It’s almost guaranteed that over the course of any financial plan, you’ll need to make adjustments.
You can plan for adjustments, and how they can impact your chance of reaching your financial goals.
Betterment’s guidance on how much you should auto-deposit to help reach a goal will tell you how to update and adapt over time.
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.
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.
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 Like a Missile
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 about jerk here).
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 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: we’re likely to miss if we actually set it and forget it. Plans should be guided missiles. 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.
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