called home bias in investing. This refers to the preference investors have for favoring assets that are “close to home”, contra evidence that would suggest a more global allocation. In other words, it's a tool for using empirical evidence to make investing decisions, with no reference to regional likes or dislikes. U.S. stock markets are only about 48% of the world stock market—the remainder is international developed (43%) and emerging markets (9%). You can see this breakdown in the MSCI All-Country World Index. Minimizing potential for loss Downside Risk and Uncertainty Optimization: Modeling for worst-case scenarios allows us to generate forward-looking views of potential downside risk and uncertainty based on the combination of the historical returns of our chosen assets. When we model our future expected returns we want to know two things — what is the frontier for expected outcomes and what is the frontier for worse than expected scenarios (e.g. everything from a mild downturn to a massive drawdown). With this model, we can evaluate a full range of future outcomes. We can also stress-test our allocations through negative market scenarios to get an idea of how severe a drawdown could be, and what duration. We can also factor in the role our continuous, algorithm-based investment management will play, primarily via automatic rebalancing. The results An easy way to see the value-add of our strategies is to look at the difference between our efficient frontier and that of a so-called "naive" portfolio, one that is made up of only the S&P 500 and an index tracking all U.S. bonds (AGG). The expected returns of Betterment's portfolio significantly outperform a basic two-fund portfolio for every level of risk. This result is a function of portfolio optimization, along with our well-crafted selection of assets and funds. Even if it's clear that these strategies are out of reach for virtually all DIY investors, you might ask: why doesn't every advisor do portfolio optimization? There are several reasons. One is the issue of quantitative capacity—these methods are mathematically complex with multiple moving parts (that's why our investing team includes experts in mathematics, statistics and economics.) Second, portfolio optimization is time consuming—whenever a new asset class become available (FX-hedged international bonds, for example), or funds change their expense ratios, an advisor needs to rerun the optimization. Lastly, there's the cost of updating portfolios—we have built a sophisticated proprietary trading platform that automates these calculations on an ongoing basis, meaning that if we update our optimization, all our customers can instantly benefit. A traditional advisor would have to process many of these changes by hand. As you can see, investing well is not just a matter of picking the right funds—it's also a matter of applying some serious computing power to squeeze out optimal performance. For you, the result of this portfolio optimization is the security of knowing that for any level of risk you select, we've done a careful evaluation to provide the optimal risk-adjusted performance, and your portfolio is re-optimized on an ongoing basis.
Stop Worrying and Learn to Love Rising Interest RatesStop Worrying and Learn to Love Rising Interest Rates A diversified bond basket can actually benefit from rising interest rates. Contrary to conventional wisdom, rising interest rates can be good for a bond portfolio. Investors might think otherwise because of the mechanics of basic bond math (‘when rates go up, yields go up and prices go down’). But, that’s not the whole story: A diversified bond basket can actually benefit when rates rise. Interest Rates and Bond Fund Returns As an example, the light blue line on this graph is the return of VBMFX, a very close proxy of Betterment’s U.S.Total Bond Fund (BND) over the subsequent two years from the date on the x-axis. This allows us to map the performance of the bond fund to the interest rates represented by the dark blue line. The dark blue line is the risk-free rate, or the Effective Federal Funds Rate, which is what banks charge each other based on their deposits at the Federal Reserve, and the primary benchmark for interest rates. The gray periods highlight when interest rates were rising. Over the past 25 years, the two-year rolling return of the U.S.Total Bond Fund—a bond fund diversified by maturity, credit quality and geography—actually increases, not decreases, after interest rates rise. Why? It’s because of how the bond market really works, beyond the simplistic bond math in investing 101. What is that? Bond prices today have as much to do with expectations for the future as the actual level of interest rates today. So a rate rise can be ‘priced in’ for a long time before it happens. The element of time, or what might happen over the duration of the bond fund, and what other investors in the market expect over the long term. Yes, very short-term rates reflect the policy set by the Federal Reserve. However, for most bonds, current yields and prices also reflect market participants’ beliefs about future changes to that policy. Bond yields can jump on the expectation of a rate rise, even if it doesn’t happen for a while. As we have written about before, market expectations are already reflected in prices. The fact that interest rates will rise at some point isn't exactly secret knowledge, so how are active managers going to beat the market? Critically, the market usually moves slowly and before the Fed announces changes. The Fed is getting better and better at transparently communicating its likely future decisions, specifically to keep bond market operating smoothly. As a result, rate moves are often smoothly reflected in prices before they actually happen. That makes it tougher for an active manager to earn their fees. Long-term rates factor in a variety of different expectations, including inflation and long-term economic growth. All those factors alter the calculus for long-term bonds that can have maturities of up to 30 years. So, for the diversified portfolio of bonds shown in the graph, the impact of an interest hike could have hit some of its bonds before the actual rate change. For the long-duration, high-quality bonds, the broader trend for total return is tracking the interest rates, earning a maturity premium, and reflecting market expectations for the future. Acknowledging that market expectations affect bond prices is a more holistic way to think about how a diversified bond fund will likely perform. Just doing the bond math oversimplifies. Bond Market: Myth and Reality The bond market is very sophisticated and very liquid, meaning that the vast majority of factors that impact prices are ‘priced in’ at any given moment, as investors constantly react to perceptions of a changing scenario. When bonds react suddenly and sharply, it’s because news that impacts the price was unexpected (i.e., market expectations were wrong). But, most of the time, market expectations are accurate, so the changes are ahead of time and gradual. The Federal Open Market Committee (FOMC) is a group that meets about eight times a year to talk about U.S. interest rates. Looking closely at notes from a meeting in June 2015, the committee explains carefully in the official statement that interest rates aren’t decided in a vacuum, but based on the country’s reported economic data. It spells out exactly what it expects so market expectations can be on the same page. Many investors never take the time to actually read the statement, but it’s probably the most instructive few paragraphs to help answer the question of where bond prices will go. For example: The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. What should strike any investor reading that is that if bond prices today perfectly reflect market expectations, the FOMC just spelled out the exact parameters of each of the factors that would compel the Federal Reserve to raise interest rates. If you want to know when the Federal Reserve might raise interest rates, the answer is really clear: after more job growth and signs of rising inflation. All of which are public data released ahead of FOMC meetings. Because bond investors knew the Fed’s framework for increasing rates, market expectations are status quo. You could read into the statement that rates might rise slightly in the medium term, which is what the prices for bonds are already reflecting could happen. You Can’t Time Bonds The lesson of all this is that trying to be tactical about interest rates and your bond portfolio is really a fool’s errand. If ‘when rates go up, yields goes up and prices go down’ leads an investor to think that now is a good time to sell bonds, look at the chart again. The dark blue line, representing the Effective Federal Funds Rate, has been at this low level for five years, and the FOMC could have decided to raise rates after any of its meetings based on the conventional wisdom that ‘interest rates have to go up eventually.’ But it didn’t. You can be wrong for a long time. Meanwhile, over that same time period, the U.S.Total Bond Fund, the blue line, generated a strong return for investors in the first half of that period, and then a weaker return, but still positive, as interest rates remained at these lower levels. If it’s reasonable to think, based on reading the FOMC statement, that the market expectations are already on the same page for a gradual rise to begin around the end of 2015 or early 2016, then what the first chart will probably look like it did during the previous three periods of rising interest rates, in gray, where the U.S.Total Bond Fund returned gains for its investors. An investor who tried to time the market during this period by selling the bonds and holding cash, let’s say, would have actually lost money. Because of the impact of inflation, the investor’s real return would have been in negative territory. Cash Often Loses (Real) Money Back to Your Betterment Bond Basket The bond portfolio at Betterment is the most diversified I'm aware of. We include both international developed bonds (BNDX) and emerging market bonds (EMB) bonds in our portfolio. This is aimed at reducing your exposure to pure U.S. interest rate risk considerably. Diversification is the key to creating long-term wealth in the market, and a position in resilient bond funds is an important part of that, whether interest rates are rising or falling. Remember these are the tenets of Betterment’s approach: Diversify: Every Betterment allocation is designed to diversify risks so that you’re not over-exposed to any one of them. Lower Stock Allocations and Risk: We take the risk of different duration bonds into account in our allocations, but purely from a risk-as-uncertainty view. Our bond allocations are based on long-term views, not any short-term moves. Always Stocks and Bonds: With the exception of 100% bonds, every Betterment portfolio has allocations to both stocks and bonds, international and domestic. Lower Duration Within U.S. Bonds: As you decrease the stock slider beneath 40% stocks, Betterment uses ultra-short duration Treasuries to help de-risk the portfolio, which is aimed at removing your portfolio’s sensitivity to interest rate changes, for better or worse. Diversified Interest Rate Exposures: We invest in both international developed (BNDX) and emerging market bonds (EMB) to help diversify our interest rate risk. This is designed so that neither of these bond funds expose the investor to currency risk. This article originally appeared on ETF.com.
Why the S&P 500 Is a Bad BenchmarkWhy the S&P 500 Is a Bad Benchmark Using a regional indicator to look at your portfolio of global holdings doesn’t provide an accurate picture. Here’s why. Using a regional benchmark to look at your portfolio of global holdings doesn’t provide an accurate picture. Here’s why. Are you tall? Your answer to that will likely depend on your own personal context. For example, if you’re a 5’9” American male, and you're comparing yourself to your American male peers, then you might say no. Why? Many of your friends are likely taller than you are, given that you're a half-inch shorter than the average American male.1 But what happens when you compare your height to all other men in the world? The global average height of men is 5'8 1/2". So let's ask again: Are you tall? The lesson here is that we can’t let where we live play an overly important role when we’re trying to provide an objective, evidence-based answer. Applying this concept to investing, let’s examine the importance so many investors attach to the S&P 500 or the Dow Jones Industrial Average. U.S investors tend to heavily measure their portfolio performance against American indices, even though they have been proven not to be the best benchmarks. The S&P 500 is an index of the largest 500 publicly traded U.S. companies, such as Apple, Microsoft, and Ford, weighted by their market capitalization. As such, it’s often used by casual investors as a gauge of stock market performance. In 2014, it did very well—up almost 14%—significantly better than non-U.S. equity markets. Performance Relative to Global Stock Portfolio In other years, however, the opposite was true. From 2002 to 2007, the S&P 500 underperformed not only the U.S. stock market as a whole, but also a diversified portfolio and international markets. As American investors, we look to the S&P 500 because it’s familiar and it’s what’s in the headlines. We can’t resist using it as a benchmark for a diversified portfolio. This phenomenon is called home bias. Betterment’s portfolio avoids home bias by reflecting global stock market weights. U.S. stock markets make up roughly half of the world’s investable stock market—the remainder is international developed (43%) and emerging markets (9%).2 It’s important to keep in mind that the S&P 500 represents just over one-third of all the world’s stocks. That means comparing your performance to it is a bit like to comparing your height against only 37% of the world’s people who all come from the same place—say, comparing your height only to the average height of the American male, which is 5’ 9 1/2.” While you might be able to fudge a little with your height, your money is a different story. Using the right evidence—rather than the most convenient context—is the smarter way to invest. Diversification Is a Smarter Investment By using the world’s markets as its baseline, the Betterment portfolio diversifies risk on a number of levels, including currency, interest rates, credit risk, monetary policy, and economic growth country by country. Even as economic circumstances may drag down one nation, global diversification decreases the risk that no one geographic area alone will drag down your portfolio. In short, diversification is a fundamental way to manage risk—it keeps your investment performance more consistent. That’s why we pay so much attention to asset class correlation. The result for you, the investor, is that you get the average performance of all the asset classes in which you are invested. If you had only selected one of these asset classes for your portfolio—say, the S&P 500—then you would be at the mercy of that sole index’s performance. By diversifying, you avoid extremes in both gains and losses, and you achieve the same average returns with less uncertainty. Diversification does not guarantee higher returns as compared to each constituent of the portfolio. Rather, diversification is about ensuring average returns—never the best, and never the worst. So, what can you use to compare your performance? The concept of a benchmark basically does not apply to an all-index portfolio. When you’re an index-fund investor—which is what you are when you have a Betterment portfolio—there is no under- or over-performance. You are the average performance. However, it can be useful to have some external yardstick to get a general sense of how you are doing. To do that, you’d need a fund that is similar to your Betterment portfolio with respect to allocation, costs, and diversification. While imperfect, Vanguard’s LifeStrategy Funds could be a point of comparison. If you choose to compare the two, make sure it’s apples-to-apples: Be careful to not equate a 90% stock fund with an 80% stock Betterment account, for instance. But keep in mind that the additional benefits of a Betterment account—general tax efficiency, including tax loss harvesting, free trading, goal-based advice, and more—are likely not included in the performance metrics of a similar non-Betterment diversified portfolio. And next time someone asks you if you are tall, remember that, to be accurate, you need to use the global average before you can say yes or no. 1 AverageHeight.co 2 MSCI All-Country World Index
9 Reasons Goal-Based Investing Leads to Success9 Reasons Goal-Based Investing Leads to Success What exactly are you saving and investing for? This is a serious moment of self inquiry. Defining goals enables better wealth management. Here's why. Before you start putting money into the market, ask yourself one question: What exactly are you saving and investing for? This is a serious moment of self inquiry. In order to invest for the future you are cutting back on spending your wealth now. There must be some future purpose for this sacrifice—some goal of tomorrow's spending which outweighs the pleasure of today's spending. Goal-based wealth management is not just a cute way to help you manage your investments as easily as you manage your Gmail account—it is necessary for maximizing how effectively you manage your money and investments, including knowing when you can afford to spend more than you might think today. For those who are new to goal-based wealth management, goals allow you to bucket your money according to its purpose and when you will need a given amount. Each goal you select has its own portfolio of stocks and bonds customized for the time horizon you set. "Goals" are a kind of budgeting methodology that have been used for decades (one old version is called the envelope system). Betterment has elevated the framework to apply it to good savings and investment strategy as well. Why? Because research shows it improves outcomes by encouraging optimal behavior and more precise wealth management (see the reference list below). Below are some of the behavioral and financial reasons why goal-based wealth management is better. 1. Avoid under-saving. Goal-based wealth management forces you to think about and enumerate your goals, often far in advance. This prevents you from underestimating how much money you'll need at any point in the future—or misaligning your expectations with your savings ability. It means that present-day you and future you have more common ground. 2. Plan ahead, save less, achieve more. Using goal-based wealth management, you'll likely see future liabilities coming down the road. And the further in advance you start saving for a goal, the less you'll actually have to save. Why? The power of returns. The earlier you start saving , the more time you give the market to grow your savings for you. For example, imagine you know you will want cash to buy a new car—let's say $65,000 for a very cool Tesla Model S. Being smart, you are not going to finance it (where you pay interest), but rather save up ahead of time. Below you can see the recommended monthly savings required depending on how far in advance you start saving. If you save monthly for one year, you're essentially saving dollar for dollar for your new car. But if you plan ahead, and start saving five years out, the market can help you—and you only need save $54,720. 3. Use a data-driven target. When you set up an investment goal at Betterment—for example, saving $150,000 for a home down payment in 10 years—we give you several pieces of advice: The first is a suggested allocation based on your time horizon and the second is advice on how much you need to save on a monthly basis to reach that goal. We also suggest an initial deposit. When you take guesswork out of your plan, it means you are more likely to hit your target. 4. Save for a tangible outcome. Goals make it far more likely you'll save for—and achieve— every one of your goals. When you can attach a real outcome to the purpose of your saving, you're more likely to actually work toward that goal rather than blind saving. In behavioral psychology, this is called affect—or the concept that we are more motivated by real things than abstract numbers. 5. Guilt-free spending. While some might find it surprising, there are people who actually feel guilty and are uncomfortable with spending large amounts of money. This is true even when it's for a planned, known expenditure. When it comes time to spend your savings, if it comes from an account specifically earmarked for that purpose, you're not overspending. Goals also make it more likely you only spend the amount saved in the goal, rather than scooping out a lump sum from a general savings account. 6. Benefits to an automated plan. For most people, it’s much easier and more practical to invest $125 a week, or $500 a month, than summon up a one-time deposit of $6,000 each year. Automating your saving makes it effortless to do the right thing—save the right amount every month. This kind of of drip-system is not only useful for budgeting and saving on an ongoing basis—it’s also great investment strategy. First, it ensures your money has maximal time in the market. Second, it is a form of dollar-cost averaging, which diversifies your cost-basis entry points over time compared to a lump-sum purchase. With Betterment, regular auto-deposits also provide an opportunity for rebalancing and tax-loss harvesting, which are investing practices that can improve returns and lower your tax bill over time. 7. Turn a bias into a strength. Goal-based wealth management makes use of 'partitioning' and leverages mental accounting to improve your savings behavior. Mental accounting means that you make decisions based on the red or black of each individual account, rather than view them in the aggregate. While this could lead to unwise decisions as it may limit a holistic view of your finances, you can also use mental accounting as a strength. By creating many different mental accounts, you ensure that you are saving optimally for each of them—and do not rely on one account to cover all your required future liabilities. 8. Better match assets and liabilities, avoid debt. Goals makes it easier to close the gap between the money you can afford to spend and the money you want to spend. In investing, we call this matching assets to liabilities. By clearly earmarking the assets of today to the liabilities of tomorrow, we ensure that we aren't going to go into debt or fail at those goals. This can also help determine if you're in danger of paying interest on something you cannot afford. For example, if you fall short of target or goal, like saving $25,000 for a luxury vacation, you have to decide whether to make up the shortfall with credit—or cut back on what you can afford. When you use credit or unexpectedly downsize, you are using a form of debt. The first is financial and the second is psychological. Goals help you manifest your intentions without incurring debt of any kind. 9. Achieve optimal returns. Goal-based wealth management matches your time horizon to your asset allocation, which means you take on the optimum amount of risk. When you misallocate, it can mean saving too much or too little, missing out on returns with too conservative a setting, or missing your goal if you take on too much risk. Occasionally, critics of goal-based investing claim that it causes users to deviate from an optimal allocation because they don't look at their portfolio holistically. In fact, it has has been shown through a series of papers (see below) that when done correctly, goal-based investing is just as efficient as holistic portfolio management. Betterment’s algorithms are smart enough to avoid these hazards of goal-based investing. For example, we look across all your goals when utilizing tax-lot information—for example, using TaxMin to withdraw—to ensure that one goal is not mis-coordinated with others. You get all the benefit of goal-based wealth management, and none of the downside. A reading list If you would like to get into the nitty-gritty on any of these points, here are my references: Rha, J.-Y., Montalto, C. P., & Hanna, S. D. (2006). The Effect of Self-Control Mechanisms on Household Saving Behavior. Journal of Financial Counseling and Planning. Shefrin, H. M., & Thaler, R. H. (1992). Mental accounting, saving, and self-control. In G. Loewenstein & J. Elster (Eds.), Choice over time (pp. 287-330). Russell Sage Foundation. Shafir, E., & Thaler, R. H. (2006). Invest now, drink later, spend never: On the mental accounting of delayed consumption. Journal of Economic Psychology,27(5), 694-712 Thaler, R. H. (1990). Anomalies: Saving, Fungibility, and Mental Accounts. Journal of Economic Perspectives. Fox, C. R., Ratner, R. K., & Lieb, D. S. (2005). How subjective grouping of options influences choice and allocation: diversification bias and the phenomenon of partition dependence. Journal of experimental psychology. General, 134(4), 538-55 Das, S., Markowitz, H., Scheid, J., & Statman, M. (2010). Portfolio Optimization with Mental Accounts. Journal of Financial and Quantitative Analysis. Brunel, J. L. (2006). How Suboptimal—if at all—is goal-based asset allocation?. The Journal of Wealth Management, 9(2), 19-34.
What To Do After A Market DropWhat To Do After A Market Drop Seeing a market dip is scary. We feel it, too. But it’s important to remind yourself that market drops are an expected, unavoidable part of investing. A sharp fall in stock prices, as we’ve seen recently, is usually accompanied by scary news headlines and red numbers. Modern media wants clicks and attention, and, unfortunately, fear sells. It’s hard to stay calm. We feel it, too. But our advice is simple and straightforward: Stay calm and make smart decisions to support your longer-term goals. We knew there would be days like this, and we planned for it. Betterment portfolios are optimized for your time horizon. They’ll stay that way. If you’re tempted to take action, remember that this is why we created Betterment—to automatically plan for and handle market drops so that you wouldn’t have to worry about them. When you opened your Betterment account, we based our portfolio-allocation advice on the time horizon for each of your goals. That means each of your portfolios is properly adjusted for risk and takes into account the likelihood and magnitude of a downturn or below-average returns. We’ve planned on seeing some dips, and adjusted accordingly. Also remember that, as with many things in life, making decisions in the heat of the moment is probably not a good idea. Investing is no different. The more you check your account, the more likely you are to see losses, and subsequently do something in reaction to a near-term drawdown. And reacting to market drawdowns is likely to hurt your returns over the long term. Other experts agree: stay calm, do nothing. You don’t have to take my word for it. Listen to some of the most respected consumer advocates in personal finance. Jason Zweig, an esteemed columnist for The Wall Street Journal, put together a 2015 list of what not to do. Read it for yourself, but here’s an overview, put more positively: Turn off the news. Stay calm; don’t panic and sell. Use this as an opportunity to diversify. Remember that what matters is the outlook for the future, not a “correction.” Ignore most commentary; no one knows what will happen next. Ron Lieber of The New York Times knows what this feels like and puts forward six excellent points to consider: You are more diversified than just the S&P 500 and (should) have bonds. This drop is nothing compared to the gains the market has seen in the past six years. These portfolios were constructed when you weren’t anxious. You (should) have plenty of time to recover. If you’re worried about panicking, it’s better to reduce your risk (say, by 20% stocks) than to move to cash. Just know this likely means you’ll need to save more. This is completely normal. This is what markets do. Cass Sunstein, author of Nudge and an experienced investor in his own right, recommends to "have a diversified portfolio, consisting in large part of low-cost index funds, weighted toward equities; add money as you get it, and diversify it as well; keep the cash you need; and otherwise hold steady (and spend a lot of time with the sports pages)." Finally, legendary investor Warren Buffett gives perhaps the most concise advice about how risky markets feel, and what you should do: "The stock market is a device for transferring money from the impatient to the patient." Stay focused on the future, not the past. Let’s answer the key question on many people’s minds: How much worse have markets performed after a bad week (a 5% or worse drop in markets) historically? The answer: If anything, they appear to perform slightly better. Recent performance is simply not informative about what will happen next. The graph below shows the subsequent returns of the S&P 500, split by if the preceding week was “bad." We defined “bad” as any week with a loss of 5% or more. We have 48 of such weeks starting from the 1950s. (Analysis from 2015) Bad Weeks and Future Returns https://d1svladlv4b69d.cloudfront.net/src/js/returns-following-bad-weeks/index.html While it might seem like future returns are more variable after a bad week, this is likely because of the smaller sample size (there are 3,376 weeks that were not bad, for comparison). Indeed, if anything, it seems like bad weeks are followed by slightly better weeks. But we don’t recommend you bet on it; the odds of it going well are the same as the odds of it going poorly. Following 4 Weeks’ Return After Normal Weeks After Bad Weeks < -20% 0% 0% -20% to -10% 1% 8% -10% to 0 39% 30% 0 to 10% 59% 51% 10% to 20% 1% 8% 20% or More 0% 2% What We’re Doing to Help You Reach Your Goals We’re in an era of uncertainty; we always have been, and we always will be. Even if people say otherwise, no one knows what will happen, so there’s no use in projecting. We understand that it might feel necessary to try to correct what’s happened, but it’s just a distraction. The more important thing to do is focus on the future and staying properly invested. Tax Loss Harvesting+ Our Tax Loss Harvesting+ can help you capture any losses in your portfolio and use them to help lower your tax bill at the end of the year. You can offset up to $3,000 of ordinary income every year with tax losses, which can be a substantial savings. Tax-Aware Rebalancing Each of your goals has its own target asset allocation. We monitor every goal daily, and will rebalance when your goal’s allocation drift passes above our thresholds. This helps to maintain your selected allocation level and buys depreciated assets at a lower price. Rest assured, Betterment will never cause short-term capital gains tax to rebalance your portfolio. Keeping Your Goals on Track When your goals start to go off track, we’ll alert you. We may suggest either a one-time deposit or a slightly higher auto-deposit amount to make up for any market losses. However, it’s important to note that most people with longer-term goals will not fall off track. If you have to do something, do something productive. There are plenty of things you can do in response to a drop in markets that can have a positive effect on your portfolio, risk management, and chance of hitting your goals. Revisit your goals and plans. A good action to take would be to make sure your goals are properly aligned with your time horizon. For example, let’s take a 30-year retirement goal (target $1 million) with $85,000 rather than $100,000 due to a 15% drawdown. The drop has increased the monthly savings amount to $647, up $10 from $637 before the crash—hardly a game changer. But, that $10 makes a difference over the following 30 years, so check to see if any of your goals have gone off track and need to be replenished. Opportunistically Deposit to Fund Rebalancing A market drawdown is one of the most frequent causes of rebalances. The losing assets (often stocks) become underweight relative to the stable assets (bonds). Sell-based rebalances are an automatic and systematic way to buy lower and sell higher. However, in taxable accounts, selling can trigger capital gains and thus taxes, even if the asset is substantially below its all-time high. Betterment will never cause short-term capital gains tax to rebalance your portfolio. But you can avoid generating long-term capital gains by making opportunistic deposits during volatile times. This allows us to buy underweight assets without selling. On the Portfolio page of your account, you can see the minimum deposit necessary to avoid a sell-based rebalance. Liquidate losses in external accounts. One of the most commons barriers to switching over entirely to Betterment is incurring capital gains in external investments. Take advantage of a short-term market drawdown and let go of an underperforming mutual fund, or diversify away from a single stock position. What can you do today? Prepare a short list of investments you would like to liquidate, and the price at which you are willing to sell them. Our tax-switch calculator can help with that. If you can’t stand the heat… turn it down. While the best investment strategy is usually to stay invested, some people could find the stress simply to be too much. If you think you might make an extreme decision—such as moving to 100% bonds—if the drawdown continues, then it’s OK to reduce your risk temporarily. Just make it less extreme than you’re inclined to. Adjust from 90% stocks to 60% stocks, for example. Make sure you set a reminder to revisit your portfolio after a month. While we don’t believe it will improve your performance from a pure investment returns point of view, it means you’ll be less likely to make an emotional decision, and you’ll have a higher return per night’s lost sleep. Take a vacation from your portfolio. My own research has shown that people are more likely to monitor portfolios during volatile periods. The only problem is that the more you monitor, the riskier your portfolio will seem to you. A better strategy is to log in less during volatile periods. When stress drives bad decisions, it pays to be the ostrich, not the meerkat. When Fidelity looked at which investors had the highest returns, it was those who never logged in. Still unsure? Get a second opinion. Our dedicated team of CFP™ professionals are here for you. If you need additional guidance and personal recommendations for your financial plan, book an advice package today. Ultimately, the best thing to do in a market downturn is nothing. Our advice takes an underperforming market into account, so trying to correct a drop could end up hurting your returns over the long term.
