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Diversification

Diversification and Performance: Two Portfolios

The Betterment portfolio has historically outperformed a DIY benchmark portfolio by as much as 1.8%. Take a look.

Articles by Dan Egan

By Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment  |  Published: December 20, 2013

The Betterment portfolio has historically outperformed a DIY benchmark portfolio by as much as 1.8%.

Diversification alpha leads to better performance over time.

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 diversification alpha. 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.

AA_ValueComparison_R70

 

 

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 For full disclosure on how we compute  historical returns, see here.

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.

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