Why Comparing Returns Is a Bad Way to Choose an Investment ManagerWhy Comparing Returns Is a Bad Way to Choose an Investment Manager Short-term or recent returns give little information about future returns, and they increase the odds you’ll make a bad decision. The greatest trick the stock market ever pulled was convincing investors that historical returns are predictive. They aren’t. In fact, historical returns not only give you very little information about future returns, but they can also increase the odds you’ll make a bad decision. We often see this bias in investors. Both reporters and prospective customers often ask us, “What are your returns?” I cringe when I hear this. Out of all the questions you should be asking, this one should be low on the list. There are far more informative and useful questions to ask, once you know what's in our portfolio. To be fair, there are aspects of the answer that can be helpful. Returns can give you an idea of the size of upswings and drawdowns, and how the portfolio relates to other asset classes. But in a passive, index-tracking portfolio, such as Betterment’s, you shouldn’t expect to see market alpha in our performance. When properly benchmarked, we are the benchmark. The other common mistake people make is comparing our portfolio to another over a short period of time. If, after six months, our portfolio has a lower return, they’ll often ask, “Why should I use you if your returns are worse?” Far too often, investors put too much weight on small sample, recent historical performance, choosing the investment with the highest investment return. How deceptive can this be? How the Data Deceives You might not realize it, but when you look at historical returns, you’re doing a statistical analysis. Any set of historical returns comprises a sample of behavior over a certain period. Any inferences you make about what they tell you of the future should be balanced by placing them into context of how variable they are. And when you do that, two clear issues arise. Fooled by Randomness The first is being “fooled by randomness,” a phrase coined by Nicholas Nassim Taleb, a risk analyst and statistician. When you choose the highest returning of two correlated investments using a small sample of historical data, the odds are incredibly high that you picked the wrong fund. The randomness of small samples overwhelms the truth. Let’s work through some examples. We’ll use hypothetical portfolios with return probabilities we know for certain, because we’ve created them through simulation, and see how well the short-term data mimics the long-term truth. These are not Betterment portfolios. Portfolio A will have a mean annual return of 6% and a volatility of 14%. Portfolio B has a mean return of 6.5% and annual volatility of 13%. The portfolios will also have a 0.90 correlation to each other—most stock funds have higher correlations. By both measures of absolute return and risk-adjusted return, Portfolio B is better. Yet over the first randomly simulated six-month period, Portfolio A came out ahead. One 6-Month Simulation How often does the worse portfolio come out ahead over a short time period? In this case, we’ll call them C and D, with the same parameters. Let’s look at running 1,000 of such simulations over a six-month period. How often does Portfolio D, who should be the winner, come out ahead? Many Simulations Over 6 Months The answer is so close to 50% as to be indistinguishable from it. In fact, we can increase the differences in expected returns and this remains true. Let’s give Portfolio D a mean return of 8% and Portfolio C a mean return of 6%. Both have 14% volatility. The significantly higher return Portfolio D will still lose over 40% of the time over a six-month period. Many Simulations Over 6 Months While the odds are just better than 50/50 in the short term, they have big consequences in the long term. Here are the distributions of 20-year outcomes for those same portfolios: Many Simulations Over 20 Years The randomness in half-year returns results in choosing the wrong portfolio about half the time, even with large difference in return. You might as well save yourself the time and expense and flip a coin. Over long periods of time (20 years), and with large differences in average returns, the odds of picking the correct choice do increase. But you may be surprised how long it can take. For portfolios with a 1% return difference, by 20 years you still have about a one-in-four chance of picking the portfolio that will have worse underlying returns over even longer periods of time. Chance of Choosing Worse Portfolio Based on Performance Return Difference 3 months 6 months 1 Year 5 Years 10 Years 20 Years 0.50% 49% 48% 48% 42% 40% 37% 1.0% 47% 46% 44% 36% 32% 26% 2.0% 44% 43% 37% 26% 16% 9% Each cell based on 3,000 simulated cumulative returns of better portfolio (8% return) versus a benchmark portfolio with a mean return of 6% and 14% volatility. Correlation of 0.90 between portfolios. To be clear, there are statistical tools you can use to improve your odds of picking the right portfolio, but most investors aren’t professional statisticians. They just go by the cumulative returns over a short period of time. Performance Chasing Is Worse Than Random If the low odds of correctly choosing a better portfolio above didn’t convince you, it’s even worse than that. Empirically, choosing the best funds, a strategy called performance chasing, is likely to reduce your returns. The graph below comes from an excellent research paper from Vanguard. It shows the returns achieved by investing in the best fund in each asset class, compared to a buy-and-hold strategy. Performance chasing—picking investment based on recent performance—produced worse returns of about -2% to -3.5%. Buy-and-Hold Superior to Performance Chasing, 2004-2013 If every year, you picked the investment manager with above average returns over the past 12 months, you’d end up underperforming an investor who stuck with the passive index-tracking manager. The Right Things to Consider If recent investment performance is such a poor way to choose an investment manager, how should you select one? Use a set of clear principles that are likely to be true in the future: Monetary Cost: A certain drag on returns, if the service doesn’t deliver value above cost. Consider commissions, trade fees, and assets under management (AUM) fees. Non-Money Costs: How much time and and effort does it take for you to use it well? Does it have a high time or stress cost for you to get the most out of it? Services Offered: Do the services offered make you better off? Does it do things for you which you wouldn’t do yourself? Does it help you make better decisions? Does it make some of those decisions for you, automatically? Experience: Is it easy to use? Do you enjoy using it? Philosophy Fit: Consider its investment philosophy, and if it is parallel to yours. Some funds seek to deviate from the index and cost more, some seek to track it passively. Tax Management: Returns will likely not take into account actual value-adds, such as tax loss harvesting. You won’t have received a comparison tax bill that allows you to compare after-tax returns across services; it will be up to you to compare them. Behavior Management: Does the service have a proven track record of reducing the behavior gap? When choosing an investment manager, the key isn’t to focus on investment performance; it’s to focus on service, fit, and investor returns.
How Disciplined Will You Be in the Next Downturn?How Disciplined Will You Be in the Next Downturn? Every investor should have a fire-drilled plan for the next market drop because anticipating your own behavior is part of what makes you a better investor. I can’t take any further losses. I’m just not comfortable with losing 8% of my money in one year. I’ll start thinking about more aggressive investments when the dust settles. The stock market is pretty rough right now. If that continues, I don’t want any part of it. I know I shouldn’t time the market, but it’s now up 3x and I can just see it reversing course soon! These are just a few paraphrased notes from Betterment customers who reduced their stock allocation in January or February 2016. From Nov. 1, 2015 to Feb. 11, 2016, the global stock market (ACWI) fell about 15%. And, of course, markets then rallied 31% up until September 2017. Looking back between February and September of 2017, a stay-the-course investor tracking the index would be up about 20% cumulatively. A reactive investor, who sold in February then re-bought when markets recovered in July, would be up only 4%. Source: Data from Xignite, total returns data for ACWI ETF representing global stock markets. This particular ETF was chosen as it is a widely used global market cap fund, and represents a commonly used investable market cap global stock portfolio. We published research showing that the more a customer changes their allocations, the worse their performance likely is. On average, investor returns dropped about 0.20% per year for each allocation change the customer made. This means if you change your allocation three times per year, you could underperform by about 0.60%. That’s more than twice the annual cost of Betterment’s advice and portfolio management. One study by Vanguard of 58,000 of their IRA account holders from 2008 to 2012 found that those who reacted to the crisis had significantly worse performance than those who stayed the course, giving up about 1% a year. When you consider that a reasonable excess rate of return for global stock markets is about 6%, that could mean giving up about 17% of your expected return. How can you ensure that you won’t succumb to the same fears and anxieties the next time a market drop hits? My recommendation has just three simple steps: Arrange your finances. Write out a downturn plan. Stick to it. Arrange your finances. Properly arranged finances make it much easier to glide through a rough market by buffering and hedging your overall downside exposure. Here are four major steps to help get your finances in order. 1. Have an emergency fund. An emergency fund is usually one of the highest priority goals we recommend customers have, and we believe it should be invested conservatively. A bond-heavy portfolio does a better job than cash at preserving the real value of your wealth. One reason it’s important to have an emergency fund is because it helps gives you peace of mind when longer term, higher risk portfolios are more affected by a market drop. If you need to make a withdrawal from your emergency fund, you’ll be able to access it since it’s invested conservatively and is less likely to experience an extreme loss than a fund invested in a more aggressive allocation. 2. Earmark your money for future expenditures. It’s also smart to earmark your money for future spending. At Betterment, we call this setting a goal. Setting up goals helps to make sure you have money when you need it, aligning our investing advice to your life needs. From existing research on goal-based wealth management and internal research on Betterment customers, I believe investors who use specific and highly personal goals could not only save more, but might also earn higher returns. 3. Don’t take on more risk than necessary given your time horizon. It’s easy to get excited when markets have gone up and increase your stock allocation to try and benefit from it. While it’s ok to deviate within a range, we generally don’t recommend going outside our recommended ranges. Our stock allocation advice is based on your goal type and how long you’re investing for. We take into account the total cumulative returns over that period and figure out an optimal amount of risk for you to take on. You generally shouldn’t take on significantly more risk than we recommend. It exposes you to drawdowns that your portfolio may not have time to recover from. 4. Don’t invest in a portfolio that might keep you up at night. Your emotional time horizon is likely much shorter than the goal term. That’s why, when setting your allocation, we show you a range of one-year performance you can expect from that portfolio. Have an honest chat with yourself about how much of a loss would be too much to bear. Imagine you had invested $100,000 a few years ago, and today you logged in to see your portfolio was down to $90,000, a -10% loss. Would that be too much? How about $70,000, a -30% loss? How about $44,000, a -56% loss? That’s how much a 90% Betterment portfolio lost in 2008-2009. For a 90% stock portfolio, up to a -27% drop over any one-year period wouldn’t be unusual, per the example below which reflects our 90% stock portfolio. You should choose a stock allocation that you could stay invested in, even during a down market. So if the “poor” market performance would be too painful for you, feel free to take on less risk. You’ll have to save a bit more, but you’ll be able to sleep at night. Write out your plan now. Prioritize your goals. In a market drop, most of your goals will likely experience a loss. That might mean shifting balances between them, or waiting longer to achieve some after the market rises again. Know ahead of time what goals you’ll prioritize and whether or not you’ll need to move money from lower priority goals to higher ones. Have an anti-monitoring strategy too. At some point, the stress of seeing losses increases the chance that you’ll do something impulsive. Rather than test your fortitude and willpower, give yourself a break from the stress. If the news is bad, you can always choose to not log into your account. I regularly use apps to restrict my access to unproductive websites at work. I recommend doing the same thing with your investments. What can you do during a market drop? Liquidate legacy losers. The most common barrier to consolidating your taxable investments is capital gains tax. Take advantage of a short-term market drawdown and let go of a high cost mutual fund or diversify away from a single stock position. What can you do today? Prepare a short list of investments you would like to liquidate, and the price at which you will give them the pink-slip. Our tax-switch calculator can also help with that. Do less than you want to. While the best investment strategy is typically to stay invested, some people could find the stress simply to be too much to bear. If you think you might make an extreme decision—such as moving to 100% bonds—if the drawdown continues, then it’s ok to reduce your risk temporarily. Adjust from 90% stocks to 60% stocks, for example, for a 60-day period. Make sure you set a reminder to revisit your portfolio at that point. While we don’t believe it will improve your performance from a ‘cold’ view, it may mean you’ll be less likely to make an emotional decision and have a higher return per nights lost in sleep. Take a vacation from your portfolio: My own research has shown that people are more likely to monitor portfolios during volatile periods. The only problem is that the more you monitor, the riskier your portfolio will seem to you. A better strategy is to login less during volatile periods—a strategy successful investors with higher emotions do follow. Sometimes, it pays to be the ostrich. Talk it out. Have a friend with a cool head? Sure you do. Contact us and our Customer Support Team can walk through your concerns with you. While Betterment is all about efficiency, we know there’s no replacement for a human conversation. And we love talking to you. Seriously. The figures contained in this article have been obtained from third party sources, and their accuracy and completeness are not guaranteed by Betterment. All performance data quoted represents past performance, and past performance is not indicative of future returns. The conclusions drawn in this article should not be construed as advice meeting the particular investment needs of any investor, and they are not intended to serve as the primary basis for financial planning or investment decisions. This material has been prepared for informational purposes only and is not a solicitation or an offer to buy any security or instrument.
Safety Net Funds: Why Traditional Advice Can Be WrongSafety Net Funds: Why Traditional Advice Can Be Wrong Don’t keep your safety net funds in cash savings accounts that give you little to no interest. Odds are you’ll lose money due to inflation, as well as lose out on the potential growth of your hard-earned savings. We recommend that everyone should save regularly towards some kind of safety net based on their monthly expenses. Conventional wisdom says that safety net funds should be held in a savings account or a similarly risk-free type of account. But is this really the wisest way to manage your rainy day fund? Our analysis finds that you can do better by investing your safety net funds in a diversified portfolio. The Risk Of Holding Cash First, let’s get one myth out of the way. Cash savings accounts are not risk-free. Why? After accounting for inflation, you may not get the money you put in back—in real terms. In that sense, cash savings accounts are not risk-free. Today, with nominal cash interest rates hovering around 2%, money in a traditional savings account could actually earn nothing, or even make a negative real return over the next few years. This means your safety net fund will need to be topped up year after year in order to maintain its real value. It also means that you’ll have a significant amount of wealth that is not growing. This could even be the case for a long period of time if you find that you aren’t needing to dip into it. Invest Your Safety Money Intelligently A better solution is to have a safety net fund and grow it, too. Our default advice for a Safety Net goal at Betterment suggests a 30% stock allocation. While this flies in the face of traditional advice, our analysis below shows that it stands up to critical examination. Example For a worker earning around $110,000 in annual salary, a safety net target might be $18,000—assuming minimum expenses of $4,500 per month for four months. This saver has two options: put this money into a savings account or invest it. We think investing is the smarter choice. However, to be smart investors, we want to also help protect ourselves against potential losses. This is why we recommend adding a buffer of 30% to your original target amount. For example, to maintain an $18,000 safety net, we recommend starting with $23,400>. Once You Reach Your Target The benefit of investing a slightly larger amount than you need is the opportunity to help earn more returns. Your safety net might get bigger than necessary on a regular basis once you’ve reached your target amount. Because of that, we advise transferring any excess to another goal when it gets to be about 20% bigger than the target amount. That excess growth can be transferred to help other goals, like retirement or a vacation. Experience The Upside We do not have a crystal ball and we’ll never know exactly what the stock market will do in the future. But, what we can see in recent history is that the downside of taking some risk is not terrible—while the upside can be very powerful. Have questions about your safety net, financial goals, or the amount of risk you should be taking on? Speak with a CFP® professional to review your current financial situation. Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark, the CERTIFIED FINANCIAL PLANNER™ certification mark, and the CFP® certification mark (with plaque design) logo in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
Memestonks: What’s Different About This Market?Memestonks: What’s Different About This Market? You might be wondering what’s going on in the world of “stonks” right now. Yes, we have a take and, no, you won’t be surprised to hear we’re thinking bigger picture. Let’s talk about this whole GME/short-squeezing/meme stock thing. Like many people, you may have a simple question: Is this time different? Here’s my impression: Most things are the same... In many cases, nothing is new about the meme stock circus. Humanity, greed, FOMO, bubbles, mania. Squeezing and vilifying shorts. You can go back hundreds of years and find loads of examples of madness in the marketplace. Throughout history, the specific game and players has changed, but the desire to win remains the same. ...but not everything. Here’s what’s different this time around: Zero-commission trading. We over-consume free things, and that’s particularly true of the no-cost trading platforms that don’t force you to think twice before hitting “buy” or “sell.” There’s often little thought given to something that costs nothing. Mobile trading apps. These days, the phones in our pockets offer powerful access to the financial markets. Normal people have greater access to higher risk investments and strategies such as derivatives and leverage (even if some of the pitfalls aren’t clear), and they can coordinate their moves together better than ever (see below). A pandemic. Social distancing has left many of us with a lot of restless energy and no outlet. We can’t go out and play sports, go to the gym, watch a ball game, go to the movie theater, or have a late dinner and drinks with friends. We’re disconnected from each other -- and looking for that connection online. Social networks. Investing is now a social participation sport: you can actually cause the price to move. You can help your team win! Social media has monetized and weaponized people's attention. These networks tend to direct people's attention into a very narrow frame -- like using a magnifying glass to turn sunlight into a laser. It’s easy to accidentally spend hours diving deeply into a specific topic -- and maybe even get sucked in by a conspiracy theory. Like the magnifying glass, that laser-like focus can have real-world impacts. How will it end? I see three scenarios: Fast and hard: A major regulator only needs to make a somewhat innocuous statement like, “Oh, we’ve seen some concerning things here; we’re going to start looking into specific actors,” and the typical market reaction would be quick. Back when Hertz was contemplating doing a secondary offering, the SEC spoke up and the Hertz bubble quickly popped. There are also financial requirements with clearing firms that could cause brokerage firms to restrict transactions in these types of situations to ensure that the firm can continue to operate. Moderately quickly, giving way to the next memestock: It’s hard for meme stocks to keep themselves in focus for long. Novelty fades, and the amount of stimulus (price changes) must rise exponentially in order to keep the focus on. In this case, options sellers are already beginning to demand higher premiums for new options. It could be a messy unwind. Slowly and permanently: As vaccines roll out, the pandemic ends, I think we’ll start spending our free hours doing more meaningful things -- like spending 3-D time with each other rather than with strangers on a message board. What’s the aftermath? It’s worth remembering that this doesn't change the underlying companies: no amount of price movement or short-squeezing can turn around a company in a bad business. Some people will get out near the top. You’ll certainly hear those people talking about it. The people who bought from them hoping it would go up further -- and that there would be another buyer waiting -- will be conspicuously quiet. We've already seen normal investors get burned by memifying trades (see: Hertz, Blackberry). In some cases, an unrelated stock was pumped up quickly by retail investors who didn't realize they weren't trading what they thought they were trading. In every case, someone is left holding the stock when it crashes back to reality. So…? This kind of trading is like going to Vegas. By all means, go, and have a great time. Just be prepared to come back home with fewer dollars in your wallet and a vicious hangover. An alternative? Invest in a well diversified portfolio and whenever someone asks if you own the hottest thing, you can say “yes”, regardless of what it is.
Video: How Can Tax Loss Harvesting Help?Video: How Can Tax Loss Harvesting Help? Tax loss harvesting (TLH) can be a silver lining in bad markets. In this video, Dan Egan, explains how it works at Betterment.
Where in the World Are You Invested?Where in the World Are You Invested? Betterment's portfolio diversification includes holdings across 102 countries. Consider where your money is invested. One of the fundamentals of good investing is good diversification. But it's hard to do well. Here at Betterment we have done that work for you—every customer can easily invest in a globally diversified portfolio of up to 12 ETFs. We picked those 12 ETFs based on careful consideration. For the bond basket, we needed to balance domestic and international interest rate risk and credit risk; and for our stock basket, we needed an appropriate mix of sectors, countries, and capitalization factors. The result is that our customers can access a portfolio that is invested in 102 countries and in more than 5,000 publicly traded companies across the world—along with exposure to government debt, corporate bonds, securitized debt, and supranational bonds with a range of creditors and interest rate sensitivities.1 Why go global? As we mentioned above, it's hard to diversify well. One problem for do-it-yourself investors is that they tend to home-bias their portfolios. They prefer to invest in companies they are comfortable with—because they know them, or they are close to home. Unfortunately, that means they are less diversified than they should be, and expected performance may suffer. Betterment’s portfolio avoids this home bias by reflecting global stock market weights. U.S. stock markets make up about 48% of the world's investable stock market–the remainder is international developed (43%) and emerging markets (9%). You can see this on the fact sheet for the MSCI All-Country World Index. By using the world's markets as its baseline, the Betterment portfolio diversifies risk on a number of levels including currency, interest rates, credit risk, monetary policy, and economic growth country by country. Even as economic circumstances may drag down one nation, global diversification decreases the risk that one geographic area alone will drag down your portfolio. To diversify risk When we selected our bond basket components, we considered which factors affect bond returns—interest rates risk and credit risk. Then we selected funds that would diversify those risks. For example, with high-quality domestic U.S. bonds, the risk comes from a potential rise in interest rates, which will cause a fall in value for longer-dated bonds. To diversify away from this specific U.S. interest rate risk, we picked another bond asset with low correlation—in this case, high-quality international bonds. The particular fund we used, BNDX, hedges out all currency risk; and includes bonds from stable international governments and international issuers, each of which have their own interest rate risk and credit risk. We also invested a smaller proportion in dollar-denominated emerging market bonds. These tend to have much higher coupons (4.9% at time of publication), but also more volatility in price, as they have a higher exposure to credit risk from international issuers. To capture growth Among our various stock basket components, we include international stocks in order to benefit from growth overseas in developed markets, including the U.K., Japan, Germany, France, Australia, and Switzerland. This helps our portfolio maintain similar expected returns as more concentrated domestic portfolios, but with lower risk. Then with the emerging markets stock component (VWO), we can capture growth in small but expanding markets such as Brazil, India, and China. This further diversifies our portfolio, and should boost expected returns, particularly at higher risk allocations. 1 The portfolio invests in 102 countries at all but 100% bonds and 100% stocks.
How Checking Performance Might Hurt Your PerformanceHow Checking Performance Might Hurt Your Performance As your investment manager, we strive to maximize your returns and reduce your investment costs. But did you know that we also try to help you reduce your stress? I believe most people check on their investments far too often. If they fully understood them, they’d spend less time monitoring their accounts, and more time gaining knowledge about investing. Don’t feel bad—I’ve done this myself. After years of reading about and following the markets, I’ve realized that I’ve wasted precious time and attention that could have been better spent elsewhere. I hope you can learn from my mistakes. Paying too much attention costs more than just your time. Checking on your investments frequently, which to me means more than once a quarter, may: Make you more risk-averse than you probably should be. Mislead you about the future returns you might accrue. Increase your risk of performance chasing, which could reduce your returns. Make you unhappy with your portfolio, regardless of the actual performance. It’s appropriate to take on risk when you’re investing for the long term. Our advice for how much risk you should take is based on how long you’ll be investing for. The longer you are investing for, generally the more risk you should be taking on. This principle is something that you know to be true intuitively. An experiment by two Nobel Prize-winning behavioral scientists aimed to prove this by showing students investment returns from the same portfolio for various timelines: a month, a year, and five years. They found that the shorter the time period the returns were generated from, the less risk the students were willing to take. These results were also replicated among workers who invest in their 401(k) plans. If you’re checking performance of the stock market daily, chances are that you’ll see a loss about 50% of the time. If you check on it just once a year, that chance drops to about 25%. At seven years, the chance of seeing a loss drops to 1%. The graph below shows that the probability of experiencing a loss decreases over time. This tells us that looking at short-term returns when you’re investing for a long time may feel riskier than it actually is, because you’re paying attention to those short-term losses. Even though you might see immediate losses, staying invested for a longer period of time means that those losses may turn into gains if the market goes up. Since the market generally tends to move in an upward direction over time, the likelihood you’ll see gains generally increases as time increases. Source: Based on S&P 500 daily total return data since 1928. The past is a poor prophecy of what the future will be. Just as today’s winning lottery number isn’t related to yesterday’s, knowing which stocks performed the best last month probably won’t tell you which stocks will perform the best this month. Apophenia is the human bias to see patterns when there are none: faces in toast, patterns in coin flips, even large-scale conspiracy theories. If a simple pattern isn’t apparent, we’ll imagine that there must be a complex one to explain it. We might see a pattern of the market going down, and we think that it will keep going down in the future. We react by changing our allocation to be more conservative. We then kick ourselves when the market shoots up the very next day. A reaction I hear a lot from customers: “I’m sure that’s true for most people, but not for me. I just look at it and never react.” Our data shows otherwise. The more frequently customers log in, the more they: Change their allocations. Turn off auto-deposits. Quit investing entirely. Source: Analysis of Betterment client data. Each line represents a different subset of customer groupings based on tenure. Performance chasing can lead a moth right into a flame. Like a moth to a flame, even professional investors can get caught in the trap of being drawn to funds just because they have performed well recently. A 2008 study looked at the decisions of professional 401(k) managers. Managers tended to “hire,” or put money into funds, which had substantially higher returns recently. They tended to ”fire,” or take money out of, funds with worse performance. The problem was that the recently “hired” funds then went on to underperform, and the “fired” funds went on to perform better. In other words, the managers earned lower returns because they chased the performance of the funds, reacting to changes after the fact. Before you laugh at the so-called professionals, know that DIY individual investors exhibited the exact same behavior, with the exact same results. A 2019 study by Morningstar showed the same behavior, including moving into previous out-performers and away from previous under-performers. Once again, the funds that performed well in the past did not go on to outperform. A 2014 study by Vanguard found that performance chasing could cost an investor between 2 to 4% per year. Bear in mind that annual expected returns on stock portfolios are generally in the 5 to 7% range. This means that investors could lose about 40% of their expected returns over time—just for making decisions based on the recent past. Checking your performance isn’t going to make you happy. There are two phenomena that behavioral scientists come across frequently when studying people: adaptation and loss aversion. Adaptation is the tendency to run on a hedonic treadmill, which means our baseline moves upward easily, but not downwards. It works like this: The first time upgrade to first class on an airline is a joy, but as you keep doing it again and again, it’s no longer as exciting as it used to be. Loss aversion means that we tend to feel losses more powerfully than we feel gains. For example, your emotional response to a 1% loss is as strong as your emotional response would be to a 2% gain. After a taste of flying first class, downgrading back to those economy seats feels bad, doesn’t it? The intensity of that negative feeling is likely stronger than the intensity of the positive feeling you felt when you upgraded. Let’s imagine that a behavioral scientist puts you into a portfolio where you can’t change your investments in response to historical returns, however, you’re still forced to watch your returns in real-time. In this scenario, you’d be unhappy the vast majority of the time. This is simply because a portfolio is always going to be either experiencing an all-time high, or experiencing a drawdown. The truth is that all markets spend most of their time in a drawdown. You can think of your portfolio as if it were a friend’s small child. If you look at a child every day, you probably won’t notice any changes. If you want the joy of saying “Oh my, how you’ve grown,” then you’ll need to space out those visits more. Here’s how we try to help you stress less. We want to help you succeed. At Betterment, we take the time to design and deliver features that help you stress less about your account so that you can focus on what matters in your life. While we do want you to check your account quarterly, we don’t want to push you to check it daily or even weekly. One of the ways we can keep you informed while also moving away from a hyperfocus on performance is by using as broad of a frame of reference as possible when we show you your performance information. Some examples of how we keep your performance context broad include: Showing the performance of all the accounts inside a specific goal as one number, rather than as separate numbers. Showing the performance of your whole portfolio, not just the individual funds inside of it. We built a diversified portfolio for a reason, after all. Showing total returns, which include price changes and dividends together, instead of breaking them out separately. Price changes alone are more volatile than total returns and don’t show the overall picture. Showing your performance over as long of a period as possible, rather than in short time frames, to help reduce the feeling of loss aversion. Since frequent monitoring of performance tends to result in worse outcomes, it’s not something we’re going to push our customers to do. However, if you do want to focus on performance, we won’t stop you. You’ll be able to see a rich and description of your performance within your account. The next time you feel the urge to check on your performance, consider if you’ll benefit from doing so. The odds are good it will lead you to take on less risk, waste your time looking at yesterday’s news, underperform by chasing winners, and ultimately be unhappy about your portfolio.
Reducing Your Biggest Retirement Expense: Where You LiveReducing Your Biggest Retirement Expense: Where You Live You’ll probably want to retire somewhere different than where you live right now. Let’s make that part of your retirement plan. Every August my family and I would squeeze into our car and drive 18 hours straight from Philadelphia to visit my grandparents in retirement. They had picked an ideal “grandparent” location: Cocoa Beach, Florida. Cocoa Beach is on a barrier island surrounded by both the Atlantic and intracoastal waterways. It’s also close to Disneyland and Cape Canaveral, where NASA space shuttles launched (a big draw for me and my brother). It was warm, had an outdoor pool, and balcony overlooking the ocean. We went there every year for vacation, and it was glorious. Source: Map data ©2019 Google Retiring to Florida helped my grandparents before retirement as well. Planning to retire to a place where their money went further meant they could save less. With no state income tax and a low cost of living compared to many East Coast cities, their retirement money went further there. I don’t think I’ll live in Manhattan when I retire, and I’d guess that’s true for most of us. What makes us happy at 65 will probably be very different than at 35: plan accordingly. How can we learn from how other people’s preferences have changed, and factor that into our retirement plans? In this case, I want to specifically think about where we retire, and how that impacts our plans now. Location Drives Your Retirement Savings Plan One of the most significant factors driving retirement migrations is lower cost of living, especially housing. One of the underrated parts of Betterment’s retirement planner is that you can try different zip codes to see how retiring somewhere less expensive can change your financial requirements. For example, let’s assume I want to retire where my grandparents lived, in Cocoa Beach, Florida. The cost of living in Cocoa Beach is significantly lower than in Manhattan. In Manhattan, I’d need to spend $242,000 to match the $109,000 per year lifestyle in Cocoa beach. As a simple calculation, multiply that by 25 years in retirement and it comes out to needing $2.8 million more dollars to retire comfortably. That’s a huge difference in savings between now and then. Caption: Above, you can see how Betterment projects the difference between living in New York City and Cocoa Beach Florida. As kids leave the house and our joints get creakier, we probably want smaller, more manageable (and easier to clean) houses with fewer flights of stairs. The benefits to ‘downsizing’ our houses are multiple, and means that we can afford a better house for the money we want to spend. Consider the two listings below, both for $300,000. Source: Image 1 and Image 2 In 1941, the average flight from L.A. to Boston cost $4,540 per person in today’s money, and it would have taken 15 hours and 15 minutes with 12 stops along the way. By comparison, a nonstop flight in 2015 cost $480 and took only six hours. As the cost and friction of living somewhere less central comes down over the years, a lower cost of living looks more and more attractive. Moreover, as home delivery services improve and self-driving cars come along, the costs of living more remotely will continue to decrease. I look forward to the day when I can hop in a car to visit my grandchild and sleep the whole way there. Think about what will make you happy. I’d be remiss if I didn’t push you to think about optimizing for future you. We tend to assume we’re more static than we are, and often mispredict our own future preferences. What makes us happy (including what we spend money on in retirement) might surprise you. For example, this study from the Center for Retirement Research states: “unemployment is the single most important negative influence on life satisfaction.” Even if you don’t need to work, you might want to consider volunteering or mentoring in order to keep yourself challenged and contributing to society. The more initial retirement planning you do, the more eventual retirement satisfaction you’ll have. The more you retire with friends, the better. The key is having people you can enjoy everyday activities with. Think about how close you want to be to your family — would it make you happier to be close to them, or a little farther away from them? General spending on social, leisurely activities were the best source of underlying satisfaction, as opposed to temporary happiness. Consider a trial retirement in a new area ahead of time. You might be surprised by how different it is to live somewhere for a year, compared to vacationing there. Finally, ask older people in your life. They’re on the same track as you, just 20 to 30 years ahead. I highly recommend reading “30 Lessons For Living,” which asks older people how they’d re-optimize their lives, and focus on what you can do now to make yourself happier then. They’ll love that you thought to ask them about their retirement planning, and hopefully you’ll get to talk the ear off some kid when you’re 70 in return.
How We Use Your Dividends To Keep Your Tax Bill LowHow We Use Your Dividends To Keep Your Tax Bill Low Every penny that comes into your account is used to rebalance dynamically—and in a tax-savvy way. There is no doubt that dividends always feel good. It’s not just well-deserved returns from the companies you are funding; it’s also a sweet reminder that investing works while you do other things, like spend time with family or hit the beach. “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” John D. Rockefeller. Here at Betterment, we also use your dividends to keep your tax bill as small as possible. Dividends Boost Your Total Returns There are two opportunities for profit when you buy a share: when the value of the share appreciates, and when the share generates income in the form of dividends. Dividends are your portion of a company’s earnings. Not all companies pay dividends, but as a Betterment investor, you almost always receive some because your money is invested across more than 3,000 companies in the world. Dividends make up a significant proportion of the total return you can expect from investing in those companies. Performance of S&P 500 With Dividends Reinvested Source: Bloomberg More Opportunities to Rebalance Your Portfolio Your dividends are also an essential ingredient in our tax-efficient rebalancing process. When you receive a dividend into your Betterment account, you are not only making money as an investor—your portfolio is also getting a quick micro-rebalance that helps keep your tax bill down at the end of the year. This is especially crucial after coming through a period of market volatility. Big market changes have a tendency to cause your asset allocation to veer off course. However, in order to better control risk, you want to get back to your correct asset allocation as quickly as possible. Reinvesting dividends helps to get you back on track by allowing us to buy assets that you are underweight in, rather than sell assets you are overweight in. Dividends + Deposits = Tax-Efficient Rebalancing When your account receives any cash—whether through a dividend or deposit—we automatically identify which investments need to be topped up. When market movements cause your portfolio’s actual allocation to drift away from your target allocation, we automatically use any incoming dividends or deposits to buy more shares of the lagging part of your portfolio. This helps to get the portfolio back to its target asset allocation without having to sell off shares. This is a sophisticated financial planning technique that traditionally has only been available to big accounts, but our automation makes it possible to do it with any size account. The Final Puzzle Piece: Fractional Shares The secret is that we can do this because we handle fractional shares. That means every penny that enters your account reinforces full diversification. This contrasts with how many individual investors handle dividends on their own. Some online brokers offer an automatic option, and may reinvest dividends into whatever fund the cash came from. However, this blind reinvesting is often not the most efficient use of dividends, and can very easily lead to a poorly allocated portfolio that requires a sell-off of assets at a gain—with the accompanying capital gains taxes—to rebalance it over time. Instead, our tax-efficient rebalancing helps you avoid such a “hard” rebalance which would require a major sale and expose you to capital gains. For the DIY investor, this automated tax-efficiency is virtually impossible to achieve. At Betterment, it’s included on every dividend and every deposit, every time, for every client. And you do not need to do a thing.
Lifestyle Creep: The Biggest Threat to Financial PlanningLifestyle Creep: The Biggest Threat to Financial Planning Lifestyle creep can severely impact financial planning by spending more income over time than we plan on saving. For the median person making $57,000 a year, it sounds ludicrous that others making $500,000 feel like they’re ‘scraping by.’ However, they’re humans just like us: we might find ourselves in a similar position in the future. How can we avoid excessive spending ruining our future? In this article, I will discuss the idea of “lifestyle creep”: what it is and how to realistically plan for it, how you can level expectations for earnings throughout your lifetime, and practical ways to avoid overspending gradual income raises. What is Lifestyle Creep? Income usually increases in irregular little jumps: 3% this year, 8% that year. After taxes and inflation are accounted for, the take-home difference is even smaller. So it seems harmless to use the extra cash to upgrade our apartment, car, sofa, TV, buy more takeout… There is always more you could spend money on. The problem isn’t the amount of money: it’s a combination of human behavior and the defaults in our financial system. When our income increases, by default, our saving rates decrease. Usually, the paycheck rolls into a deposit account and it’s spent. Spending more today is easy and pleasurable; saving more requires effortful planning. Two caveats to what I’m about to say: If you’re at a low income level, spending most of your income makes sense: a warm coat, a safe home, and reliable transportation are worth it. I’m discussing enjoyable spending only. A new home, car, food, clothes, phones, are all fair game. When daycare for my daughter, life insurance, and my mortgage end, I won’t feel worse. Lifestyle creep is one of the biggest invisible dangers to retirement plans. Why? Your requirement for ‘enough’ goes up. Downsizing our lifestyle is very unpleasant. People will take extreme actions to avoid it, including choosing risks and acquiring debt. It takes a strong person to voluntarily reduce their spending when they lose their job or take a pay cut. And increasing your lifestyle means you’re constantly raising the table stakes for contentment higher. It can blindside you long before retirement: a larger lifestyle means a larger emergency fund, further to fall if you lost your income, and more pressure to keep a high paying job you hate. One of the best ways to protect yourself against the pain of future income drops is to keep your lifestyle modest, which can give you breathing room if you want or need to have a lower income for a while. It also increases career options: I took a serious salary cut for a job once, which was okay because I had kept my lifestyle humble. A happy retirement gets more expensive. At retirement, you’ll probably want to maintain your previous lifestyle, or even bump it up temporarily by doing more traveling. By my estimate, for every additional $100 in monthly lifestyle spending you start having before retirement, you’ll need about an additional $30,000 at retirement to keep steady. It really is simple: An additional $100 per month x 12 months per year x 25 years in retirement = $30,000 Now, let’s analyze what that looks like depending on different levels of lifestyle creep. If you’re 25 years old making $40,000 a year, with a 60th percentile lifetime earnings—and who can earn a 1% in returns—then how much will you need in retirement savings if your lifestyle creeps upward? That’s what I show in the figure below (the horizontal axis shows lifestyle creep). Just look at it for a moment: Someone in that situation who spends 80% of their raises needs a retirement balance that is 41% larger than somebody who only spends 20% of their raises. While yes, there are some easy criticisms of this analysis—not including social security, spending on children that ends, possible investment returns, or taxes—the fact is, lifestyle creep’s impact on retirement is complicated enough as it is. And perfect is the enemy of what’s clear and understandable. The figure above shows a hypothetical simple view of the required retirement balance needed based on increases in “lifestyle creep” or current pre-retirement spending. This analysis is based on the simple scenario described above of a person making $40,000 per year and who earns 1% in returns as if earned in a savings account that isn’t subject to market changes. Neither the base scenario or percentage increases shown in the figure account for the impact of taxes or market changes. A few assumptions we made: The 25 years old we described will retire at 65 years old and plans to live until 90. We also accounted for taxes. We simulated gross income reduced by appropriate Federal, Social Security and Medicare, and a fixed 5% state tax rate. Lifestyle creep ruins your future savings plans. When we see how much we need to save for retirement, it can seem like it’s too much, we can’t afford it. And that since we plan on earning more in the future, we can save then, right? Yes, this can work out if you stick to it. But saving more tomorrow means saving a significant proportion of your increases, which requires a lot of self control. Challenges To Keep in Mind So, our challenge is to be intelligent about: How much we’re likely to earn over our lifetime, now and in the future. How much we will spend and save, now and in the future. How to set ourselves ourselves up to have a path over our lifetime through retirement which is robust to income and expenditure shocks. Have realistic lifetime earnings expectations. At 50 years old, the median individual earned slightly twice what they earned at 25 before tax, according to the Federal Reserve Bank of New York. However, that’s the point of greatest difference: after about 55, the earnings ratio begins to drop. The graph below shows a summary of earnings curves from the same paper with data on millions of American workers divided up by their lifetime earnings percentile. While we can’t predict what lifetime earnings percentile we’ll fall into, we can use these data as a guide. Over time it seems people either work fewer hours or a less financially rewarding job. This may or may not be voluntary: it could reflect changes in life priorities or job options available as the demand for specific skill sets decline in an area. Whatever the cause, it means less potential savings. Saving more vs. spending more: the balance act. You can run numbers to see how earning and saving more in the future is reasonable. Let’s consider the same typical 25 year old with no retirement balance, earning $40,000 a year, spending their full, likely after-tax income of $32,612. Again, we’ll assume they’ll be in the 60th percentile of lifetime earnings. Let’s look at 30% lifestyle creep. Each time they get a raise they save 70% of it and spend 30%. When their income starts declining later in life, they don’t spend less because their lifestyle spending has magnified. As a result, their highest savings rate happens at 50 years old, and they’re actually saving nearly nothing the year before retirement - they’re spending it to keep up with their lifestyle. Pre-retirement they’ll be spending $40,399 per year (adjusted for inflation). To maintain that standard of living for 25 years in retirement would require a $842,025 balance. Let’s assume a 1% real rate of return over the entire investment period. At retirement our example will have saved a total of $427,810, which has grown to $516,730. That’s not going to hit their $840,000 target balance. How much lifestyle creep could our youngster bake into their financial plan, and still be ok? It depends on the return they will experience. Reasonable returns you could plan on. Acceptable lifestyle creep is very sensitive to the expected real return. Remember, real returns mean inflation has already eaten away about 2% of your growth. With a Betterment portfolio, you would need a portfolio with 45% stocks, 55% bonds to have an average expected return of 3.5%, and that comes with an expected 9.4% annual volatility (those are our actual projections). The graph below shows that the individual can hit their target retirement balance with a 4% or higher return, but with anything less, they’re in trouble. Putting this all together, below I show the minimum return required to support any given level of earnings growth and lifestyle creep. For a person with median earnings growth, a conservative 2% real return yields an acceptable lifestyle creep ratio of 5%. You should save 95% of each raise you get, starting from 25. Practical Ways To Avoid Lifestyle Creep So what can we do to avoid the lifestyle creep trap? As long as you’re willing to live intentionally and thoughtfully, there is a ton you can do. It’s a very manageable problem. Escalate your savings rate. Evidence has shown that escalating your savings rate over time is one of the best ways to avoid spending what you should be saving. I like to do this both when I get income increases (I usually dedicate 75% of any raise to saving), and by small amounts over time so I don’t notice the loss of spending. If you have a way to do this automatically, either through your 401(k), payroll, or your financial advisor, that’s even better. Choose your peers and environment wisely. The best way to make someone go bankrupt is to have their next-door neighbor win the lottery. It’s very hard for us to resist trying to keep up with our peers, so be thoughtful about who you spend time with. Could you live in a less expensive house or apartment? Could you move to a neighborhood where your economic standing is in line with that of your neighbors’? When you vacation, could you choose inexpensive settings like outdoor trips and small cities? Spend time with people who value conversations over carats, books over Bugattis, and closeness over square footage. Mr. Money Mustache and Morgan Housel are wonderful at showing the joy in needing less. Cultivate a taste for inconspicuous consumption. It’s trivial to see that someone has an expensive car, watch, handbag, clothes, etc. Don’t be fooled by the surface: you can’t see if they’re in debt, or have no retirement savings, or how much they learned and shared last year. The longest lasting and most joyful experiences are rarely defined by their cost: a walk in nature; getting lost in a book in a cozy pub; helping someone overcome a challenge; a late running dinner with just a bit too much wine and good friends. Feel free to consume as much of these as possible: they’ll just set you up for an even more enjoyable retirement.
How Much to Save: Our Advice Guides You Towards Your GoalsHow Much to Save: Our Advice Guides You Towards Your Goals A good financial plan has to adapt over time to be successful. Here’s how Betterment helps you do that. Voyager 1 and Rosetta were two very different space probes that achieved their missions in my lifetime. How they accomplished their missions is a lesson in planning. Voyager 1 was a bullet. Aim. Adjust for wind, gravity, friction. Fire. Pray. When Voyager was launched in 1977, we needed to get everything exactly right. Once it left Earth, it’s fate was sealed. Whatever path it would take… was set. A lot of unexpected events can happen across the millions of miles it was set to journey. Rosetta’s mission was magnitudes harder: it had to catch a comet. Launched March 2, 2004, Rosetta took 14 years to accelerate and catch it’s target. It used a lot of the same methods as Voyager, but finding the right path to take with so many moving bodies in the inner solar system is orders of magnitude harder than the bullet shot that was Voyager 1. Rosetta needed the ability to adjust as time went on and to deal with unforeseen changes. Rosetta was a guided missile: over half of its launch weight was taken up by fuel. That cost a lot at launch time, but it gave it the ability to adjust along the way, to make course corrections, and to opportunistically change its future position. It could avoid obstacles that would have ended Voyager. "Voyager 1 and Rosetta were two very different space probes... How they accomplished their missions is a lesson in planning." How Voyager and Rosetta were managed reflect different approaches to planning, including financial plans. My life now is so different than what it was five years ago. I have a dog, a mortgage, and a child. I work for a startup. I can’t imagine what my life will be like 5 years from now. I can’t plan like Voyager, I have to plan like Rosetta. So, when I plan, I need to expect some future flexibility: Some ability to opportunistically make the most of circumstances when they come up. The humility to let go of some ambitions when my priorities change. How Betterment Guides Your Investment Deposits One of the questions Betterment helps customers answer is “How much do I need to save?” We could provide you with a simple number, say $750 per month. That number is a bullet calculation. It will likely never be perfectly right in hindsight. For any given goal you set up at Betterment, our own advice and projections forecast that there is roughly a 20% chance you’ll be within ± 5% of your target balance if you took our initial advice and never refreshed it. But, since there’s a 60% likelihood of reaching your target based on our initial deposit recommendation, our saving behavior needs to be future-flexible—to account for how the future actually pans out. So what does being future-flexible look like? How much extra fuel might you need? In this article, we describe how our deposit recommendations really work. We make deposit recommendations by simulating possible futures. The analysis we’ll describe in this article—the analysis that informs how much we recommend you deposit—is based on our hypothetical simulations of Betterment’s recommended portfolios’ expected investment returns, because that assumed rate of growth informs how much we recommend you deposit. We do simulations to be highly realistic about our deposit advice. Not only that, we simulate the portfolios’ returns using our standard projection methodology taking into account our advice for portfolio allocations based on your goal, and assumptions about an individual’s savings behavior. In this article, to make our examples easier to understand, let’s assume your goal is for a major purchase with a target of $100,000 in 10 years. To be clear, our simulations, which are month by month, will assume that your portfolio follows our recommended portfolio strategy and target allocation. They also assume that the hypothetical returns include immediate dividend reinvestment, which is built into how Betterment operates—and a flat 1% risk-free rate of return. Further, we assume performance is net of the 0.25% annual management fee. The different scenarios you’ll see come from the distribution of possible expected returns. We generate 100 such portfolio return paths, and then for each path simulate the behavior of an individual using either a ‘regular’ deposit strategy or a ‘ratchet’ deposit strategy. In the ‘regular’ case, the individual saves the amount we recommend every month. In the ‘ratchet’ case, she saves the greater of our recommended amount, or their previous months amount. The recommended amounts vary based on the simulated portfolio performance. Since this is an illustration of how deposit recommendations should work—not actual portfolio performance—we’ve simplified for your convenience. Remember that these simulations should be considered illustrative and hypothetical. It’s better to be precisely right than approximately wrong. Let’s start by looking at how our savings advice might change over time. We’ve done a single backtest before that examines a possible poor market scenario, but a more thorough analysis, like a Monte Carlo simulation, offers a much richer view of how advice should change in response to future scenarios. The charts below show how we’ve put this kind of analysis into action at Betterment in our advice on saving. Our recommendation changes over time in response to positive or negative market movements. Underlying our simulation is an investment goal ten years away with a target stock-to-bond allocation that follows our recommended moderate glidepath. You can see that there is a wide spread of recommended monthly deposits over time and that most paths involve changing how much you save. In general, that’s not a bad recommendation because most of us are likely to make more money over time. Gentle increases to how much we recommend depositing makes for fairly acceptable advice. Yet, notice the far right side of the figure. If you were to experience poor performance leading up to the date of your goal, the only thing we can do is recommend to increase your deposit abruptly. The figure above shows Betterment’s recommended deposit amounts for a sample goal following our glidepath. The figure is based on the hypothetical simulations mentioned above, and is meant to show how our auto-deposit recommendations are likely to vary over time due to realized returns being higher or lower than planned for (based on our own projections). The graph is in no way meant to guarantee any type of investment performance. When we analyze such problematic possibilities in these unfriendly scenarios, we can start to find ways of making the smart pivots of a Rosetta-like journey. For instance, let’s assume any increases of >2% per year more than our starting recommended deposit amount are unacceptable (i.e., too much acceleration), and any increase of more than 6% over a 12 month period is also unacceptable (i.e. too much jerk—read more). Using these assumptions, we see unacceptable change at some point in time in 55% of the possible scenarios. Let’s be honest: that is a high rate for having to change your savings amount up by an unexpected and unacceptable amount. As an advisor, we don’t like making that kind of recommendation, and as an investor, you’re not likely to be able to follow it. Instead of settling for such a high hit rate, we should expect to have to change over time and let those expectations shape our advice on how much you should save and invest. Making More Rosetta-like Savings Recommendations What can we do to help reduce the need for these bumps up and down? How about a simple behavioral strategy, called a savings ratchet. A savings ratchet means you increase how much you save when you have to, but never decrease it afterwards. Below we show the month-to-month changes from a regular (downward adjusting) strategy versus a ratchet (only adjust upward) strategy. The figure above shows Betterment’s current recommended auto-deposit amounts for the hypothetical sample goal used in the simulations. It shows how our recommendations are likely to vary over time due to differences in projected and actual returns. The “ratchet” is a variant of Betterment’s savings advice, which will only increase over time, as explained below (versus regular goal savings advice that might decrease auto-deposits for a variety of reasons). The “ratchet” figure is hypothetical in nature, and not meant to guarantee any type of investment performance. Rather, it is meant to indicate how a “ratchet” strategy recommends only increasing deposits over time. As shown in the graph, ratcheting savings rates can produce greater final portfolio values, with only slightly more in total deposits. The ratchet uses market downturns as catalysts to help save more, but it doesn’t use performance above expectations as a reason to save less. As a result, future market drops can have a much smaller effect, and we don’t need to save more. The hypothetical ratchet strategy above sees unacceptable increases in only 24% of the simulations we ran, or less than half the original strategy. This chart shows final portfolio values for the simulations described above. You can see that for the total deposits made using a ratchet strategy, the range of final portfolio values has a broader possible range, compared to the regular strategy. However, please note that these are only simulations, and do not fully reflect the chance for loss or gain. Actual results of applying these strategies can vary from the results above. A missile like Rosetta makes the most of ongoing optionality. So does Betterment. Optionality is when you reserve the right to do something in the future, like when you pay for just the option to buy a certain security at a certain price in the future. Financial plans shouldn’t be bullets like Voyager 1: we’re likely to miss if we actually set it and forget it. Plans should be guided. But we need to strategically use fuel—our deposits—in a way that maximizes optionality in the future. Optionality isn’t free. A ratchet savings strategy does require more in deposits over time. But the optionality has value in that the other choice is to stick with the relatively high possibility of needing to deposit more than you have to reach your goal too close to its date. In the case of Betterment’s deposit recommendations and our advice for saving in general, we try to guide toward greater optionality: Maximizing your ability to adjust your goals as they change and re-prioritize where your savings are going. Sometimes that means realizing you won’t achieve certain goals you care about. But often it means purchasing some future optionality you’re not sure you’ll need. This post was inspired by The Constant Reminder and Hurricanes and Retirement.
Advancing the Betterment Portfolio StrategyAdvancing the Betterment Portfolio Strategy Betterment’s core portfolio strategy is based on Nobel Prize-winning research. We continually improve the portfolio strategy over time in line with our research-focused investment philosophy. At every stage of the investing process, Betterment holds to the same basic philosophy: We use real-world evidence and systematic decision-making to increase the take-home value of our customers’ wealth. That’s not just a claim. It’s actually how we go about investing your money. Our process for constructing portfolios is a great example of our investment philosophy at work. We start with a body of well-developed, robust research, then use a system of rules to remove bias and preconceptions from our decision-making process. Through research, we can easily iterate on our portfolio strategy construction. Since we originated the Betterment Portfolio Strategy, we’ve found nuanced ways to improve it over time. In this article, we’ll provide an overview of how we make such improvements, in line with our investing principles. What the Betterment Portfolio Strategy aims to achieve for you: 1. We set the stage for personalized planning and behavioral discipline. When developing the Betterment Portfolio Strategy, we set some basic prerequisites based on our most fundamental principles. Any good portfolio strategy should enable customers to pursue any of their goals and to implement their plan. The portfolio strategy should also set up investors for strong discipline. The strategy should enable easy goal-setting and keep investors focused on their bigger picture, rather than creating worry about comparative performance. A result of setting these prerequisites of the portfolio strategy is our set of 101 allocations in the Betterment Portfolio Strategy, instead of just a few allocation settings, which is more conventional. 2. We use asset allocation to develop and maintain diversification. At its foundation, Betterment’s portfolio strategy is based on Modern Portfolio Theory, which means we start by selecting asset classes that represent the total investable global market. Importantly, we exclude commodities and private equity, which have unusually high costs in products accessible for retail investors. In traditional total market portfolio strategies, the “total market” was assumed to be the United States, so only U.S. stocks and bonds were included. However, since 2011, Betterment has included equities from both developed and emerging markets, reflecting the global market of today. The portfolio strategy has held a diverse array of bonds since 2013, when we added granularity to the bond basket by including ultra short-term treasury bonds, inflation protected bonds, investment-grade corporate bonds, international developed market bonds, and emerging market bonds. In 2014, we made the portfolio strategy more tax advantaged by including municipal bonds in taxable accounts only. Read our full process for how we diversify. 3. We increase value by optimizing the portfolio. The series of additions above encapsulates changes to the strategy’s basic asset class selection meant to capture the total market, and it’s equivalent to our target anchor portfolio. We then optimize the portfolio strategy by mathematically maximizing each portfolios’ forward-looking return given the correlated risk. In other words, we try to develop portfolio combinations with realistic alignment with the efficient frontier. While there are plenty of practical constraints involved with portfolio optimization, our process results in 101 different portfolios within the strategy, each with value and size tilts shown to increase your clients’ returns. In 2017, we updated our portfolio optimization techniques, resulting in improved diversification in each individualized portfolio and better expression of portfolio tilts toward value and small capitalization. The main objective of these changes are higher expected returns. Building on our existing process, we improved how we forecast returns and the way we apply factors historically shown to drive performance. Due to price movements in various markets compared to our previous optimization, our optimization resulted in different weights. The tilts of the Betterment Portfolio Strategy—toward value and small capitalization—arise from the landmark research of Fama-French, which demonstrate how the returns of any equity security are driven by three factors: market, value, and size. The underlying structure of the Betterment Portfolio Strategy ensures the market factor is incorporated, but to gain higher returns from value and size, we must tilt the portfolios, using a framework known as Black Litterman. The final weights of each portfolio are influenced by constraints imposed by the liquidity of the underlying fund and are controlled by our level of confidence in each factor. 4. We tilt the portfolio strategy in taxable accounts to help manage taxes. For investors with taxable accounts, portfolio returns can be further improved on an after-tax basis by utilizing municipal bonds. This is because the interest from municipal bonds is exempt from federal income tax. To take advantage of this, the Betterment Portfolio Strategy in taxable accounts is tilted toward municipal bonds. Other types of bonds remain for diversification reasons, but the overall bond tax profile is improved. For investors in states with the highest tax rates—New York and California—Betterment can optionally replace the municipal bond allocation with a more narrow set of bonds for that specific state, further saving the investor on state taxes. We’ll continue to improve the Betterment Portfolio Strategy Our investment philosophy is to use rules-based decision-making whenever we see evidence that Betterment’s investment strategies can be improved. Over time, we continue to evaluate new portfolio construction research and carry out our own analysis. As with improvements to any Betterment offering, our goal is to help each and every Betterment customer maximize the value while invested at Betterment and when they take their money home. For more information about the Betterment Portfolio Strategy, check out our full white paper.
Personal Investing Strategies Tailored For YouPersonal Investing Strategies Tailored For You We’ve long tailored customer portfolios based on factors like goal type, and risk tolerance. Now, we’re further personalizing our advice at the level of the portfolio strategy itself. We believe that truly optimal wealth management is always personal. A holistically optimal investment recommendation includes the investor’s circumstances, goals, personality, and views. At Betterment, we focus on helping customers achieve higher take-home returns, not just investment returns. Investment returns are the public, pre-cost, pre-tax, pre-behavior investment growth you might read about on a fund’s prospectus. “Take-home” returns make up the growth that individual investors actually achieve once you consider the cost, tax, and behavioral losses they often experience. It’s the additional dollars you actually take home. Our goal is to add value—real dollars—through improved financial planning, risk management, tax management, and behavioral optimization, in addition to offering an appropriate investment strategy for you. We’ve long tailored customer portfolios based on goal type, time horizon, risk tolerance, account type, and the use of asset location. Now, we’re further personalizing our advice at the level of the portfolio strategy itself. In addition to Betterment’s core strategy, we will now offer the following four portfolio strategies to help ensure that your investments are personalized to your preferences: The Betterment Portfolio - A globally diversified mix of exchange-traded funds, chosen to help you earn better returns at each level of risk. Betterment SRI Portfolio - This strategy maintains the diversified, low-fee approach of the Betterment portfolio while increasing exposure to companies that meet SRI criteria. BlackRock Target Income portfolios - A low-risk alternative to the Betterment portfolio, composed entirely of bonds, with different income targets that seeks to provide steady income with low risk. Goldman Sachs Smart Beta portfolios - This strategy is for investors seeking to outperform a market-cap strategy, despite potential periods of underperformance. None of our strategies is “best” when evaluated in a vacuum. We offer these strategies to fit an investor’s goal and personal preferences. In financial planning terms, we understand this fit by measuring individualized investment success in precise ways. We’ll dig into this approach in the next section. Regardless of which strategy you choose, our financial planning advice can continue to work on your behalf when appropriate. Real investment success is personal. A key insight in our approach is respecting the difference between the generic value from using a portfolio strategy and the actual, individual-specific results of doing so. Hypothetically speaking, any two people who invest the same amount of money in the same strategy, at the same time, should earn the same incremental pre-tax return. However, for each individual investor, personal factors like tax rates affect how much of your return you actually take home. Preferences, like how comfortable you are with risk, affect how much you choose to invest, how committed you are in rough markets, and whether or not you feel your earnings are worthwhile. When analysts compare two funds’ returns, they’re typically doing surface-level analysis. They usually aren’t factoring in the individualized cost, tax, and behavioral losses that actual investors realize. Pursuing the highest possible gross returns is a zero sum game. Everybody involved is competing for the same value—the raw gross returns—and almost nobody wins because they’re all largely locked into the same calculus. When you focus on gross returns, you’re liable to end up suffering the Winner’s Curse. In contrast, when we focus on increasing value for individual investors, we can find opportunities that can make all parties involved better off: We see the older investor who wants to reduce risk sell some of her stocks to the younger investor who has a longer time frame on an open exchange. We find an investor wishing to invest in companies with high social responsibility increase demand for better corporate governance. We see the retiree who wants a predictable payout sleep better at night because he holds a portfolio of bonds optimized for income. We see an investor who strongly wants to outperform the S&P 500 accept the pain of potential underperformance in the interim. The more we dig deep into what makes for successful investors, the more we confirm our prerogative to help people grow their personal take-home returns. To help maximize the individualized value you get from investing (and in effect, generate the scenarios above) we’re continually improving Betterment to align with the aspects of life that contribute that value. We can sum up these elements of life in four categories. 1. Personal Circumstances Personal circumstances include facts such as the size of your household, the tax bracket you fall into, and your state of residence. These cold hard data points are part of the foundation for helping to grow your personal take-home returns because they often present specific opportunities. For instance, a high-rate tax payer in New York may personally be better off investing in New York municipal bonds due to the state tax exemption. This would not make sense for a low-rate tax payer in Texas. 2. Your Goals Where do you want to be in the future in regards to your finances? Goals are what you want to accomplish with your money, in a general sense. Two investors with similar circumstances, personalities, and views but with different objectives should have different strategies. Exactly what we intend to spend our money on can have serious implications for the best account type, investment approach, risk level, and ongoing management. Goals may include pro-social activities like funding charities or improving environmental stewardship. Dedicating money toward a charity, an impact investment, or a socially responsible fund may be the best way of attempting to achieve a social impact goal. Thus, it is likely optimal for an investor whose goal is to improve social impact, corporate governance, and disproportionately fund ethically focused companies to invest in an SRI or ESG managed portfolio. In order to achieve their goal, they may need to forego some potential investment returns, but this can comfortably be viewed as “spending” toward their goal. 3. Personality Your personality is who you are and how you behave. Two individuals with the same circumstances, goals, and views may still differ in terms of their personality, especially when it comes to financial or investing matters. Personality traits such as sensation seeking, emotional intelligence, and composure have all been linked to financial and investing behavior. Studies have shown that genes even play a role—the more closely related two individuals are, the more likely they are to take on similar levels of risk. How much absolute loss can you handle before you freak out? How closely do you follow markets? How hands-on do you want to be with your investments? All of these can inform how we help you choose the right portfolio. For example, an investor who is anxious about stock market risk, is comforted by predictable, consistent returns, and has high sensitivity to short-term capital losses might be best served by an income optimized portfolio. Income portfolios seek more predictable returns (in the form of coupons), low correlation to stock market movements, and low daily capital volatility. If an investor is more liable to frequently check his or her portfolio, and is more likely to react adversely to day-to-day losses, a steadier balanced portfolio with less chance of abruptly sharp losses will fit the bill. 4. Views Investors with the same circumstances, goals, and personalities may hold different views about future risk and reward. They may want to feel a sense of involvement and individuality in their investing, or follow an investment strategy that resonates more strongly with them personally. At Betterment, we aim to provide portfolio and allocation advice in your best interest, which means a portfolio must resonate with you. If you don’t have specific views, then we use the other aspects of your life to formulate a financial plan. But if you do have a view, such as a belief that factor-based investing is better than a passive market cap-based approach, our advice will help you express it within your investing strategy. For example, research (Vanguard, Research Affiliates, AQR) has shown that smart beta has historically outperformed market capitalization benchmarks over long holding periods. And many investors may be more comfortable with a strategy that doesn’t rely on market capitalizations to determine its portfolio weights. But, we must be cautious: expressing views can be behaviorally tricky. The pursuit of higher returns can result in lower take-home returns, even in smart beta funds. If the investor is not truly committed to the strategy, their views may be influenced by recent returns, the news, and what they hear from friends and family. Chasing good performance has a strong tendency to lead to lower returns. So when Betterment customers want to express views, our job as an advisor is to request commitment to a strategy—to offer a subtle, yet important, push to think carefully. One way we do this is to make clear that a strategy such as an aggressive smart beta portfolio strategy may very well underperform market benchmarks, especially for shorter time periods. The factors driving our selected smart beta strategy underperformed the S&P 500 in five of the 17 years from 2000 to 2016 (when you compare performance at year end). Yearly returns calculations based on S&P 500 and factor index data from Bloomberg for the period January 1999 to December 2016. Personalized portfolio strategies are just the start. Betterment’s core principles for investing success include helping every customer develop a personalized plan and building in discipline to one’s investing practice. By offering more personalized portfolio strategies that help solve for the important elements of life above, we’re advancing in our goal to fulfill these principles. Now you can access a strategy that seeks predictable, consistent income with our income portfolio strategy. You can invest in a portfolio designed to outperform a market-cap strategy in the long term using our smart beta portfolio strategy. You can express your environmental, social, and corporate governance values by investing in the Betterment SRI portfolio strategy. Offering more personalized portfolio strategies is just one improvement. We’ll continue to add more features, services, and investment strategies to deliver on our mission of helping you make the most of your money, so you can live better.
4 Myths About Diversification4 Myths About Diversification What is diversification? Many investors know that they should be diversified, but don’t understand what that really means. Here, we break it down for you—along with four big misconceptions about being diversified. When you invest, it’s good to mix things up. Diversity applies to many things in life—our friends, our colleagues, food, and sports—but it is most well known in the context of investing, and it’s commonly referred to as being diversified. Diversification: What It Means Many investors know that they should be diversified, yet they often misunderstand—and therefore misapply—the concept. That can leave investors with more risk than they should bear, or not enough risk to effectively maximize their investment returns. Diversification occurs when an investor spreads money across different investments in a portfolio. Consider a collector who holds sports memorabilia (which he enjoys) and artwork (which he doesn’t), versus another who only collects sports items. Over time, the collector who holds both art and sports items may benefit from a well-rounded portfolio, whereas the sports collector’s portfolio value will depend on the demand unique to sports to retain value or relevance. The logic behind this diversification strategy is that a mix of collectables will, on average, have less extreme swings in value over time. The mix will also return a healthy average compared to any single group of collectables on its own. The same applies to a solid investment diversification strategy. When one asset surges, another may trail. Assets can be driven by various underlying factors, for example one may be more heavily tied to economic health (stocks) than others (bonds). As long as two or more investments don’t move in the same direction all the time, but do go up on average, they can diversify a portfolio. Diversification aims to reduce exposure to any one specific risk, and the volatility accompanied by inevitable market ups and downs. While diversification can apply to many investments, including those in property such as real estate, art, or even gold, in this context we’ll discuss diversification as it relates to portfolio allocations in stocks and bonds. Mixing Stocks and Bonds When you hear investing professionals talking about diversification, they’ll typically mention stocks and bonds. The reason: How you invest your portfolio across both types of asset classes is one key element of diversification. Stocks are tied to the price of a share in a particular company, and these prices can vary by the second. When traders or investors discuss stocks, they’ll also often generally refer to them as equities. Stocks are a go-to when investors want to take on more risk in search of higher returns. On the other hand, bonds are certifications and issuances of debt to be paid back by companies, institutions, or even governments. Prices on bonds also vary, however are generally far less volatile than equities. Stocks and bonds commonly have an inverse relationship. Stocks tend to rise when economic growth accelerates. On the other hand, investors often allocate their money to bonds and bond funds when they are anxious about the near future and want their money to be more stable. As a general rule of thumb, a mix of stocks and bonds are part of any diversified portfolio, because one is inclined to zig when the other zags. Top Four Myths About Diversification While the principle of diversification may be fairly easy to grasp, there are instances when investors misinterpret the concept. Myth 1: Diversification is fail-safe. No investment strategy is without its risks, which is why simply diversifying a portfolio cannot produce miracles. It cannot eliminate the possibility of negative returns. It can also create anxiety when one asset outperforms the other, and the underperformer is a drag on overall performance. You often find yourself having to invest in things you dislike. Unfortunately, there is no crystal ball that predicts the way any stock, bond, or market will behave, only hindsight. While past performance helps to inform us about the size of potential movements and how they move in tandem with others, attempting to predict the precise short-term trajectory of investments is a guessing game. Myth 2: You’re diversified if you have investments across multiple brokerage accounts. Investors may also believe that they are diversified when they are invested in different “places.” For example, if you’ve accumulated several retirement accounts from working at multiple employers over the years, holding accounts with different brokers does not translate to being diversified, especially since these accounts are generally invested in similar underlying assets. If you have three funds that all invest in U.S. large-cap stocks (say, those appearing on the Standard & Poors 500 index), held at different places, it’s possible you’re paying more than you would than were they all managed by one broker. Myth 3: You’re diversified if you own shares in multiple stocks. Investors who simply own a large number of well known U.S. stocks may think they have a well-diversified portfolio, but they likely do not. is not just a matter of holding numerous investments but an adequate number of investments that move independently or opposite from one another. Holding investments in both Ford and GM, for instance, is not actually a very diversified strategy. There’s also an investing myth about buying one good stock to keep for life. Proponents point to such “blue chips” and love to talk only about winners, but seem to forget about the losers. Overconfidence is a well-known and prevalent investment attitude, but is nonetheless irrational in the face of the value of diversification. Myth 4: You’re diversified if you invest in complex assets. Constantly adding to a medley of assets makes a portfolio more complicated, expensive, and no less risky—possibly even riskier. Investing in a newer breed of well-marketed exotic funds and more asset classes may also provide a false sense of security in diversifying, but remember: Complexity is not diversity. Costs are often higher for vehicles that hold exotic assets, and the more investments, the more trading and transaction costs involved, and thus more fees. If you’re adamant about or particularly tied to a certain investment, set aside a small percentage of your wealth for just that —and wisely diversify the rest. A single investment as an overall investment strategy generally exposes you to much more risk than necessary. When diversifying avoid the common misinterpretations about diversification as stated above. No amount of wealth or confidence will ever be enough to protect you from risk as well as diversification can.
Experiencing Short-Term Losses Is a Part of Long-Term GainsExperiencing Short-Term Losses Is a Part of Long-Term Gains Far from unusual, downturns are an integral part of even the highest returning investments. Customers are often surprised when I say that I expect losses in the Betterment portfolio. No, I’m not a masochist nor pessimist. Instead, this perspective comes from having studied and experienced financial markets for years. I’ve learned that losses are usually common, fleeting, and benign—as long as you know you’re invested appropriately and are expecting, rather than reacting, to them. Being invested appropriately means taking our recommended risk level for your goal and time horizon. Betterment’s advice incorporates a balanced risk and return over the number of years for which you’re investing, but it’s up to you stay the course. Taking on more risk than recommended means you’re risking a significant decline, which can cause you to miss your goal or react emotionally. Conversely, taking on too little risk means you are leaving potentially higher returns on the table over a period where you could otherwise afford to take the risk. As demonstrated below, it’s nearly impossible to achieve even the most impressive level of returns without going through some pretty significant declines. A Top-Return Decade Shows Almost Two Drops Per Year To illustrate this point, we’re showing data on the S&P 500 index, not because it’s a good investment comparison benchmark, but because it has a long history of measureable data going back to 1950. We looked at every possible decade, starting on every day of every year, to find the best return periods. For example, the highest returning decade started on Sept. 25, 1990, ending Sept. 25, 2000. Over this period, the S&P 500 returned an amazing 487%, or 17.2% on an average annual basis. Best Possible Period for S&P 500 Return Data Source: S&P 500 index data from Yahoo Finance However, what the graph masks are the dramatic losses in value that an investor had to bear. Let’s take a look at the declines an investor would have lived through in order to achieve those remarkable returns: Drawdowns Within Best Possible Period Data Source: S&P 500 index data from Yahoo Finance Maximum Drawdown within Each Year Data Source: S&P 500 index data from Yahoo Finance This pattern is found in only average-performing market outcomes as well. In fact, all of the top 10% decades of returns—or those with cumulative returns over rolling 10-year periods that are beyond the 90% quantile of the distribution—experienced substantial declines. This accounts for 1,404 portfolios in total. As reported in the table below, 100% of these portfolios experienced drawdowns of up to -15%. Chance of Significant Drawdown for Best Time Periods Loss Percent of Periods 5% 100% 10% 100% 15% 100% 20% 39% 25% 35% If we look at all decades, in an average decade of returns, the chance of experiencing a drawdown of at least -15% is 100%, and 79% (about four out of five years) for experiencing a drawdown of 25% or more. Significant short-term losses are common, even in what are pretty average investing environments. Chance of Significant Drawdown for All Time Periods Loss Percent of Periods 5% 100% 10% 100% 15% 100% 20% 88% 25% 79% Actual Betterment Customer Returns The graph below depicts the actual time-weighted returns of all live Betterment customer goals for individuals saving at least $100 a month, based on for how long the goal has been active. Newer goals (those with less than two years investing) on average have moderate losses. However, on average, those goals older than two years have significant positive returns. All Goal Returns By Tenure Data Source: Betterment. All live goals saving at least $100 per month as of Jan. 15, 2016. Time-weighted returns net of fees and dividends reinvested. "Active investors" make more than one allocation change every two years. "Set-it-and-forget-it" investors make less than one allocation change every two years. You may be wondering why some goals have below-average returns even in the later years. There are usually three main causes of this: At some point, the account was saving less than $100 a month, and thus had a $3 per month fee (using Betterment's previous pricing structure1). The individual has frequently changed their allocation. The goal was always a very low-stock allocation goal. As we’ve shown previously, changing allocations frequently is the one of the the most likely culprits for lower returns. Reacting to market drops does not help long-term investment goals. Expect Volatility in Sound Investments If significant and worrisome market activity is such a frequent part of investing, what’s an investor to do? The first step is to get used to the idea of watching your portfolio value roller coaster to achieve long-term goals. Preempt downturns by remembering that these drops are usually short-term risks, and bearing short-term risks is what makes long-term portfolios experience higher expected returns. Your “job” in order to earn those potentially high returns is to soldier on through tough times. Scratching an itch usually won’t prevent it from recurring, and the same goes for reacting to short-term losses in your portfolio. In this case, the recommended best practice is to let your understanding of volatility trump emotional or impulsive reactions which could lead to mistakes. If you react to losses in your portfolio, you are engaging in market timing, and attempting to chase performance. This involves taking money from investments that have performed poorly, and putting it into asset classes that have performed well. As we’ve noted, short-term returns are not a reliable gauge for long-term performance, and performance chasing generally leads to investors under-performing. Based on the performance of the S&P 500, as well as Betterment’s average cumulative returns among long-term investors, any investment strategy will include short-term losses. Instead of reacting with panic at any sign of market volatility, preempt anxiety and fear with the knowledge that you are invested appropriately for your goals. 1We've updated our pricing structure since this article was published. Learn more at betterment.com/pricing.
Debunking Myths About ETF LiquidityDebunking Myths About ETF Liquidity What exactly happened with ETFs on Aug. 24? Here’s what: A sequence of global volatility, trading disruptions, and thoughtless selloffs. We break down what happened and why. On Aug. 24, 2015, the Dow Jones Industrial Average saw its largest-ever intraday decline. Major stocks, such as JPMorgan, KKR, Ford, and General Electric, all experienced at least 20% price declines before recovering, according to Blackrock1 and Barron’s. The disruption was short-lived, but while it lasted, a set of ETFs traded at large discounts to the underlying securities. ETFs were supposed to be liquid in good and bad markets, but there is the perception among investors that they played a major role on August 24 in causing the market’s strange interlude. But, in reality, based on the factors below, ETFs were not the cause of the trading problems; they were a victim of them. The trading problems occurred because of volatility from the previous night’s global market activity, and (counter-intuitively) the exchange circuit-breakers that were meant to prevent such problems. The Setup Even before markets opened in the United States, markets were already anticipating significant price volatility. Asian markets sold off substantially overnight, with the Shanghai Composite down 8.5%—its worst plunge since 2007. This weakness in Asian markets rattled the U.S. market, putting the latter under selling pressure before its trading day began. U.S. investors started placing aggressive sell orders without restrictions. The First Crack: Rule 48 Prior to the opening bell, market makers typically disseminate price indications of where they think securities will trade. This allows traders to facilitate an orderly market open and have more stable prices when the market opens. This did not occur on the morning of Aug. 24 because the New York Stock Exchange (NYSE) invoked Rule 48, which suspends the requirement of stock prices to be announced at market open. According to a Blackrock report, almost half of NYSE equities failed to open that morning, even after the stock market had been open for 10 minutes. The lack of information made it difficult for traders to know where they should price stocks and give accurate bid-ask spreads. In effect, traders worried that without transparency, they could be overpaying or under-selling for securities. Amidst the turbulence and lack of clear prices during the first 30 minutes of trading, traders acted conservatively and quoted bid prices that were abnormally low (if buying) or ask prices that were abnormally high (if selling). As a result, the stocks that did open on time generally traded at unusually low levels. This in turn led to larger price moves, resulting in widespread trading halts in individual securities, further aggravating liquidity issues. Widespread Trading Halts A trading halt occurs when a stock’s price has moved up or down too quickly in a particular trading range. According to an ITG report, on Aug. 24 there were almost 1,300 such occurrences, which is 30 times the daily average of 40 halts over the past year. ETFs typically represent one-third of the total trading halts. On Aug. 24, ETF halts made up 78% of total halts. The widespread trading halts in ETFs were partly the result of Rule 48’s impact on a specific subset of securities. Despite some stocks not opening on time, many ETFs did open on time, as rule 48 did not apply to them. The ETFs were more liquid than their underlying securities; research shows this is true a surprising amount of the time. But, the underlying securities were impacted, so many ETFs opened without valuations for some portion of their underlying assets. Traders quoted wide bid-ask spreads (high sell prices and low buy prices) on the ETFs to generally to protect their own positions, in case the underlying assets traded at abnormally low levels when they did begin trading. ETFs can often provide more liquidity, but in this case, not when there is none in the market and there are artificial limits to trading. ETFs aim to trade closely to the value of the securities that they track, and they usually do. But on Aug. 24, some of the biggest and most well-known U.S.-listed ETFs traded at steep discounts to the value of their underlying securities. This meant that the ETFs declined more in price than their underlying holdings (noting that it’s not clear what the correct price for their underlyings was, given that they were halted). For example, according to the Wall Street Journal, the Vanguard Consumer Staples Index ETF plunged 32%, while the value of the underlying holdings in the fund fell 9%. The substantial price dislocation experienced by many U.S. ETFs led some to conclude that ETFs were to blame for the widespread market disruption. But in fact, their volatility was a byproduct of the illiquidity of the underlying instruments. Lessons from Aug. 24 Lesson 1: Invest in Funds Tied to Liquid Assets ETFs can be more liquid than their underlying assets, but only get good pricing when those underlying assets are actually tradeable. When trading in the basic securities is halted, the ETF that tracks those securities may also be difficult to trade. Without liquidity, market makers cannot keep ETFs in line with the securities to which they’re tied. Thus, it is important to pick ETFs that track as liquid underlying investments as possible. Although many ETFs that saw trading disruptions do track liquid markets, picking ETFs that only track liquid markets can help prevent liquidity crunches in your portfolio. It’s also worth noting that trading halts on Aug. 24 caused a normally liquid market to generally become illiquid. The same is largely true for mutual funds, as well, and they cannot provide additional liquidity by delivering in-kind redemptions, as ETFs can. When Betterment chooses ETFs for our portfolios, we filter for liquid ETFs that also track liquid markets; for example, we don’t recommend high-yield bond ETFs. Lesson 2: Don’t Sell When Others Are Selling For steady, passive investors, the price dislocations experienced on Aug. 24 probably went by unnoticed. However, those who saw the problems and chose to sell as others were selling may have incurred substantial losses. Had they ignored the market, a significant portion of the losses seen in the initial minutes of trading would have appeared as a blip rather than a serious portfolio hit. Betterment knows that market opens and closes are typically more volatile than any other times during the trading day, so we purposely avoid trading during those windows. We do not guarantee specific execution timelines. Deposits generally trade the same day if requested at least a half an hour prior to market close. Otherwise, withdrawals will be executed the following trading day. Lesson 3: Avoid Stop-Loss Orders Some investors were impacted on Aug. 24 because of stop-loss orders. These are orders that are automatically triggered when certain trade price thresholds are met, regardless of why they are met. In a market where ETF prices drop abruptly, investors may have stop-loss orders executed automatically at a price dramatically lower than the trigger price. When the market bounces back, the investorwho sold at the lower price may have to get back into the same security at a much higher price level. This is the classic “sell low, buy high” scenario that investors should avoid. Looking Back The price dislocations of Aug. 24 were the result of global market volatility that led to disrupted pricing and trading in the U.S. market. This negatively affected ETF market trading, which was further exacerbated by stop-loss orders and a lack of liquidity providers. The events from that day can teach us to invest in funds tied to liquid assets, avoid stop-loss orders, and hold steadily as others sell. 1https://www.blackrock.com/corporate/en-us/literature/whitepaper/viewpoint-us-equity-market-structure-october-2015.pdf, pp. 2-3 This article originally appeared on ETF.com.
The ETF: Portfolio Management’s Best ToolThe ETF: Portfolio Management’s Best Tool We believe ETFs’ superior cost, transparency, and tax management make them the ideal investment tools for the modern world. When John Bogle, Vanguard’s founder, pens an op-ed calling ETFs “the greatest marketing innovation,” we had to read it. And we’re happy to see that we agree with him for the right reasons … and disagree with him for the right reasons. For a quick review, unlike mutual funds, ETFs can be priced and traded intraday by exchanges and market makers. Mutual funds can only trade once per day, right after the close of the markets. Mr. Bogle quite rightly is concerned that ETFs can trade intraday means that some investors will speculate with them by buying low in the morning, and selling high in the evening. Such short-term speculating is likely to harm long-term successful investing. On that score, we’re 100% with him. However, the difference in how ETFs and mutual funds trade and price has significant benefits for portfolio management, too. For one, ETFs trade throughout the day, and therefore see a wider range of prices in a single day, allowing tax loss harvesting and rebalancing to provide more value. In fact, we believe ETFs’ superior cost, transparency, and tax management make them the ideal investment tools for the modern world. For example, ETFs are more transparent, as they don’t embed 12b-1 fees, which a salesman or broker can earn from selling the mutual fund (creating a conflict of interest in the mutual funds they sell). Here, we’ll focus on how ETFs are superior investment vehicles when it comes to portfolio management. When it comes to portfolio management, short-term fluctuations in the prices of securities may not be a bad thing—they can create more opportunities to rebalance and tax loss harvest. These aren’t short-term speculative moves—they are long-term tax and risk management benefits, made possible by efficient technology. In addition, they can more correctly reflect current underlying prices. However, because of intraday fluctuations, it is possible for ETFs to trade at prices very different to the underlying index in the very short term. If you care a lot about getting a perfect price open-end mutual funds may be more attractive, as they always are priced at the net asset value of the underlying assets… but once per day, after close. The one-time pricing has its own downsides. Fund Types and Characteristics ETFs Open-End Mutual Funds Closed-End Funds Diversification Benefits Yes Yes Yes Share price determined by supply and demand Yes No, price determined by net asset value of the underlying assets Yes Can new shares be created? Yes, through creation and redemptions Yes, through creation and redemptions No generally, the pool of money collected for the investment vehicle does not change after the initial IPO however shelf programs can be created to help w/ liquidity Can trade at premium/discount to NAV Yes No Yes Intraday NAV? Yes No No Below we took a look at how intraday changes could significantly affect how your portfolio is managed by comparing the frequency of tax loss harvesting and rebalancing when observing intraday prices rather than just closing prices. The chart below depicts the close-to-close return (represented by the dot), which is the closing price for a certain date compared to the closing price of the day before. We’ve normalized it so that all close-to-close returns have a value of zero, to compare other returns to. It also shows the return generated by the daily high and low of intraday trading for EEM, the iShares MSCI Emerging Markets ETF. This lets us see the range of returns we observe with an ETF compared to a mutual fund. When the close is the high or low price of the day, the high/low bracket is not plotted. As you can see, on the vast majority of days, the highest or lowest return is very different from the close to close return. In other words, ETFs have significantly more tax loss harvesting opportunities (the lows) and rebalancing opportunities (both lows and highs) than mutual funds. One-Day Range of EEM Returns Prior Day Close to Today’s High and Low The Opportunities for Intraday Trading Most days have a range of returns that is significantly different from the close-to-close return. Both mutual funds and ETFs price daily, but only ETFs can trade intraday. How much opportunity actually occurs intraday? And, more importantly, how much incremental opportunity does intraday provide? It turns out, quite a lot. In the table below, we present the count of observing a 3% loss, when looking at close-to-close prices for one day’s return. Count of Close-to-Close Losses Intraday Loss AGG VTI EFA EEM -1% 14 397 487 656 -2% 4 130 189 282 -3% 1 49 83 142 -4% 1 28 42 76 -5% 1 13 24 42 -6% 1 9 11 29 -7% 0 3 7 23 -8% 0 3 4 13 -9% 0 2 3 9 -10% 0 1 3 7 The above table shows four different ETFs, each representing a different asset class. We chose the AGG, a bond ETF that encompasses the broad U.S. bonds market; VTI, the total U.S. stock market ETF; EFA, a developed markets stock ETF; and EEM, an emerging markets ETF that covers the emerging markets. We chose these ETFs because we wanted to look at several different geographies and asset classes. The table above illustrates the number of times one can expect a mutual fund (using close-to-close returns) to experience a portfolio management event, whether it’s tax loss harvesting or rebalancing, because the mutual fund experienced a 3% loss. As we move down each column, the loss level hurdle increases and the number of occurrences decreases for all four funds. If we look at the same data below, but for close-to-low prices (the difference between closing price and the lowest price for that day), we have how likely it is that an ETF sees a given loss when we can observe intraday prices. The number of occurrences increases by a significant magnitude if an investment trades throughout the day rather than trading only once at market close. Count of Close-to-Low Losses Intraday Loss AGG VTI EFA EEM -1% 43 702 865 1108 -2% 9 209 319 492 -3% 5 79 125 224 -4% 2 41 70 119 -5% 1 26 38 72 -6% 1 17 21 49 -7% 1 14 15 36 -8% 1 11 10 20 -9% 0 5 8 14 -10% 0 2 3 10 The table below shows the increased odds of seeing a level of loss for an ETF relative to a mutual fund. As you can see, being able to trade intraday generally creates roughly a 2x increase in potential tax loss harvesting opportunities per day. Increase in Likelihood of Loss Intraday Loss AGG VTI EFA EEM -1% 307% 177% 178% 169% -2% 225% 161% 169% 174% -3% 500% 161% 151% 158% -4% 200% 146% 167% 157% -5% 100% 200% 158% 171% -6% 100% 189% 191% 169% -7% NA 467% 214% 157% -8% NA 367% 250% 154% -9% NA 250% 267% 156% -10% NA 200% 100% 143% It might not be obvious, but these are intraday return differences that are resolved by the end of the day—ETFs and mutual funds have the same close-to-close return. So these are ephemeral opportunities to tax loss harvest and rebalance. But the good news is even if we look over larger periods, we still see significant increase in potential tax loss harvesting opportunities by looking at intraday prices. Instead of looking at just the one-day intraday differences, we can check on a longer five-day range, and find that ETFs will still see many more opportunities to tax loss harvest and rebalance than mutual funds. Increase in Likelihood of Loss Over Five Day Period Loss AGG VTI EFA EEM -1% 165% 138% 130% 125% -2% 208% 142% 128% 129% -3% 233% 153% 139% 133% -4% 300% 144% 134% 148% -5% 150% 177% 145% 144% -6% 100% 162% 159% 145% -7% 200% 147% 153% 145% -8% 200% 200% 168% 151% -9% 100% 176% 153% 140% -10% 100% 193% 154% 155% Up-to-Date Prices on International ETFs The fact that ETFs can price intraday provides other benefits. With ETFs that track international indexes, but trade here in the United States for local investors, when the international markets are closed investors can use them to provide an estimate of the value of the underlying index. This is especially true with international ETFs because when the underlying markets are closed, the ETF still trades in the United States. As information and news about those countries break and are continuously processed throughout the day, the prices are not reflected by the underlying securities (as that market is closed) but are reflected in the prices of the ETFs that trade in the United States. So if you look at the net asset value (NAV) of a mutual fund, it probably doesn’t reflect the most up-to-date information about the price. But the ETF will. The reality is ETFs are sometimes the only tools for discovering the price at which the underlying assets should trade. While they may not reflect 100% accurately the movement in the underlying market, ETFs hold substantial predictive value when it comes understanding the underlying market. Bogle may have penned an attack on ETFs, his attack is really an attack on trading concentrated niche ETFs that are active in nature for speculative purposes. Betterment’s portfolio of ETFs are all passive ETFs that track an index. We never buy or sell for speculative purposes. Rather, we trade if there’s value to be gained from portfolio management. The way that Betterment uses ETFs very much resembles Bogle’s philosophy of long-term index investing: buy and hold, and don’t try to beat the market. This article originally appeared on ETF.com.
How Betterment Helps Keep You on Track Through Tough MarketsHow Betterment Helps Keep You on Track Through Tough Markets Historical data suggests that customers who follow our advice will stay on track to reach their goals, even in a market downturn as bad as the 2008 crisis. Imagine going for a weekend upstate New York. You rent a car, load your destination into your phone’s GPS. It lets you know that you have about a two-hour journey ahead of you, and it suggests that you take the highway. About an hour and a half into your drive, your GPS notices that there is an accident on the highway up ahead. It knows that it will slow you down, so it reacts by advising you to take a different route, using back roads, in order to get to your destination as quickly as possible. Because of the accident, it's going to take a bit longer (not much—just 20 minutes or so)—but you're back on track. This example is very similar to Betterment’s goal-based advice; just as the GPS recommends the best route to take to reach your destination, we recommend the smart path to take to reach your financial goals. And just as the GPS updates its recommended route based on road conditions and accidents, we update our advice based on various circumstances, such as a shorter time horizon as you approach your target date, or a market downturn. Because our advice is constantly taking these factors into account, you’re always taking on the right level of risk and saving the right amount (if you’re following our advice). Historical data suggests that customers who follow our advice will stay on track to reach their goals, even in a market downturn as bad as the 2008 crisis. How Our Advice Works At the beginning of your journey with Betterment, we’ll recommend your starting risk level. We’ve chosen this risk by considering what stock allocation would be appropriate in a bad-market scenario. That means that even in a worse-than-expected market, you’ll be taking on the right level of risk for the goal you want to achieve, and you’ll be set up to ultimately reach your goal. Second, we’ll estimate how much you need to save, and adjust that not for average returns, but, to be conservative, slightly below-average returns (the 40th percentile, if you’re being precise). So we’ve built in some degrees of conservatism from the outset. From that point, you’re on your way but not on your own. As you get closer to your goal, making your time horizon shorter, we’ll update our advice for your recommended risk level and suggested monthly savings amount. While you might experience interim losses or market drops before your goal’s target date, subsequent positive returns are likely to offset them. Close to your target date, your portfolio will be designed to take on less risk, as you will have less time to recover. As a result, you won’t take on significant goal risk, which is the chance you’ll miss your goal by a large amount of money or time. In the case of a really big market drop, we might advise you to do something about it, such as make a deposit, which will help keep your goal on track. But if it’s early on in a long-term goal, it’s unlikely you’ll need to change anything significantly, because you still have a lot of saving to do. Historical Performance of Our Advice To see how this advice plays out, let’s review a scenario that many people worry about: a goal that has two pretty unpleasant market drawdowns over its term. We’ll use a hypothetical investor who opens a Betterment Major Purchase goal with $100,000 on Jan. 1, 2000. The goal has a target date of March 2009, and a target balance of $150,000. We’re using a Major Purchase goal because the investor intends to completely liquidate that goal at the target date (as opposed to a Retirement goal that wouldn’t be liquidated all at once). This time period (January 2000 to March 2009) was one of the worst times to invest. The investor would have had to contend with both a market drop from 2000 to 2004, and the fact that the market would have dropped right at the end of her investing period, in 2008-09. Recommended Asset Allocation Because this was a Major Purchase goal (where the funds are liquidated at the target date), Betterment would have recommended a high stock allocation early on, but decreased that significantly as the goal date approached. When the goal has roughly one year left, our advice would have been to have 27% stocks, with 18% of the portfolio in cash. The graph below depicts our allocation advice over the term of the goal. Recommended Asset Allocation, 2000-2009 Portfolio Weight in Stocks and Bonds as the Investor Nears Goal Portfolio Returns Below we show the cumulative returns of the portfolio. This investor would have seen two large drawdowns over her investing period, in 2001 and 2008. Compared with keeping the initial allocation, the allocation takes on less risk over time. This means it goes down slower when markets fall, but also up slower when they rally. Over this period, the investor would have seen a cumulative return of 28.6%, which averages out to 2.7% per year. Even in a pretty unlucky environment, still positive returns. Growth of First $1 Invested, 2000-2009 At the very end it avoids the crash a bit, not because we saw it coming, but because it wasn’t appropriate to take on lots of risk so close to the goal date. Note that the portfolio still experienced drawdowns along the way, in fact, for most of the first three years. Would you have stuck with Betterment through that period? Savings Advice In the beginning, it seems possible the investor would hit her target with no savings, given the $100,000 starting balance. Of course, we realize markets rarely deliver average returns: It bounces up and down around the average. Early on in this goal, market returns are below average (global stock markets measured by the ACWI ETF dropped nearly 50%), and so the probability of achieving her goal dips below 50%. Probability of Success, 2000-2009 This causes our advice to change: Our response is to do the one thing that’s guaranteed to improve the investor’s odds—increase her monthly savings amount. Starting in late 2001 (during the crash) through mid-2003, we’d recommend an increasing savings amount—up to $250 a month. At that point, the market starts increasing rapidly. Recommended Monthly Savings Amount, 2000-2009 Rather than reduce savings, we view this as a chance to increase the probability of the investor achieving her goal. Results: Portfolio Value But, here is the key graph—the portfolio value. In this case, the investor was aiming for a final value of $150,000. As you can see, even with savings, the portfolio value was flat for the first three years. That would have been a long time to stick with an investment manager, even if this was just what global markets were doing. Starting in 2003, the stock market takes off, and the combination of savings plus returns gets us to our goal in 2007, two years early. However, if the investor had stayed invested, she’d have experience a pretty dramatic, significant drawdown toward the end. But because Betterment was recommending decreasing risk, it’s not a big deal. And, even despite the 2008 crisis, she reaches her goal. Portfolio Value, 2000-2009 Even better than probability of success is projected shortfall in a bad market, given the current balance and savings rate. We can see below that while the crash in 2008-09 definitely hits the balance, the expected shortfall from our goal is relatively minor. Shortfall Amount, 2000-2009 As time time horizon reduces, and the portfolio risk reduces, we decrease the uncertainty of the outcome. The graph below depicts, for any point in time looking forward, the expected range of outcomes at the target date. The range does follow portfolio returns and savings paths, but is always decreasing at the effects of time and portfolio risk reduce. Uncertainty Reduces Over Time, 2000-2009 A good financial advisor is always updating advice to take into account your current situation and goals. This might mean adapting to setbacks and unlucky outcomes, but being proactive about what clients need to do in order to get back on track. It’s almost guaranteed you’ll have losses in your portfolio at some point in time, so it’s critical to plan for how those setbacks impact your plan. While Betterment can’t guarantee risk-free high returns, we can guarantee we’ll always be giving you advice that’s personalized to your goals and circumstances, and completely up to date. A word about backtested performance data: These results are hypothetical and past performance does not guarantee future results. The Betterment portfolio historical performance numbers are based on a backtest of the ETFs or indexes tracked by each asset class in a Betterment Taxable portfolio. All percentage returns include the Betterment fee (0.15% for $100,000 or more, charged quarterly), standard rebalancing, reinvesting dividends and the expenses of the underlying ETFs. All values are nominal. Monthly contributions are assumed to be made at the beginning of the month. Performance returns are calculated using the time-weighted rate of return methodology that ignores cash flows. We've updated our pricing structure since this article was published. Learn more at betterment.com/pricing. Data and performance returns shown are for illustrative purposes only. Though we have made an effort to closely match performance results shown to that of the Betterment portfolio over time, these results are entirely the product of a model. Actual individual investor performance has and will vary depending on the time of the initial investment, amount and frequency of contributions, and intra-period allocation changes and taxes. Please see additional details at: https://www.betterment.com/returns-calculation/.
The Forward Curve: How Betterment Forecasts Interest RatesThe Forward Curve: How Betterment Forecasts Interest Rates Does your automated investing service regularly update its forecasted future risk-free rate assumption? At Betterment, the answer is yes, on a quarterly basis. The SEC and FINRA issued an alert in May 2015 about automated investing services. In the process, they surfaced some good questions consumers should ask before placing their money with a service that uses algorithms to drive advice and portfolio management. As transparency is one of the core principles of Betterment, we make ongoing efforts to educate investors on the assumptions that we use in our algorithms. We took this alert as an opportunity to do more of just that. The alert specifically drew focus to interest rate assumptions underlying automated investing: “If the automated tool assumes that interest rates will remain low but, instead, interest rates rise, the tool’s output will be flawed.” This is another way of saying, “Does your automated investing service regularly update its forecasted future risk-free rate assumption?” At Betterment, the answer is yes, on a quarterly basis. But what does that mean, and why is it significant? To answer that, we’ll need to understand the forward interest rate curve. The Risk-Free Rate The risk-free rate is a rate of return for an investment with nearly zero risk—such as an ultra short-term Treasury. The fact that the issuer is the U.S. government means it has insignificant credit risk, and the ultra short-term maturity means it has minimal interest rate exposure. Of course, this ignores inflation risk, but you know exactly what your return will be, in nominal returns. For as long as I can remember, economics and finance textbooks spoke of a risk-free rate pegged from 2% to 5%. This made classroom math easier, but for the past decade of low interest rates, the number doesn’t come close to reflecting the real world. When we calculate returns, both historic and forward-looking, we consider a portfolio’s performance in the context of the risk-free rate in the same period. If you could have achieved the same (or higher) return risk free, why would you take the risky asset? In the typical classroom example, if an investment earned a 12% return last year, we would want to adjust that down by the risk-free rate—let’s say 5%—which paints that investment as a seven percentage point return above the risk-free rate. This is what we call an excess return—a return above the risk-free rate. From the other perspective, if an investor wants to consider a new potential investment that takes on risk, it would need to offer an expectation of a return greater than the risk-free rate. Otherwise, why bother? In these examples, the ultra short-term U.S. Treasury is usually the stand in for risk-free rate. While that was 5% or more for years (that was the rate in 2000), today the three-month U.S. Treasury yield is actually just 0.04%. Risk-Free Rate Since 1982 So, the first implied question in the regulatory alert item is: Does the Betterment algorithm know that the three-month U.S. Treasury yield is no longer anywhere near 5%, but a lot closer to 0.04%? The answer is yes. And, that number is automatically updated in the underlying algorithm on a quarterly basis. Future Risk-Free Rates: What Will They Be? Of course, if you have a 30-year goal with Betterment, you don’t expect risk-free rates to be at zero over the next 30 years. But how might we forecast future risk-free rates, especially without resorting to overconfident expert judgments? Well, we can use the market’s estimate. Because the bond market is very efficient, we can use market prices to estimate the expected yields at specific points in time in the future. The classic example is a bond with a two-year maturity and a bond with a five-year maturity need to move together, so that an investor could buy the two-year instrument and then afterward invest in some three-year instrument to bring him to the total return of the five-year instrument. If the yields are known on the two-year and on the five-year bonds, calculating what the three-year note would yield becomes the question at hand. The CFA Institute gives a nice example of how this works. If our two-year bond is paying 2%, then the math is: 100 x (1.02) x (1.02) = 100 x (1.02)^2 = $104.4 If our five-year bond is paying 5%, then the math equation would be similar: 100 x (1.05)^5 = $127.63 Future forward rates refer to what is the implied rate for a bond we could hold for years three, four, and five, whose return would allow the owner of the two-year bond to have the same total return as the original five-year bond. A simple equation to solve for the missing variable (i) would be: $104.04 x (1 + i)^3 = $127.63 That means the first return, times 1 plus the missing interest rate, and that raised to the power equal to the number of years, has to equal the return from the full five-year yield. Doing some easy algebra brings you to: Forward interest rate = [($127.63/$104.4)^⅓] - 1 In this example, i = 0.070489, or 7.05% So, the answer is that the forward rate, implied by the two original returns, means that an investor could earn 2% on the two-year bond, then invest that in a three-year bond yielding 7.05%, to equal what he could have also got through owning the five-year bond yielding 5%. Note that the three-year bond will have a higher yield than the average yield of the five-year. Because the five-year is an average over five years, if the first two years are below average, the following years must be above average. We can see this relationship in the actual bootstrapped forward curve below—the implied forward curve is higher than the yield curve. Yield and Forward Curves What This Means for You Expected future returns are comprised of two parts—the risk premium (above the risk-free rate) that assets earn, and the risk-free rate. Expected Return = Risk-Free Rate + Risk Premium (or excess return) When we forecast our forward-looking returns, the risk-premium component of the portfolio changes at a gradual rate, but the risk-free component can reflect the bond market’s forecasts over the course of your goal. For customers, what’s important is that our estimates of expected returns are being updated to take into account market forecasts of future risk-free rates. If future risk-free rates are anemic, this means you might need to save more to achieve the same goal. On the other hand, if future rates rise, it may mean you will have more certainty about having at least as much as, if not more than, your goal target. We adjust this quarterly so that our forecasts can be as accurate as possible for our clients, be their goals short term or long term. We don’t believe more frequent than quarterly would be beneficial. While future risk-free rates are important for our savings advice, they don’t influence our allocation advice. Betterment’s investment philosophy is that you should diversify a portfolio and hold it for the long term, adjusting frequently, but not taking big bets that can easily be off. As for the original question posed by the SEC about the underlying assumptions used in the algorithm, rest assured that Betterment’s algorithm is using current and accurate data.
Eliminating the Black Box: How We Automated ETF SelectionEliminating the Black Box: How We Automated ETF Selection The 30 funds we use in our portfolio were selected on merits so clear that we codified it. Here’s how we narrowed our ETFs down to 30 from more than 1,600 choices. When you use algorithms and data to make decisions, you agree to a very basic principle: You clearly and logically lay out the steps you follow, and then use the answers that your analysis produces—whether or not that jibes with a personal opinion or feeling, or worse, incentive provided by someone other than your customers. At Betterment, this is a philosophy we apply at every level of the company—including how we selected the funds that are used in our portfolio. As mentioned in our portfolio selection white paper, the following core criteria drove our ETF selection process: Positive expected return, after adjusting for taxes and risk Low cost Highly liquid Passive/index-tracking Low turnover Tax efficiency We considered the full universe of U.S.-listed exchange-traded funds (ETFs). For our ETF selection, we created a filtering and ranking algorithm (using the free open-source programming language R) to choose ETFs that met our core criteria and ranked highly on qualities aligned to our investment objectives. We applied these filters to remove asset classes and investment vehicles that did not meet our standards, and then selected from the top remaining candidates. We assessed the universe of 1,654 ETFs (as of Sept. 4, 2015). This transparent process resulted in 30 different ETFs for customers to invest across 13 asset classes. We outline the type of ETFs we sought as well as the ones we actively avoided. The process reduced average expense ratio for the overall set from 0.64% to 0.20% for the final set. ETF Exclusion By Category Asset Class An asset class is a group of investments that share similar characteristics and behaviors. Funds with an asset class of equity or fixed income were included in our analysis. Funds that were in alternatives, commodities, asset allocation, and currency categories do not align with our investment objectives. They are either highly speculative, expensive, or generate uncertain expected returns. The average expense ratio of ETFs that were filtered out was 0.97%, while that of the included set was 0.57%. The spread was similarly reduced from 0.15% to 0.07%. By filtering out asset classes with high expense ratios and bid-ask spreads, our algorithms can steer clients away from expensive and illiquid investments right from the beginning. Inverse ETFs Inverse ETFs are constructed using derivatives that allow the investor to profit from a decline in the value of the underlying benchmark. In line with Betterment’s investment philosophy, Betterment does not engage in strategies that mirror shorting because of its risky nature and negative expected returns. Inverse ETFs were therefore eliminated altogether from consideration. The mean the expense ratio of inverse ETFs was 1% per year, while the mean expense ratio of the remaining noninverse ETFs was 0.5%. Leveraged ETFs Leveraged ETFs often allow for two or three times the exposure to the underlying indexes using derivatives. Betterment does not hold leveraged ETFs because of their high cost. The mean expense ratio of the excluded set was 0.96%, while the mean expense ratio of the included set was 0.46%. The TACO The total annual cost of ownership (TACO) is Betterment’s proprietary fund scoring method. TACO takes into account an ETF’s transactional and liquidity costs as well as fund management costs. TACO balances the expense that’s incurred annually (expense ratio) with a transactional cost such as the bid-ask spread. The weight given to the bid-ask spread, which is incurred only when bought and sold, is calibrated to reflect the average turnover in a Betterment portfolio, which is designed to be bought and held. As such, the bid-ask spread is effectively weighted less than the expense ratio. In other words, since we do not trade actively in our portfolios, we prefer a fund with an expense ratio of 0.10% and a bid-ask spread of 0.20% to a fund with an expense ratio of 0.20%, and a bid-ask spread of 0.10%. Within each asset class, we specify a maximum acceptable TACO number. This serves to filter down the total number of funds per asset class to a top-tier set. The maximum TACO threshold differs by asset class. In general, emerging market equity and bond funds have a higher expense than U.S. corporate bond funds. The average expense ratio of the included set was 0.24%, and that of the excluded set was 0.35%. Average Daily Volume and the 10% ADV Test We then rank funds based on the liquidity and depth of their market, measured by the average daily volume (ADV) of their trading. ADV measures how deep the market is for a fund, in terms of the amount of shares traded by active buyers and sellers. A fund with a low ADV may have higher-than-expected liquidity costs on days when Betterment needs to buy or sell that fund. We therefore select the top 12 candidates in each component. In addition to ranking based on ADV, to help ensure Betterment’s orders do not account for more than 10% of the funds’ total daily volume, we create a 10% of ADV test. The test uses an upper bound on expected daily volume in Betterment’s portfolio, and breaks down that volume into the volume per each component. Funds chosen for Betterment’s portfolio cannot exceed the 10% total traded daily volume threshold. As with previous steps, eliminating thinly traded ETFs reduced expense ratios as well. The excluded set had a mean expense ratio of 0.50%, while the mean expense ratio of the included set was 0.21%. While this list of our filters and criteria is far from being comprehensive, it gives a flavor for the kinds of characteristics we look for in an ETF. All in, 30 ETFs met all selection criteria and were placed in the Betterment portfolio. How We Decide to Change Our Funds The process above is run quarterly to update our assessments. However, we do not thoughtlessly change our funds immediately when this output changes. By investing customers into a fund, we are potentially committing to them holding it indefinitely, or incurring tax or transaction costs to change it. We must consider if a relative improvement is likely to be permanent, or if a competitor is likely to match the reduction (hooray, competition!). To decide to make a change, we convene our investment committee and discuss whether we believe such a change is merited based not only on current statistics, but on the trend and behavior of market participants. We are constantly on the watch for new ETFs that come to market. Meanwhile, we are also monitoring our current portfolio for changes to our ETFs such as increases in expense ratio, tighter bid-ask spreads and shrinking assets under management. The value of this ETF automation selection process is how easy it is to evaluate the full universe of U.S.-listed ETFs and select the ones that most closely align with our investment philosophy. Through this process, we seek to drive transparency, efficiency and cost-effectiveness on an ongoing basis when re-evaluating our portfolio of ETFs. This article originally appeared on ETF.com.
Why Your Index Fund Has a Different Return Than Its IndexWhy Your Index Fund Has a Different Return Than Its Index When it comes to your returns, indexes matter. But the fund you choose to mimic that index matters even more. Index funds are turning 40 this year, but they’re hardly over the hill. In fact, quite the opposite—investors are investing in them now more than ever. In 2014, investors poured $250 billion into U.S.-listed index-tracking exchange-traded funds (ETFs), shattering the 2013 record inflow of $188 billion. Market share paints a similar picture. In 2014, traditional index funds and ETFs made up a quarter of total bond and stock fund assets, compared to just 1% in 1990. Index Funds: Assets and Market Share Investors use index-tracking funds because they’re typically cost-effective, transparent, easy to use, and give investors access to their preferred indexes, such as the S&P 500. But many investors are confused when their index return doesn't match that of the index it's tracking. What they may not know is that the index itself is just one factor to consider when choosing a fund. It's also important to look at an array of characteristics, including degree of turnover, frequency of rebalancing, how reasonable the expense ratio, and transparency of fee reporting. A Quick Guide to Indexes An index is nothing more than a basket of securities. The way indexes differ from each other is how they select and assign importance (i.e., weight) to those securities. For example, the S&P 500, an index that’s made up of the largest 500 publicly traded companies in the United States, weights its securities by market capitalization. So, if Apple makes up 5% of the total size of those 500 companies, then it gets assigned a 5% weight inside the S&P 500 index. Similarly, the CRSP U.S. Total Market Index is weighted by market cap, but instead of including just the top 500 companies, it includes nearly all publicly listed U.S. stocks. While you can’t invest directly in an index, you can invest in a fund that tracks an index. This is called an index-tracking fund. For example, if you wanted to invest in the S&P 500, you can buy SPDR’s S&P 500 ETF (SPY), Vanguard’s S&P 500 ETF (VOO), or alternatively iShares Core S&P 500 ETF (IVV). VOO has the lowest expense ratio of the three. Domestic and International Indexes In the United States today, the main index providers are: MSCI (Morgan Stanley Capital International) FTSE (the Financial Times Stock Exchange Group) Standard & Poor’s (S&P 500) Dow Jones Each index provider uses its own criteria in selecting and weighting companies. When it comes to indexes that track markets outside of the United States index providers classify geographies differently. For example, FTSE classifies South Korea as a developed country, whereas MSCI classifies South Korea as an emerging market economy, putting it in the same index with China, India, and Brazil. This divergence in geographical classification may impact the risk and return of your portfolio if you are heavily invested in emerging markets. Choosing which emerging markets fund to invest in can translate to real differences in country exposure. Differences in Market Coverage Even if two indexes classify geographies similarly, be aware that they may not define large-, mid-, and small-cap segments the same way. Take the treatment of companies that are small in market capitalization, otherwise known as small-cap stocks, as an example. Traditionally, the FTSE All-World Index (an index of approximately 2,900 stocks in 47 countries) excluded small-cap stocks, whereas the S&P Global Broad Market Index, also a broad global index, included small-cap stocks in addition to large and mid cap companies. Furthermore, indexes may define smalls caps differently. For example, FTSE includes the smallest 10% of all securities in their small-cap exposures while MSCI, S&P, and Dow Jones cover the smallest 15%. An investor who is not aware of this difference may unintentionally create an unwanted overlap in a portfolio by obtaining the larger segments of the market from one provider and smaller segments of the market from another provider. What Makes a Good Index-Tracking ETF? As index-tracking ETFs become more popular, there are more and more that track the same index. However, this overlap doesn’t necessarily mean they’re created equal—some are better than others at exposing investors to their intended markets while reducing costs. So how do you know what to avoid and what to look for? Choosing a good fund is not just about the index—it’s also about what’s true of the fund that tracks it. In general, a good index-tracking ETF is accurate in tracking its underlying index, intelligent about managing turnover and trading, reticent to pass on capital gains generated internally, diligent in rebalancing, generally inexpensive to access, and transparent in its fee reporting. It’s important to understand each of these characteristics and how to measure them. Tracking Error: This is the standard deviation of the fund’s excess returns vs. its benchmark. Tracking Difference: Similar to tracking error, tracking difference is the annualized difference between a fund’s return and its benchmark’s return. A small difference indicates that the ETF has done a good job of mirroring its index. Expense ratio, rebalancing costs, cash drag, and dividend tax can all contribute to tracking difference. Fund Turnover: This is a measure of how frequently assets within a fund are bought and sold. Higher turnover leads to higher transaction cost. Fund turnover costs are not included in the expense ratio. They can represent a significant additional cost that reduces your long-term investor returns. Rebalancing: Whether and how often a fund changes its holdings to maintain established asset allocations. Rebalancing does not impact portfolio returns as much as it minimizes risks. Expense Ratio: This is the annual cost that a fund charges for managing assets. It does not include portfolio transaction fees and brokerage costs. Expense ratio is reflected in the tracking difference. There are also two expense ratios: gross expense ratio and net expense ratio. Gross expense ratio is the expense ratio before fee waivers and reimbursements. Net expense ratio is post fee waivers and reimbursements. If there is a big difference between the two expense ratios, it could be a sign that the fund’s expense ratio may increase once the fee waiver expires even though the investor is locked into the fund. Tax Cost Ratio: The reduction in a fund’s annualized tax return because of taxes on distributions. The degree of turnover, frequency of rebalancing, how reasonable the expense ratio, and transparency of fee reporting can be gleaned from an ETF’s prospectus. Good ETFs, in short, minimize unnecessary distortions and provide easier access for the everyday investor to invest in her desired market. S&P 500 Index and Funds That Track It, 2004-2015 How ETFs Reflect Index Composition Changes But what happens if the underlying index that the ETF tracks changes its constituents or even the methodology it uses to track indexes? How will the ETF provider respond? Recently, two index providers, MSCI and FTSE, made different decisions about including China A-shares in their core emerging market indexes. If you’re new to A-shares, they are shares that are traded on the biggest Chinese stock exchanges in local currency (Renminbi), and they have not been available to foreigners for purchase due to government restrictions. Despite being the world’s second largest economy, China’s stock market has been difficult to access for foreign investors. Historically, foreign ownership of China A-shares have been limited to those who hold unique licenses that allow them to invest in domestically domiciled and listed Chinese companies. But China has made significant efforts in opening its market to international investors. License and quota approvals have been increasing at a rapid pace since 2001. Because of the recent developments in regulatory reform, market accessibility, and expansion of the stock market, FTSE recently decided to include China A-shares into its emerging market benchmark. Most of the time, when there is a change in the index, the associated ETFs mirror that change. This is true of Vanguard, a provider of funds that track some of FTSE’s indexes. When FTSE announced that it would include China A-shares in its Emerging Market Index, Vanguard followed suit by adding China A-shares to its Vanguard Emerging Markets exchange-traded fund, VWO. MSCI, another index provider, decided against including China-A shares in its global benchmarks as it awaits the resolution of several issues surrounding market access. EEM, the iShares ETF that tracks MSCI’s Emerging Markets Index, mirrored the decision of MSCI to not include A-shares. Wolf in Sheep’s Clothing: Active Indexes The examples we mention above involve passive index-tracking ETFs. However, there are ETFs that are active, which means they don’t track the performance of the index. These active ETFs have grown significantly in the last decade. They allow fund managers to change their allocations and deviate from the index as they see fit. Active ETFs tend to generate higher costs in the form of higher expense ratios, turnover, and taxes. At Betterment, our portfolios only consist of ETFs that are passive ETFs because we believe that active ETFs do not generate higher returns over the long term. Therefore, we don’t think their higher fees are necessary and justified. To screen out ETFs with higher fees and expenses, we identify categories of ETFs that are associated with higher costs and exclude them from our basket. An example is inverse ETFs. These ETFs are created for the purpose of profiting from a decline in the price of the underlying benchmark. The average expense ratio associated with inverse ETFs is around .99%, while those that are not inverse have an average expense ratio of .61%. Our algorithm screens out inverse ETFs automatically. For the same reason, we screen out active funds. One way to identify these active funds is to look at their weighting method, which tend to be weighted based on beta, volatility, momentum, or entirely proprietary. How Do A-Shares Affect My Betterment Portfolio? While FTSE’s composition change certainly affects the Betterment portfolio, the effect is rather small. The launch of two transition indexes will start out by weighting China A-shares at 5%. As an example, a 70% stock 30% bond portfolio at Betterment only has a .32% exposure to Chinese companies. However, the index change does signify the willingness and readiness of index providers to get broader market access to the second largest stock market in the world. The change allows investors to have exposure to a more global and comprehensive portfolio.
Currency Risk Does Not Belong in Your Bond PortfolioCurrency Risk Does Not Belong in Your Bond Portfolio International bonds can help improve your portfolio’s performance, but leave currency bets to gamblers. When you buy things in a foreign currency—whether that’s goods and services as a traveler, or stocks and bonds as an investor—you are faced with a central issue: How far will your dollar go? Exchange rates ebb and flow on a daily basis, which creates currency risk. For the infrequent traveler, that may be an acceptable risk, but for the investor, the currency risk could wipe out his portfolio gains. Today, this is an increasingly visible issue for investors as the integration of global financial markets is making it easier for investors to access far-flung markets and asset classes. When foreign investments are denominated in a currency other than U.S. dollars, the returns you make on them must be translated back to American currency. That means an international fund’s performance, when reported in U.S. dollars, also includes the effect of exchange-rate movements. Individual investors are not immune to currency movements, either. If his or her own investments are issued in a foreign currency, he or she may lose if the exchange rate moves against them, even if the investment itself has a positive return. For example, if John is invested in Apple Inc. bonds that are denominated in the yen, and the yen depreciates against the dollar, when John converts from the depreciated yen back to the dollar, his investments may be worth less even if Apple sees great returns. Yet a well-diversified portfolio can help avoid that risk, allowing investors to tap the upside of diversification while managing risk associated with currency fluctuations. The Origin of Currency Risk Governing bodies around the world set economic agendas independently. Monetary policies, as a result, range from economic region to economic region, resulting in varying interest rates. Interest rates, in short, are the rate at which borrowers pay lenders. Countries use interest rate targets as tools to manage their own economies. For example, central banks can reduce interest rates to encourage investment and consumption in that country—or raise rates to deter borrowing. Interest rates directly affect currency exchange rates and thus create currency risk. While rates are being re-evaluated by countries, the good news is that rate changes do not work in lock step. For an investor who’s invested in bonds of different countries, the internationally diversified bond portfolio may allow investors to lessen their overall interest rate risk. Importantly, however, this exposure to currency risk is an uncompensated risk. Changes in exchange rates create return volatility without introducing additional expected returns. While rate changes may randomly add returns in your favor in the short term, the expectation should always be of zero return over the long term. It is true that currency moves can be profitable if you are on the right side of them. The “carry trade” involves borrowing from low-interest rate currencies to invest in high-interest rate currencies. This strategy has demonstrated it can be profitable over some periods of time.1 However, the same carry strategies exhibited large losses during the 2008 financial crisis, making the point that such strategies’ “tail risk” (risk of unpredictable losses) potentially cancels out their profitability during more normal times.2 How to Mitigate Currency Risk in Bonds There are two ways to mitigate currency risk: 1. Buy foreign securities issued in U.S. dollars. A U.S. investor who wants to invest in the bonds of the Mexican government, for example, can invest in bonds that are purchased, have income issued, and have principal returned in U.S. dollars. By doing so, he or she she is never exposed to USD/MEX currency risk. In contrast, a U.S. investor who purchases a U.S. bond issued by Apple Inc. but denominated in Japanese Yen (JPY) is exposed to currency volatility. So a U.S. investor investing in a U.S. company can still be exposed to currency fluctuations if the bond is denominated in another currency. 2. Hedge currency risk. Another way to mitigate currency risk is to put on a hedge. In the simplest terms, a currency hedge is insurance against a currency move in either direction, for or against you. A currency hedge technically involves two parties exchanging a set amount of one currency for another at a predetermined exchange rate and amount at a future date. When you hedge currency risk, you can remove currency risk from your investment… at a cost. The hedge itself costs something to manage and maintain. The cost depends on the currency being hedged—liquid developed currencies are generally easier and cheaper to hedge than emerging ones. In exchange for this cost, your investment will likely have lower volatility, as the currency fluctuations are removed. There are many ways to hedge currencies. These include forwards, swaps, futures, and options. All of these methods allow investors to lock in a set exchange rate today to eliminate potential exchange rate volatility that may arise in the future. To permanently hedge an investment, an investor must continually close contracts that have come due, and invest in new ones further into the future. This process is called “rolling” the contracts, and can have a small ongoing transaction cost. Hedge International Bonds, Not International Stocks Currency hedging, like most insurance, is not free, and so the benefits need to be balanced against the cost. If hedging costs you more than it benefits you, you shouldn’t do it. To find out, weigh the reduction in volatility against the incremental cost of buying the hedged (rather than unhedged) version of the ETF. A Vanguard study analyzed the impact of currency hedging on foreign bonds and stocks and found that hedging is beneficial for bonds but not for stocks.3 This is because of the different volatility characteristics of stocks and bonds, and their correlations with currency moves. Bonds, as an asset class, are typically less volatile than both stocks and currencies: Equity Volatility > Currency Volatility > Bond Volatility When you take a position in unhedged foreign currency bonds, the volatility of the investment will come predominantly from the currency fluctuations, not the bonds themselves. Research has shown that the volatility of unhedged currency fluctuations often overwhelm the diversification benefits that international bonds bring to a portfolio. In contrast, because currency risk is usually a very small proportion of volatility in foreign stocks, there is far less benefit from hedging the stock exposure. Compare the relative contribution of the currency component to the overall return and volatility in bonds and stocks: Impact of Currency Risk on Bonds vs. Stocks Whether it’s stocks or bonds, currency does not contribute substantial returns. However, it has a substantial risk in terms of volatility, and all the more so when it comes to bonds. The increase in risk of not hedging bonds is significant and cannot be overlooked. Currency Hedging Reduces Volatility The graph above illustrates the volatility difference between international bond ETFs with currency risk versus their currency risk-free counterpart. Vanguard’s Total International Bond ETF (BNDX) hedges out the currency risk through currency forwards. In contrast, the iShares International Treasury Bond ETF, IGOV, keeps the currency volatility intact. The daily volatility inherent to IGOV is more than twice that of BNDX. The sharp increase in volatility because of currency fluctuations applies to emerging market ETFs, as well. The Vanguard emerging market government bond ETF, VWOB, eliminates currency risk by investing in dollar denominated government bonds issued by emerging markets. The iShares emerging markets bond ETF, LEMB, likewise tracks emerging market sovereign bonds but includes currency risk by investing in bonds denominated in the local currency. The local-currency version has nearly twice the volatility of the dollar denominated version. Balancing Cost and Volatility Reduction Volatility is only part of the equation. The other aspect of making the decision about hedging is the cost of hedging. The below chart illustrates the additional cost of the hedged ETF and the volatility reduction associated with using a hedged ETF. As is seen with the Vanguard Total International Bond ETF, BNDX, the ETF without the currency risk is not always the most expensive. Although BNDX eliminates the currency risk, it also charges 15bps less in terms of expense ratio cost. The reduction in currency volatility associated with stocks, on the other hand, is less drastic despite the higher cost of hedging. If you are not as familiar with the funds, see the bulleted list below. Volatility Reduction and the Additional Cost of the Hedged ETF Asset Class Hedged Fund Expense Ratio Unhedged Fund Expense Ratio Additional Cost of Hedged ETF Volatility Reduction Developed International Stocks 0.70% HEFA 0.09% VEA 0.61% -3.40% Emerging Market Stocks 1.46% HEEM 0.15% VWO 1.31% -5.60% Developed International Bonds 0.20% BNDX 0.35% IGOV - 0.15% -7.90% Note: HEFA, HEEM have fee waivers until 2020. We are using the expected long-term expense ratios. HEFA: iShares Currency Hedged MSCI EAFE ETF tracks the performance of large and mid-cap equities in Europe, Australasia, and the Far East. VEA: Vanguard FTSE Developed Markets ETF tracks the performance of the FTSE Developed ex North America Stock Index. The companies are mostly large and mid-cap companies. Canada and the U.S. are excluded. VEA is in the Betterment portfolio. HEEM: iShares Currency Hedged MSCI Emerging Markets ETF tracks the performance of large and mid-cap emerging market equities. The currency exposure is offset through currency forwards. VWO: Vanguard FTSE Emerging Markets ETF invests in large-, mid-, and small-cap equities in emerging markets. VWO is in the Betterment portfolio. BNDX: Vanguard Total International Bond ETF tracks the performance of the Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged). BNDX is in the Betterment portfolio. IGOV: iShares International Treasury Bond ETF tracks the performance of an index of non-U.S. developed market government bonds. Currency Risk at Betterment If you invest with Betterment, we have designed your bond portfolio to mitigate currency risk. We believe that the volatility attributed to currencies is not a compensated risk, and so, when affordable, it should be avoided. Whether we eliminate the risk through hedging or through a direct purchase of U.S. denominated bonds largely depends on the geography of the bond ETF. (See our interactive graphic to determine the exact geographical allocation of your portfolio.) Geography is an important factor to take into account when determining the best way to mitigate currency risk. While it’s prohibitively expensive to hedge emerging investments due to the larger number of currencies and the inefficiency of those markets, a basket of developed market currencies can be hedged efficiently. Because of these considerations, your international developed-country bond ETFs at Betterment are hedged at the ETF level (BNDX). BNDX hedges currency fluctuations inside of the fund. In this case, the fund purchases one-month forward contracts to exchange currencies in the future at today’s rates. If rates move between now and then, the investor is not exposed to those moves, because the value of the forward contract will offset the moves in currency. In contrast, your emerging market bonds are denominated in USD (VWOB, EMB, PCY) because of the cost considerations when it comes to hedging multiple emerging market countries. While the bonds are issued from developing countries, both their value and interest is defined in USD, removing concerns about currency risk. 1Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo. "Carry Trade and Momentum in Currency Markets." Annu. Rev. Fin. Econ. Annual Review of Financial Economics 3.1 (2011): 511-35. Web. 2 Lustig, Hanno, and Adrien Verdelhan. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk." American Economic Review 97.1 (2007): 89-117. UCLA Publications. UCLA, 2007. Web. 16 June 2015. https://www.econ.ucla.edu/people/papers/lustig/lustig303.pdf. 3 Thomas, Charles, and Paul Bosse. "Understanding the ‘Hedge Return’: The Impact of Currency Hedging in Foreign Bonds." Understanding the 'Hedge Return': The Impact of Currency Hedging in Foreign Bonds(2014): n. pag. Vanguard Research, 1 July 2014. Web. 1 June 2015. https://personal.vanguard.com/pdf/ISGHC.pdf. * Volatility based on MSCI EAFE (hedged and unhedged) indices from Figure 4: Average rolling 12-month standard deviation over 10 years (7/1/04–6/30/14). Kittsley, Dodd, and Abby Woodham. Purer Return and Reduced Volatility: Hedging Currency Risk in International-equity Portfolios. N.p.: Deutsche Asset and Wealth Management, Sept. 2014. PDF. Deutsche Asset calculations ** Volatility based on MSCI Emerging Market (hedged and unhedged) indices from Figure 4: Average rolling 12-month standard deviation over 10 years (7/1/04–6/30/14). Kittsley, Dodd, and Abby Woodham. Purer Return and Reduced Volatility: Hedging Currency Risk in International-equity Portfolios. N.p.: Deutsche Asset and Wealth Management, Sept. 2014. PDF. Deutsche Asset calculations * Volatility based on MSCI Barclays Agg (hedged and unhedged) indices from Figure 4: Average rolling 12-month standard deviation over 10 years (7/1/04–6/30/14). Kittsley, Dodd, and Abby Woodham. Purer Return and Reduced Volatility: Hedging Currency Risk in International-equity Portfolios. N.p.: Deutsche Asset and Wealth Management, Sept. 2014. PDF. Deutsche Asset calculations This article originally appeared on ETF.com.
The Hidden Costs Inside Mutual FundsThe Hidden Costs Inside Mutual Funds Investors pay, on average, 0.35% more for an index-tracking mutual fund than for an index-tracking ETF, based on the expense ratio. They say you get what you pay for, but sometimes you don’t. Even when you do, you may not understand how much you had to shell out and exactly what for. In the case of mutual funds, you may have to pay a lot more than you realize—and keep paying for as long as you own them. Typically, mutual funds that passively track a stock or bond index are cheaper to operate than actively managed funds. Exchange-traded funds (ETFs) are even cheaper because nearly all ETFs track indexes, too, and the ETF structure lets them do that more efficiently than mutual funds. Mutual funds are usually more expensive than ETFs. The average asset-weighted total expense ratio (TER) for a mutual fund investing in a blend of all equities is 0.74% of assets, according to the most recent information from the Investment Company Institute. That number encompasses the management fee and certain other outlays. Because many of those costs are fixed costs (the same regardless of the size of the fund), smaller funds tend to have larger expense ratios, all things being equal. The “asset-weighted” average corrects for that phenomenon. The corresponding figure is 0.39% for ETFs, according to Morningstar. So a mutual fund costs you 35 basis points more than an ETF right there—or $3.50 for every $1,000 invested per year. These higher expenses come out of shareholders’ pockets. That helps to explain why a majority of actively managed funds lag the net performance of passively managed funds, which lag the net performance of ETFs with the same investment objective over nearly every time period. These higher expenses come out of shareholders’ pockets. Funds are required to disclose their TERs, so at least investors can make an informed choice about whether owning a mutual fund or availing themselves of a manager’s skill is worth the extra money. Fair enough. The problem is that the TER is not the only cost of fund ownership; there are others that can be significant but are not clearly disclosed and, therefore, harder for investors to quantify. Add trading and turnover costs. It should come as no great shock that there can be a lot of activity involved in actively managing a mutual fund, but the sheer amount of trading may surprise investors. Many funds have an annual turnover exceeding 100%, meaning that every stock or bond bought for the portfolio is sold, on average, within a year. It’s also not uncommon for funds to take positions in hundreds of securities, producing a frenzy of trading. A fund’s TER includes the expense incurred when investors buy or sell fund shares, but it doesn’t account for trading costs incurred by the fund itself, such as brokerage commissions (for the fund’s active trading), the bid-ask spread (the gap between what the seller of a security receives and the higher price that the buyer pays), and market impact. That’s the term applied to the fact that a big order can move a stock’s or bond’s price disadvantageously; buyers may have to pay more than prevailing market prices to find enough shares to fill their orders, and sellers may have to accept lower prices to dispose of all of their shares. When you add up all these costs, well, they add up. A study by the think tank Demos highlighted research indicating that a fund’s trading costs can exceed its TER, more than doubling the total cost. ETFs and other index funds can have large numbers of holdings and incur trading costs, too, but they tend to be far lower, as the portfolio holdings change only occasionally. That means that the true gap in expenses between ETFs and actively managed mutual funds may be far wider—and impact returns to a far greater extent—than the difference in TERs. Add load fees. The added expense of active management doesn’t stop there. The way that financial advice is dispensed and paid for has changed dramatically in recent years, but some funds still tack on a sales charge, or load, ostensibly to compensate the investor’s advisor. A typical load is 5% and assessed when a fund is bought—though it can be lower. Still, investors pay. Todd Rosenbluth, director of fund research at S&P Capital IQ, a financial data provider that is part of McGraw-Hill Financial, pointed out that some funds feature a trailing commission instead, say 1% deducted from a fund’s returns, that’s kicked back to the advisor for every year that the shareholder remains invested. “Trailing fees are spelled out front and center, but people may not realize it,” Rosenbluth said. “That’s 1% a year on top of everything else.” Lastly, add taxes. Beyond sales charges, trading costs, and administrative and marketing expenses, “everything else” includes tax liability. ETFs and mutual funds alike are required to distribute capital gains to shareholders each year. Distributed (taxable) gains are likely to be higher in the case of actively managed mutual funds because they engage in more trading in the normal course of running their portfolios and also because they must do more buying and selling to accommodate investors entering and exiting their funds. To make matters worse, investors often are forced to pick up someone else’s tab. The gains that a fund distributes may have been realized on positions held for many years, Rosenbluth explained, but all current shareholders, even recent investors in the fund, are on the hook for them. The amount can be substantial after a lengthy bull market. “What we saw in 2014 is that some actively managed mutual funds had capital gains of as much as 10% of net asset values,” he said. “Active management creates capital gains [and the taxes on those gains] eat into investor returns more than you realize.” Sometimes managers organize their buying and selling to be as tax-efficient as possible, he added. They try to book long-term gains instead of short-term gains or wait until after the start of the year to lock in a gain. But other managers pay far less regard to tax issues, he noted. In contrast, the ETF structure can provide a persistent boost in returns. What’s so insidious about hidden fund costs is that they are seldom seen but always there, eroding returns year in and year out. But it works in reverse, too. Any savings that accrue from owning vehicles with lower expense ratios like ETFs, for example, will provide a persistent boost to returns for as long as investors own them. To be sure, some brokerages do add trading and other fees for ETFs as well, but generally ETFs will be less expensive. As Rosenbluth put it, by owning more expensive funds, “you’re already starting off behind on your goals, so anything you can do to shave those costs down will help you get ahead of the game.”
The Real Cost of Cash DragThe Real Cost of Cash Drag A broker that’s selling you cash as an investment should make you think twice, especially when it’s not in your best interest—but it is in theirs. Cash has a significant chance of a real negative return over time due to inflation risk. Cash assets can present a conflict of interest when the investment manager is advising cash and then re-investing it for its own revenue. For the goals you set at Betterment, you never hold cash because we use fractional shares to invest every cent you deposit. Every dollar—down to the penny—is fully invested in a diversified portfolio of stocks and bonds. It’s pretty plain and simple: Cash is not a good investment for the long term. After taxes, inflation, and its current expected return (zero), you are actually losing money when you hold cash in your investment portfolio over the long term. In other words, cash is a drag on your returns. If you must hold excess cash, you should do so in a vehicle that helps to mitigate the effects of inflation and is tax-efficient. We are hardly the only investment manager to take this stance. In a research paper published in Financial Analysts Journal last year, Vanguard founder John Bogle cited cash drag as one of the ways investors are not making the most of their investments.1 Cash Costs You Returns Certain investment services require you to hold cash in your account. In practice, your cash holdings could range from a tiny fraction of your balance to a substantive allocation in your portfolio. Across the universe of U.S. equity mutual funds, Morningstar Inc. calculated an average cash weighting of 3.2%.2 As Bogle noted in his paper, index-tracking funds tend to carry a lower cash load than active funds. One recent example is with Schwab’s new automated portfolio, one of the latest imitators of Betterment’s automated investing technology. Its new offering requires a cash position from a minimum of 6% to as much as 30% cash, according to Schwab’s disclosures.3 Then there are other automated services and traditional managers that force you to keep a small amount of cash on the side because they aren’t able to do fractional share trading. We’re not fans of either scenario, but the first one is especially troublesome. For the smart investor, there are several red flags here. Cost No. 1: You’re not earning returns, and are losing money. First, the most obvious issue is that cash is simply not a risk-free investment and doesn’t belong in any moderate to long-term investment portfolio. It currently returns almost zero and when you factor in inflation, can lose you money. That means the more cash in your portfolio, and the longer you invest, the less your portfolio may be worth compared to a portfolio without cash. Be wary of any advisor who talks about cash without adjusting for inflation. While a small portion of cash, for example an allocation of 6%, may seem like an insignificant amount, it still can have a significant drag on returns. This is especially true for a long-term investor who should be in a high-stock allocation. For illustrative purposes, let’s have a look at Schwab’s recommendation for “Investor 2,” a 40-year-old with moderate risk tolerance. The portfolio is 61% stocks, but you’re forced hold 10.5% cash.4 A Betterment portfolio at 61% stocks, with no cash drag, has an expected annual return of 5.8%. Let’s generously assume that cash returns 1% annually (currently, it’s much less than that). With 10.5% of your assets on the sidelines, the effective cost would be 0.5% in lower expected returns every year. The Cost of “Cash Drag” on a $100,000 Investment Over the next 30 years, having 10.5% cash in your portfolio will cost you $73,417 compared to the same portfolio with zero cash drag Cost No. 2: It’s a conflict of interest. A small amount of cash in your portfolio resulting from an inefficient trading structure is one thing. But an entire asset dedicated to cash holding should raise eyebrows. This is particularly important when it comes to a portfolio that is billed as “free.” For example, Schwab is marketing its new portfolio as “free,” yet there exists a very real underlying cost hidden in the allocation structure. You, the individual investor, are paying a hidden fee via the cash allocation you are forced to hold. (We’re not the only ones to point this out.) How does that work? In Schwab’s fine print, Schwab is explicit that it will use your cash, held in its company’s bank, for its own investing, providing them with revenue and reducing your expected returns.5 Herein lies the conflict of interest: As a customer, you now have a portfolio manager who is incentivized to have you hold more cash than might be optimal for your investment strategy—simply because they make money on it. Schwab even acknowledges this conflict of interest in its recent filing with the U.S. Securities and Exchange Commission (SEC), specifically calling out that not even other Schwab entities would allocate so much of a portfolio to cash: In most of the investment strategies, the percentage of the Sweep Allocation is higher than the cash allocation would be in a similar strategy in a managed account program sponsored by a Schwab entity or third parties. This is because, as described below under “Fees,” clients do not pay a Program fee. (page 3)5 This conflict can have some unexpected consequences. For instance: such an allocation to cash might feel intuitively sensible because of a mental association with a “rainy day” fund. We’ve written before about how you can do better. However, let’s assume you do want a cash safety net. With an automated, enforced cash allocation such as Schwab’s, you will never be able to withdraw just the cash if a rainy day does come. Since the cash allocation is the backdoor method by which Schwab gets paid, the service would rebalance you back into the target cash allocation, selling securities in the process, and possibly triggering capital gains. From the same filing: [Schwab] may terminate a client from the Program for withdrawing cash from their account that brings their account balance below the minimum… (page 4)6 If you want some cash on the side, this is not it: you’ll need another cash stash in your bank account, both costing you returns over the long term. Cost No. 3: You can better manage risk with bonds. “But cash is safe,”’ I hear you say. “It helps stabilize the portfolio.” “Actually so do bonds,” I say. “And they don’t reduce your expected returns like cash does.” The vast majority of the time, you’ll be better off using bonds rather than cash. You can achieve both the lower drawdown risk while protecting against inflation risk with high-quality inflation-protected bond funds, such as Vanguard Short-Term Inflation-Protected Securities (VTIP). The chart below depicts the rolling two-year real returns of a basket of five-year Treasury bonds versus a cash savings account. When assessed properly (at a portfolio level), Treasury bonds have dominated cash for any non-immediate time horizon. Even through the 2008 financial crisis, you would have been better off investing in Treasury bonds than cash. Critically, bonds tend to rally when stocks are crashing, a process called the “flight to quality.” Moreover, it’s not just the frequency with which bonds win, but also the extent of the advantage. Let’s look at the cumulative performance of a portfolio of stocks and Treasury bonds versus a portfolio of stocks and cash savings since 1955. It turns out that investing in a $100,000 portfolio of stocks and Treasury bonds in 1955 would have outperformed the same stock portfolio with cash by $44,013. Cash Drag Reduces Portfolio Returns Bonds beat cash by $44,013 on $100,000 initial investment Cost No. 4: It’s not efficient. Lastly, let’s talk about efficiency. As you may know, trading on an exchange only happens in round, whole share amounts. The result is a little bit of cash permanently left on the side. This is not an efficient way to do things. Imagine that you have a portfolio with 12 ETFs, and one share of each ETF costs $100. Now, you make a $90 deposit (or your ETFs pay a total of $90 of dividends). With a platform that only uses whole shares, you cannot use any of that cash—read: zero dollars—to add to your investments because it’s not enough to buy a single share of anything. So that 90 bucks will just remain uninvested, waiting for additional cash, before you can buy even a single share. As deposits and dividends flow through this account over time, it will always have some amount of pesky cash remainder sitting there. This is sub-optimal investing. At Betterment we use fractional shares, which means you invest down to the penny. In the end, it’s important to understand the role investing has in your financial plan—and the role cash plays. When you pay for investments, whether that’s through an expense ratio or a management fee, you’re paying for the potential to earn returns, not to lose money with cash. If you’re comfortable keeping cash on the side, remember, you can always use a savings account. The results above are hypothetical and for illustrative purposes only. Investing in securities always involves risks, and there is always the potential of losing money when you invest in securities: even Treasury bonds. Past performance does not guarantee future results, and the likelihood of investment outcomes are hypothetical in nature. Before investing, consider your investment objectives and Betterment’s charges and expenses. 1https://johncbogle.com/wordpress/wp-content/uploads/2010/04/FAJ-All-In-Investment-Expenses-Jan-Feb-2014.pdf 2https://www.investmentnews.com/article/20150206/FREE/150209947/low-mutual-fund-cash-levels-not-telling-the-whole-story 3 https://www.adviserinfo.sec.gov/Iapd/Content/Common/crdiapdBrochure.aspx?BRCHRVRSNID=277224 (page 2); https://intelligent.schwab.com/public/intelligent/insights/whitepapers/role-of-cash-in-asset-allocation.html 4 Under “Can you give me an example of what these asset allocations look like?” https://intelligent.schwab.com/public/intelligent/about-intelligent-portfolios 5 “Schwab Bank earns revenue based on the interest we receive by investing the cash, minus the interest paid on the deposit and the cost of FDIC insurance (which Schwab pays).” https://intelligent.schwab.com/about-sip.html 6 Schwab goes into more detail in its disclosure brochures: “Schwab Bank earns income on the Sweep (i.e., cash) Allocation for each investment strategy. The higher the Sweep Allocation and the lower the interest rate paid the more Schwab Bank earns, thereby creating a potential conflict of interest. The cash allocation can affect both the risk profile and performance of a portfolio.”
High-Frequency Monitoring: A Short-Sighted BehaviorHigh-Frequency Monitoring: A Short-Sighted Behavior Investing is a rare case of generally earning more by working and stressing less. Our advice? Take a vacation from monitoring your returns. There are 10 million bits of information moving through this space every second.1 And it poses a subtle threat to your retirement savings. It’s not high-frequency traders—it’s closer to home. It’s high-frequency monitoring, driven by your own brain. The more frequently you check on your investments, the worse it will likely seem they are performing. So the more frequently you monitor, the less likely you are to be investing correctly for the long term. And it’s getting harder not to look—we are prone to look at our smartphones, home to your money and finance apps, up to 150 times a day.2 While it may seem like good stewardship to frequently log into your account to check on your performance, in reality this is likely to: Stress you out Encourage you to tinker with your investment allocations Hurt your investment performance Yes, all three. Research has shown that the more investors monitor their portfolio, the more risky they perceive investing to be—a phenomenon known as myopic loss aversion. Over-vigilance also gives investors more opportunities to react to short-term returns by changing their asset allocation. Betterment’s own research found that higher login rates is associated with an investor’s behavior gap—the difference between your investment returns and your personal take-home returns. It’s a statistical artifact of the stock market that the more frequently you monitor your portfolio, the more likely you are to see a loss since you last looked. This fact, taken in combination with loss aversion, has been proposed as the reason the equity risk premium is so high. An investor who checks his or her portfolio quarterly instead of daily reduces the chance of seeing a moderate loss (of -2% or more) from 25% to 12%. And that means he or she is less likely to feel emotional stress and/or change allocation. Perceived Losses by Login Frequency Evidence supports the idea that myopic loss aversion reduces investor returns. Directly from the research itself: Investors who got the most frequent feedback (and thus the most information) took the least risk and earned the least money.3 Ensuring our customers behave themselves and are not stressed by short-term returns is a big part of our job. One of the ways we are starting to improve investor behavior and sentiment is simply by measuring it first. As we learn more, we are developing systems to improve investor behavior (and we will be publishing more analysis on this topic in the future). In the chart below, you can see the distribution of “login rates” amongst our customers across mobile and web. High-Frequency Monitoring About 10% are superstars—they log in less than once per month. By doing so, they have reduced their chance of seeing a loss by about 6%. The majority of customers (55%) log in less than once per week. About 30% of customers log in between once per week and every other day. We are super flattered that they love our website so much… but there isn’t too much information to be gleaned about your performance over such short periods of time. Finally, we have the cases who might want to dial back on their investment monitoring—customers who log in at least every other day. These customers are likely stressing themselves out needlessly, without any improvement in performance. Customers' login rates show the patterns behavioral finance would predict. The following characteristics correlate with a tendency of an individual to monitor his or her account: Being male (8% higher) Being younger (3% higher for age 30 and younger) Less tenure with Betterment (4% per year) Lower net worth A higher balance Using Betterment’s mobile app (much easier to check it, after all) Note, however, that these are average demographic tendencies; there are young men in our customer base with high balances who do not log in often. Individuality matters. Who Monitors Their Portfolio Most? Individuals who log in often may counter that they are systematically improving their performance by being more active and diligent. Unfortunately, this is rarely the case. Login rate is usually associated with a higher behavior gap, i.e., lower investor returns compared to a passive approach. Investing is a rare case of generally earning more by working and stressing less. Rather than work against that, take advantage of it, and take a vacation from monitoring your portfolio. 1https://www.eurekalert.org/pub_releases/2006-07/uops-prc072606.php 2https://www.kpcb.com/insights/2013-internet-trends 3 Thaler, R., Tversky, A., Kahneman, D., & Schwartz, A. (1997). The effect of myopia and loss aversion on risk taking: An experimental test. The Quarterly Journal of Economics, 112(2), 647-661.
Advice for a Market Downturn: Have a Calm Heart and Clear MindAdvice for a Market Downturn: Have a Calm Heart and Clear Mind Some financial pundits say a market correction is due. Here’s how to prepare yourself. The markets have been on a tear following the recovery from the financial crisis—with some pundits saying a market correction is due. Here’s how to prepare yourself. It’s a fact that people make decisions differently when calm and collected (academics call this a "cold state") compared to when we’re reacting to an emotional situation. You don’t need to be a behavioral economist to guess which state of mind results in better decisions. So it’s smart to discuss those situations as far ahead of time as possible, to set up a plan you can stick to. It’s time to have one of those discussions. Our customers have been investing with us since late 2010, and so have witnessed a strong positive market. Since the 2008-2009 financial crisis, global financial markets have more than recovered and have been on a tear, returning more than 115% cumulatively in a Betterment 70% stock portfolio since January 2009.1 While this has caused increasing speculation of an imminent drawdown, the fact is that without a crystal ball, efforts to call a top or bottom are just as likely to hurt your returns as help them. Recent market dips and recovery Looking back, there have been multiple false ends to the rally through this period. Some of the drawdowns have been as much as 18% in a Betterment portfolio with an allocation of 70% stocks. However, it’s important to know that those who reacted to these short-term drawdowns would be significantly worse off now than investors who stayed invested throughout. I don’t have a crystal ball. Nobody does. But I do believe there will be a significant market drawdown sometime in the future—that’s part of investing and bearing risk. However, it’s helpful to acknowledge today that you will go through that stressful situation tomorrow or in seven—or 17—years from now. This preparation will help you be less stressed, perform better and give you the ability to tune out the short-term noise in the future. Remember, one broken egg doesn't ruin the whole dozen. On average you are better off staying invested at the correct risk level for your investment horizons than trying to maneuver and avoid a temporary market loss. The key is having a good long-term plan and sticking to it. Try the feeling on for size I want you to plan for this event in advance and not react when it happens. Spend some time imagining how this would feel: It’s Friday morning, and in the past week the S&P500 has fallen 20%. When you hear the morning news, it’s nonstop about how badly the markets are doing. The paper is comparing the drawdown to 2008. Frankly, it’s scary as hell, and when you look at your investments they are down 18% to where they were earlier that week. What will you do? (A) Increase your stock allocation or throw money into the market hoping to get some bargain prices. (B) Nothing. Time to go work and conduct business as usual. (C) Decrease your stock allocation to all cash. I hope it’s clear that our advice will be (B), at least as long as you are already at your correct stock allocation. Reacting to market drawdowns by moving to cash is like swerving your car after you have hit the pothole. It won’t help you fix the damage that is already done, and it’s likely to cause a new accident or problem in the future. That said, there are beneficial steps you can take in response to a market downturn—and some steps Betterment automatically does for you. Automated benefits during a downturn After or during a drawdown, Betterment will automatically: Tax loss harvest—this can help you capture any losses in your portfolio and use them to lower your tax bill.2 Rebalance each of your goals to maintain your selected allocation level and/or buy depreciated assets at a lower price. Alert you if you go off track for reaching your goals. We may suggest either a one-time deposit or a slightly higher auto deposit amount to make up for any market losses. However, it's important to note that most people with longer-term goals will not fall off track. Keep calm and carry on Here are some actions you can consider during a downturn: Revisit your goals and plans. Now, when the market has been doing well, is a great time to check on your Safety Net goal. Is it fully funded and at the proper allocation level? Have any of your goals gone off track and need a top-up? Rebalance opportunistically. Market drawdowns are one of the most frequent causes of rebalances, as the losing asset become underweight relative to the stable assets. Rebalances are an automatic and systematic way to buy lower and sell higher. However, in taxable accounts, selling can trigger taxes, even if the asset is substantially below its all-time high. Rest assured, Betterment will never cause short-term capital gains tax to rebalance your portfolio. But you can additionally minimize long-term capital gains by making opportunistic rebalance deposits. Under the Portfolio page of your account, you can see the minimum deposit necessary to avoid a sell-based rebalance. Liquidate your legacy losers. The most common barrier to consolidating your investments is capital gains tax. Take advantage of a short-term market drawdown and let go of an under-performing mutual fund, or diversify away from a single stock position. What can you do today? Prepare a short list of investments you would like to liquidate, and the price at which you will give them the pink-slip. Our tax-switch calculator can help with that. If you can’t stand the heat… turn it down: While the best investment strategy is typically to stay invested, some people could find the stress simply to be too much. If you think you might make an extreme decision—such as moving to 100% bonds—if the drawdown continues, then it’s ok to reduce your risk temporarily. Adjust from 90% stocks to 60% stocks, for example, for a 60-day period. Make sure you set a reminder to revisit your portfolio at that point. While we don’t believe it will improve your performance from a ‘cold’ view, it means you’ll be less likely to make an emotional decision, and you’ll have a higher return per nights lost sleep. Take a vacation from your portfolio: My own research has shown that people are more likely to monitor portfolios during volatile periods. The only problem is that the more you monitor, the riskier your portfolio will seem to you. A better strategy is to login less during volatile periods—a strategy successful investors with higher emotional follow. Sometimes it pays to be the ostrich. Get a second opinion: Have a friend with a cool head? Sure you do—or give us a call. While Betterment is all about efficiency, we know there’s no replacement for a human conversation. And we love talking to you guys. Seriously. The core reason investing has higher expected returns compared to a cash account is that it is the compensation for bearing risk. Your “job” as an investor is one of the easiest ones in the world, at least physically—you must do nothing. That said, it’s not emotionally easy. It’s very uncomfortable to not react, even when it’s the right choice. So choose your reaction with a calm heart and a clear mind. 1 See full disclosure on how we compute historical performance. 2 Tax loss harvesting will only occur for qualified customers who have turned on the service for their account. Learn more about our tax loss harvesting.
Portfolios Now Include Municipal BondsPortfolios Now Include Municipal Bonds We added a municipal bonds asset class to make your non-IRA portfolio even more tax efficient.In our ongoing efforts to create the most tax-efficient portfolio possible for our customers, we have added a new asset class, represented by a tax-exempt national municipal bond fund, the S&P National AMT-Free Muni Bond ETF (MUB), for primary domestic bond exposure. It will replace the US High-Quality bond index fund (AGG) in taxable portfolios. Dividends paid on this ETF are exempt from federal taxes. We will continue to use AGG, the core bond fund, in IRA accounts, where tax-free dividends do not provide the same advantage. Improved after-tax returns with municipal bonds Municipal bonds are expected to increase after-tax returns by more than 1.0% per year, as compared to the asset class they replace. Below, you can see the pre-tax yields of the two asset classes side-by-side. MUB is currently yielding significantly more than AGG even before taxes, but that could change. What won't change is the advantage built into MUB once you factor in federal taxes. At the highest possible federal rates (single, income of $400k+), nearly half of AGG's dividend is lost to taxes, while MUB's yield is unchanged. Even assuming a more common tax bracket (earning roughly $100-200k), the advantage is clear. Ticker Pre-tax yield After-tax yield (43.4%) After-tax yield (28%) MUB 2.90% 2.90% 2.90% AGG 2.20% 1.25% 1.58% The only drawback for investors is that munis are often thought to carry greater default risk than US Federal government debt. The US has yet to default in modern history, and has the ability to literally print money, which state and local governments do not. So while municipal defaults are not unheard of, they are actually quite rare as compared to corporate bonds, and relatively benign when they occur. This is because municipal bonds are often either insured privately, or have the backing of the state in the case of a default. It’s also worth noting that when a municipal bond defaults, it tends to mean you get $0.80 back, rather than $1—rather than lose all your principal. Most importantly, MUB comprises more than 2,000 muni bonds across 44 states—diversifying away any default risk for a particular issuer. Due to these factors, municipal bonds tend to have relatively high credit ratings—comparable in quality and long-term performance to the US High-Quality Bond index. What do you need to do? Nothing. Existing customers’ portfolios will automatically be transitioned to the new asset class over the coming months. We will replace AGG with MUB and reduce the weight of LQD and BNDX; we will also then increase the weight of MUB in the portfolio in order to maximize its tax-exemption benefit. Customers using our new Tax Loss Harvesting+ service will have MUB as the primary ticker for the asset class, and Barclay’s Municipal Managed Money (TFI) as the alternate.
The Right Way to Gauge Investment ReturnsThe Right Way to Gauge Investment Returns Of course you know what your portfolio earns. Or do you? Here’s the best way to gauge your returns, so you always make the smartest choices. Did you know that most investors don't know their own returns?1 It’s not because they don’t read the numbers, but because there’s a widespread misunderstanding about how to calculate your true net returns. Studies have shown, for example, that most people care more about raw returns than anything else. Unfortunately, this isn't actually the return you should care about, and it can lead you astray. Only looking at the raw return can skew your perceptions about your portfolio and lead you to make bad choices—such as taking on an inappropriate level of risk or misplacing expectations—which can impede your investing goals. In fact, there are several important factors to consider when evaluating how your portfolio has performed. This guide will help you reach the right conclusions when judging historical investment returns. By following these steps, you’ll avoid the errors many investors make, and you will correctly infer how well your portfolio has performed, and how it compares to others. The steps outlined in this detailed primer can be read in order, or you can click down to the topics that are most relevant: Use the Right Returns Total returns, not price returns Real returns, not nominal returns After tax, not pre-tax returns Adjust for Risk Market risk (beta) Manager risk (negative alpha) Adjust for cash flows Adjust for Time Ignore short-term returns Annualize returns before comparing them Adjust for Costs Transaction fees Expense ratios Bid-ask spreads Entry/exit fees Trading costs 1. Use the Right Returns Total returns, not price returns One of the most common errors investors make is to consider price returns, not total returns. The total return includes not only the change in price of your securities, but also the dividends or coupons they’ve paid out over the time you’ve held the investment. Figuring out total returns can be a challenge to individual investors, as most news reports and brokerage return figures are based on price returns only. For example, over the past year the S&P 500 has had a price return of 29.7%, but a total return of 32.3%. This implies a dividend return of 2.6%, which is just slightly above historical averages. Not using the total return when assessing performance means that you could incorrectly penalize investments which have a higher proportion of their total return due to dividends. And remember, reinvested dividends experience the power of compound growth as well. The graph below depicts the total return and price-only return of the S&P 500 since 1993. The total return growth of a $100,000 portfolio is $514,237 as of January 2, 2014, while the price-only growth is $316,294—a difference of 63%. Put into annual return figures, the price-only return is 8.2% while the total return is 10.2%. There are six months over this time period when the price return was negative, but the dividends pushed the total return into positive territory. Thus dividends can make the difference between what appears to be a negative return and a positive return. Just as important, the total return gives you a more accurate sense of how risky or not certain assets were. Real returns, not nominal returns To get the most accurate returns, you also have to factor in the bite of inflation, especially when comparing returns from different time periods (or different geographies). A stock that returned 20% in 1920 Weimar Republic, for example, still wasn’t as good an investment as a loaf of bread or a shovel. More relevantly, in 2011 when inflation was an average of 3%, investment returns had to be higher in order to increase wealth in real terms when compared to 2013, with inflation at 1.2%. In other words, inflation can affect the risk/return profile of any asset, including cash. Money stashed under the bed is virtually certain to lose value over time. Savings accounts seem to provide a certain guarantee that equities and bonds don’t. In reality, while savings accounts may guarantee your nominal investment, they are also guaranteed to steadily erode your real wealth over time. By including inflation, you can pinpoint real returns, which is a more accurate gauge of growth than nominal returns. After tax, not pre-tax returns Finally, most investors care about the growth in wealth which they (as opposed to the government) actually benefit from. But estimating your net-of-tax return can be tricky, as the short-term capital gain you realize in February won’t be taxed till the following April—but it will be taxed. As such, you should consider your portfolio’s returns after you’ve deducted the amount of tax you’ll have to pay on it. (Note that this only applies for taxable portfolios.) There are generally three sources of tax-drag on your portfolio: Ordinary income tax vs. capital gains tax: Although qualified dividends (generally from large, U.S. companies) are taxed at a reduced rate, other income generated by your portfolio, be it bond interest or non-qualified stock dividends, will be taxed at your highest marginal income tax rate. Given that your income tax rate will generally be the same as, or higher than, your capital gains tax rate, it’s important to bear in mind that the same dollar return is likely to give you a higher after-tax return if it comes from capital gains rather than other investment income. Short-term capital gains vs. long-term capital gains: Capital gains on investments which you’ve sold after holding for a year or less (short-term) are taxed at a higher rate than those you’ve held for more than a year (long-term). Strategies which realize short-term capital gains are therefore penalized up to an additional 20% on such gains, versus strategies that favor holding for more than 12 months. This is a major reason why frequent trading can lose any lustre once returns are calculated on an after-tax basis. Those costs may be invisible until next April, but they are there. Taxes now versus taxes later: In general, the longer you defer taxes, the longer that money you’ll eventually part with can work for you in the meantime. Even long-term capital gains are taxed when you realize them, and so avoiding realizing capital gains has its own benefit—greater tax-deferred growth. Strategies which defer taxation can therefore be better, all else being equal, than those which realize capital gains. If you realize your gains at a point when you have a relatively low marginal tax rate (if you take a year off, or in retirement), you could owe as little as zero capital gains tax, meaning you pay zero tax on that portion of your returns. 2. Adjust for Risk When comparing two different investments, you must consider how much risk you took on to achieve the returns of each. Consider two investors, Jake and Debbie. Jake achieved a return of 7% this year, and Debbie achieved 6%. You might say that Jake performed better than Debbie, but Jake had a very risky portfolio, in which he had a chance of losing more than 50% of his investment, and had to endure a bumpy ride throughout the year. Meanwhile, Debbie had a zero-risk investment with no drawdowns. In other words, Jake bore a lot of risk and stress to earn a 1% higher return. So in fact Debbie’s portfolio performed better—i.e. had higher risk-adjusted returns—than Jake’s did. There are generally two sources of risk you should consider—market risk, and idiosyncratic manager risk. Market risk (beta) Market risk is uncertainty and volatility due to the financial markets as a whole. Most stocks are all fairly correlated with each other—whether or not expectations for the world economy are positive or negative. This single source of risk—or market beta—drives the vast majority of stock returns, and most stocks are subject to it. Thus, the amount of stocks in your portfolio will determine how sensitive it is to beta. So the first thing you should do is consider how much of your portfolio’s return was due to beta. It’s not correct to compare a portfolio with a beta of 90% to a portfolio with a 70% beta unless you adjust for the fact that one has a higher risk exposure than the other. To compare returns with different levels of risk, econometricians use a metric called a Sharpe ratio, defined as the excess return2 of the portfolio divided by the standard deviation of the return (the volatility). Thus, if two portfolios receive the same return in a given time period, the one with the lower volatility will be awarded the higher Sharpe ratio—it has achieved the higher return with greater certainty. Manager risk (negative alpha) While investing in a well-diversified market portfolio means that you have a controlled exposure to market risk, many investors use managers who actively deviate from holding a market portfolio. This often means you hold a subset of stocks or bonds which reflect the manager’s views. As a result, they are taking on idiosyncratic manager risk, i.e. the greater variance in outcomes associated with using an active manager. This risk is independent of the beta in your portfolio. As we discussed above, you should only take on more risk when you expect higher returns in exchange. Unfortunately, as we found in our white paper with Rick Ferri, A Case for Index Fund Portfolios, the expected return of bearing manager risk is negative. Active mutual funds are riskier, and have lower expected risk-adjusted returns than a passive portfolio. Another key insight from this white paper is that the time frame matters. Over a shorter period, you may conclude that a given manager has skill. But over a one-year period, odds are just over 50% that an active manager will underperform the index. Over five years, that rises to 77%, and over 15 years, 83%. So one year of good performance is a weak indicator that the manager is a long-term winner. When assessing your portfolio’s performance, and comparing to an active manager, it’s important to consider this manager risk factor. You took an extra chance by using a manager—you should be consistently rewarded with above-average returns for that risk. If your manager doesn’t outperform consistently, it’s probably not worth the risk. Adjust for cash flows Finally, we should mention that you, the investor, are also a manager. You could be making deposits and withdrawals over the course of the year, and these cash flows mean that you may experience different overall returns than a buy-and-hold portfolio. Significant amounts of cash flows may result in a positive or negative behavior gap, i.e. the difference between the returns of the market (assuming a buy-and-hold strategy), and the actual returns you the investor received, based on your behavior. Research has shown that the riskier the fund, the greater the behavior gap. While we can’t completely prevent bad behavior, Betterment’s customers have the lowest measured behavior gap we know of. 3. Adjust for Time The period of time you’ve been invested is perhaps one of the trickier but more important adjustments to be made. The two things to keep in mind are to not trust short-term returns, and always annualize returns to compare like-for-like. Ignore short-term returns A very liberal definition of “short-term” means anything less than three years of monthly return data (36 observations) just to look at an investment on its own. A conservative definition is about 12 years. And If you want to compare two investments, you may need twice that amount of time. While we can’t completely prevent bad behavior, Betterment’s customers have the lowest measured behavior gap that we know of. Why shouldn’t you trust short-term returns? The shorter the period of time, the higher the chance you have of coming to the wrong conclusion. There is too much randomness in short-term returns to make them reliable. It’s very easy to have a diversified portfolio be beaten by any of its constituents in the short-term—only to beat all its constituents in the long-term. Looking at short-term returns is like performing a statistical test with very little data—you just can’t have any confidence in the results. Annualize returns before comparing them Second, you should always annualize returns. For example, imagine you had a two-year return of 25%, and were comparing it to a three-year return of 30%. Which one is better? Clearly, the 30% is larger, but it’s also had more time to grow. What would the 25% return be equivalent to over three years? If you annualize the returns using the equation below, you’ll find that in this case, the two-year return is equivalent to an annual return of nearly 12%. The three-year return is equivalent to an annual return of 9%. So adjusting for the amount of time you’ve been invested, the two-year actually has better performance. Annual return = ((1 + return / 100) ^ (1 / years invested) - 1) x 100 Two-year example: 11.8% = ((1 + 0.25) ^ (1 / 2) - 1) x 100 Three-year example: 9.1% = ((1 + 0.30) ^ (1 / 3) - 1) x 100 4. Adjust for Costs Every investment has its own costs that an investor must pay in order to get access to its returns. Therefore, any comparison of returns that fails to account for all costs associated with the relevant investment products is misleading. Let’s take a look at some of the costs most commonly encountered by individual investors: Transaction fees: This is money you pay to trade a security, and you’ll usually pay about $5-$20 for a discount broker, and often $150 or higher for a full-service broker. Given that you’ll sell at some point as well, consider these costs doubled. Moreover, as you accumulate wealth, you’re likely to want to add to your holdings, and $10 every time you want to put a little away can really add up. There are some brokers that offer some free ETF trades, but these carry limitations—typically only a limited number of trades are allowed, and only a limited range of ETFs are available. Expense ratios: This is the total annual amount of a fund’s assets that is used to cover its operating costs—including administrative, management and advertising costs. Both mutual funds and ETFs have expense ratios, but returns are normally stated net of this cost. One thing to remember, however, is that indices, such as the S&P 500, are not actual investable assets. Thanks to great innovations such as Vanguard’s VOO, you can get very close to true S&P 500 returns—but you’ll still have to pay an expense ratio for an index fund that tracks the S&P. Bid-ask spreads: This charge is also a trading cost of sorts; you can think of it as money lost to friction each time you trade. The bid-ask spread is simply the difference between the ‘buy’ and the ‘sell’ price available at market. For the most liquid securities this is normally only a few hundredths of a percent, but can be much higher in extremely volatile or illiquid markets. For micro-cap stocks, for example, the bid-ask spread can be huge, and stocks may have to increase by several percent—or even much more—before they can be sold at a profit. Entry/Exit fees: Also known as sales fees, load fees are particularly nasty charges that are commonly 5% of assets or more. You pay a front-end load when you buy the fund, or a back-end load when you sell it. Here’s the real kicker: Current research shows that mutual funds with a load fee actually underperform those with no load fee, even taking into account the loads themselves. Thus, load fees should be avoided at all costs, and if your advisor or broker recommends one to you, you should think about whether their incentives are conflicting with yours. Other fees to consider are advisory fees, subscription fees, or brokerage maintenance fees that aren’t tied to specific assets and so can’t reasonably be included in returns when those are reported. But if you’re paying those costs, they are nipping into your returns. Remember: any percentage you save in these costs will 100% go towards increasing your returns. Your returns, the full picture When you add up all the points above and calculate how, in concert, they all may have an impact on your returns, you can see why looking at just your portfolio’s raw returns is not an effective way to understand performance. And while it may seem that these numerous factors would mostly eat into your final returns, the more useful perspective here is to remember that your focus—and ours—is to optimize investing returns and inoculate your portfolio’s growth against the potential hits from taxes, idiosyncratic risk, costs, and so on. By being aware of each of these and how they operate you can better protect your returns and feel more confident about reaching your investing goals. Patrick Burns contributed to this post. 1Glaser, Markus and Weber, Martin, Why Inexperienced Investors Do Not Learn: They Do Not Know Their Past Portfolio Performance (November 15, 2007). Finance Research Letters, Vol. 4, No. 4, 2007. 2An excess return is the return above and beyond that achievable from investing in a risk-free asset. For instance, if a portfolio has an 8% return over a period of time when the risk-free rate is 2%, the portfolio’s excess return is 6%.
Diversification and Performance: Two PortfoliosDiversification and Performance: Two Portfolios In an all index-fund portfolio like Betterment’s, enhanced performance comes from finding and making the most of a diverse set of assets. The investing world abounds with simple formulas for do-it-yourself investors—the simplest is a basic portfolio made up of two funds: one with stocks and one with bonds. A benefit to this ultra-simple portfolio is that it’s easy and time-effective to manage. (Even the father of Modern Portfolio Theory, Harry Markowitz, famously said he used a 50-50 stock-bond portfolio.) But is this simple option truly the best for investors who value simplicity and their time, but want a better expected take-home return? Yes, a two-fund portfolio might be cheap and easy, but does it actually deliver the best return even after taxes, trading costs, etc.? The answer is no. After analysis of the Betterment portfolio versus a standard DIY investor benchmark of a super-simple stock/bond portfolio, we show that Betterment came out clearly ahead during the period over which it's possible to make a meaningful comparison. Our asset allocation delivers better risk-adjusted returns—and our automation delivers the ease and simplicity sought after by these thrifty investors. Our asset allocation improves upon a simple DIY asset allocation in thoughtful and specific ways that boost risk-adjusted performance at all risk levels. Our asset allocation improves upon this standard DIY asset allocation in thoughtful and specific ways that boost risk-adjusted performance at all risk levels. As a result, the Betterment portfolio has historically outperformed a simple DIY investor benchmark portfolio by as much as 1.8% per year on a risk-adjusted basis. We blend the best growth factors Where did this extra performance come from? It’s smart asset allocation, or what is called . In our portfolio, we used a wider set of market and growth factors — like emerging markets and small-cap companies— and blended them together to create a whole which is greater than the sum of its parts. Furthermore, all our strategic allocations are ones we are comfortable holding for a year or more, as matched by our recommended risk level. That's a piece of our core investment philosophy as an index-based investment manager. Comparing portfolios We compared how $100,000 would fare when invested in the stock/bond benchmark, or so-called “naive portfolio ” against our 12-asset class portfolio. To be sure, it’s not comparing apples to apples in terms of assets—but it shows that for less effort (time, cost, energy), an individual investor can do much better by choosing a Betterment portfolio. In the DIY portfolio, we used the S&P 500 and TIPS. This is the portfolio often recommended for a so-called “naive” investor who goes for the most commonly known stock market and bond funds. Next, we compared three of the most typical stock allocations: 50% (a risk allocation recommended for shorter-term goals), 70% (the typical allocation), and 90% (our long-term recommended allocation). It’s important to know that our diversification alpha occurs at all points along the risk-level spectrum. Betterment’s portfolio had significantly higher returns than the naive portfolio. While the Betterment portfolio did have a significantly larger drawdown in the financial crisis, previous gains meant that it was never worth less than the benchmark portfolios, even at the nadir of the financial crisis. The value of diversification alpha At the same stock allocation percentage, the Betterment stock funds are riskier than the naive portfolio funds. Does that mean the higher return is due to higher risk taking? To control for this, we looked at risk-adjusted performance. To adjust for risk, we divide the excess return by the level of volatility the portfolio experienced. By doing this, we equalize portfolios that have higher returns purely because they have higher volatility. Any remaining return difference is due to diversification alpha. Historical average annual return 50% stock 70% stocks 90% stocks Naive 5.2% 5.6% 5.8% Betterment 8.1% 8.8% 9.5% Outperformance vs. naive, not risk adjusted 2.8% 3.3% 3.6% Outperformance vs. naive, risk adjusted 0.9% 1.4% 1.8% Source: Betterment Analysis of monthly returns, Jan 2004 - Dec 2013. Includes Betterment costs & DIY trade fees.1 Read full disclosure on how we compute historical returns. As you can see, Betterment outperformed, even when adjusted for risk, by between 90 to 180 basis points, depending on the stock allocation. This comes purely from better asset allocation. And here’s the best part The benchmark portfolio, while simple, still requires maintenance. That means time and additional trading costs (we factored that into our analysis).1 However, in the Betterment portfolio, rebalancing and trading is done automatically as our algorithms use all account cashflows to regularly maintain precise asset allocation without incurring taxes or trading fees. With Betterment, you never need to settle for lower expected returns just because it's simpler to manage. We offer the optimal index-based portfolio—which can be adapted for any level of risk—and manage it optimally for you, automatically. 1We assumed DIY trade fees to cost $10 per trade, with 36 trades per year.
We Built A Better Bond BasketWe Built A Better Bond Basket We are re-optimizing our portfolio and improving the bond basket. Take a look at what's inside the new bond portfolio. This fall we are re-optimizing our portfolio and have been blogging about the benefits for our customers. In a related post, we explained how the new portfolio mix is likely to boost expected returns overall at every level risk. In this post, we’re taking a closer look at each of the new bond ETFs we are adding to our optimized portfolio. Bonds are key for managing risk and creating an alternative source of returns to stocks alone. As with every investment we include in Betterment’s portfolio, our investing experts adhere to certain criteria to ensure we’re delivering the optimum performance at the lowest cost. We don’t believe in active management, so every investment must track an index. We only choose ETFs that are broad-based, suitable for the long term, and have a low expense ratio. Given our baseline selection criteria, here are the ETFs that comprise our new bond basket. There is no longer a set distribution percentage for each ETF across the bond basket. Rather, the distribution is based on the overall stock-to-bond allocation. Here are the key characteristics of our new bond ETFs: Bond ETF (ticker) Within basket allocation at 30% stock Within basket allocation at 70% stock Risk level (relative to each other) Risk factors Expense ratio Short-Term Treasuries (SHV) 21% 0% Very low U.S. interest rates 0.15% Short-Term Inflation -Protected Bonds (VTIP) 12% 0% Very low U.S. interest rates; inflation 0.10% High-Quality U.S. Bonds (AGG) 27% 35% Low U.S. interest rates 0.08% U.S. Corporate Bonds (LQD) 12% 17% Mid Default risk; U.S. interest rates 0.15% High-Quality International Bonds (BNDX) 21% 34% Mid to High Non-U.S. interest rates 0.20% Emerging Markets Bonds (VWOB) 7% 14% High International credit risk; non-U.S. interest rates 0.35% Short-Term Treasuries (SHV): One of the key ways to control risk in a portfolio is to have at least one asset which is as low-risk as possible in the basket — such as a very high-quality, short-duration set of bonds which has almost zero risk and is liquid (unlike, say, a certificate of deposit). In the old portfolio, this role was played by SHY. Now we will be using SHV, an iShares ETF made up entirely of even shorter term treasuries, with an average maturity of five months. This is similar to what a money-market fund holds. Short-Term Inflation-Protected Bonds (VTIP): The only other bond ETF in the prior portfolio was an inflation-protected bond fund (TIP). Now that we are diversifying the basket more broadly, we can hedge against inflation risk with more precision. VTIP is a fund very similar to TIP, except that it tracks shorter-term bonds, which means that it tracks inflation more closely than TIP. High-Quality U.S. Bonds (AGG): High-quality U.S. bonds represent a large part of global capital markets. They are issued primarily by the government and other highly rated issuers, and tend to have very low default rates. The broad nature of the index that tracks these bonds means they have higher yields, but also more interest rate risk. We selected AGG based on its very low expense ratio (just 0.08%), and high liquidity. Corporate Bonds (LQD): Corporate bonds typically have higher returns but a higher risk, because the companies issuing the bonds have a slightly higher credit risk (i.e. risk of default) than a government bond. The issuers tend to be corporations that are financing projects or short-term needs with debt rather than equity. High-Quality International Bonds (BNDX): The high-quality non-U.S. bond market is similar in size to the overall U.S. market, but offers significant diversification of risk. A diversified basket of British, European, Japanese bonds, and bonds from other countries have their own specific and independent risk factors. One concern when investing in international bonds is the exchange-rate risk. We have selected a newer Vanguard ETF, BNDX, as our high-quality international bond offering, which hedges out all exchange-rate risk. Emerging Markets Bonds (VWOB): Emerging markets bonds -- lending to support infrastructure projects and governments in developing markets -- tend to be more volatile, with movements more characteristic of a stock rather than a bond. That means they do an excellent job diversifying our bond basket, but are less appropriate at lower risk levels and we use them sparingly in the overall portfolio. We have chosen VWOB for our Emerging Markets bond instrument. Like BNDX, we are not taking on any exchange-rate risk in our Emerging Markets bonds, as they are denominated in U.S. dollars. Managing Risk Better While all portfolios benefit from these additions, low-risk goals, which are more vulnerable to volatility, will see a particular benefit for two reasons. First, we are reducing the average maturity of the bond basket for low-risk goals, by replacing the existing bond ETFs, SHY and TIP, with SHV and VTIP. Generally, the shorter the maturity of a bond, the less sensitive it is to interest-rate changes. Second, we have also diversified away from U.S.-only bonds. For example, if you hold 70 percent bonds, a third of your bond basket will now be international bonds (with no foreign exchange-rate risk). International bonds are still somewhat responsive to U.S. interest rates, but that movement should be dampened significantly compared to a U.S.-only bond basket.
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