• KEY TAKEAWAYS
  • Betterment's advice provides allocation advice based on your investment horizon, balance, and goal.

  • It is similar to a target date fund or glide path—but it can be personalized to each of your goals.

  • We are constantly optimizing your portfolio and savings or withdrawal recommendations based on a quantitative assessment of potential outcomes.

Introduction

If you have ever worked with a traditional investment manager or have a 401k plan at work, you have likely answered a “standard” risk questionnaire. It often starts with your estimated retirement date and how much money you have, and then ask you what kind of returns you want to see.

But these questionnaires measure what kind of risk-taker you think you are, not what kind you need to be in order to achieve your goals.

At Betterment, we believe that your investment horizon—how long until you will need your money—is one of the most important determinants of how much risk you should take. The more long-term your investing goals, the more risk you can afford to safely take. Money saved for short- and medium-term goals, such as saving for a house or buying a car, is invested at a different risk level than a longer-term goal, such as retirement.

Another consideration is how you plan to use the money when you need it. Will you take out the investment in a lump sum or will you gradually make withdrawals over time and use that money for income? These are key pieces of information we use when providing personalized investment advice.

Below, we walk you through the rationale of our risk advice model. Unlike the standard risk questionnaires, our algorithm weights investment time horizon and downside risk more heavily, and allows you to deviate from our advice—within a range—if you want to deviate.

This is the heart of Betterment’s risk advice algorithm.


We start with your goals

First, let’s talk about goals. At Betterment, you can think of goals like different investment buckets. They are technically subaccounts that you can use to silo your retirement savings from vacation savings, for example. Every goal you set up at Betterment (and every customer can set up several ) will have its own customized allocation of stocks and bonds.

Each goal has different final liquidation assumptions, so it is important to select the one that most closely matches your real intentions. Below we can see the diversity of goals you can manage at Betterment.

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…and then look at your investment horizon.

Once we know your goal, we next consider how long you will be invested in that goal, as well as the withdrawal plan for that goal. Is it a goal that you plan on cashing out in 10 years, or a goal such as retirement in 30 years, give or take a few years? That actually makes a big difference in the advice we’ll give.

We assume you will plan to fully liquidate a Major Savings goal at a specific point in time. You might withdraw your full House goal investment after 10 years when you have hit the savings mark for your down payment. In contrast, with a Retirement goal, we assume you will withdraw funds over a number of years rather than in one lump sum withdrawal. That’s the nature of a nest egg—it’s the basis for your monthly income in retirement.

If you don’t have a specific investment horizon or target amount, we will use your age to set your investment horizon (our default target date is your 65th birthday) in a Build Wealth goal. It has a similar liquidation assumption as retirement, but maintains a slightly riskier portfolio even when you hit the target date, since it’s not clear you’ll liquidate those investments soon.

With this information about your time horizon and goals, we can determine the optimal risk level for your investment horizon. We do this by assessing the best outcome for your time horizon across a wide variety of bad to average markets.

Getting to the optimal risk level, generally attained through exposure to stocks versus bonds, involves weighing the trade-offs between potential gains from higher risk investments and the potential for falling short by playing it safe. We have customized our formula so that it works especially well with our portfolio, which contains multiple globally diversified asset classes.

Now, we know we can’t predict what the future will be. So we use a projection model that includes this uncertainty by including many possible futures, weighted by how likely we believe they are.  We use these probability-weighted futures to build our recommendation based on a range of outcomes, giving slightly more weight to potential negative outcomes and building in a margin of safety—which technically is called ‘downside risk’ and uncertainty optimization. If you’re interested, you can also read more about our projection methodology.

Paying particular attention to below-average scenarios we are able to to select the level of risk which minimizes potential downside risk at every investment horizon. By some standards, we have a fairly conservative allocation model—but as we mentioned above, our mission to get you to your goal through steady saving and appropriate allocation, rather than taking on unnecessary risk.


How we balance risk and time

Now, let’s consider now how risk and time work together. The example below shows the forecasted growth of $100,000 in a 70% stock portfolio over three years. The expected return, or median outcome, for this portfolio is $121,917 based on our model, but the range of possible outcomes moves from at least $180,580 for the top 5% of potential outcomes to no better than $82,312 for the bottom 5%. This is a great example of how stocks can bring both a lot of upside—as well as downside in the short-term.

Outcome and risk over a three-year term

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If  the graph above shows the predicted volatility that stocks can bring to very short-term time horizons, what happens to the same portfolio over a 10-year time horizon?

Outcome and risk over a 10-year term

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After 10 years, our models predict that you are less likely to lose money and more likely to come out ahead on an absolute dollar basis.


How we manage downside risk

Now that the relationship between risk and time is clear, let’s turn back to allocation.

In order to make an appropriate recommendation of stocks and bonds, we have to look at potential outcomes for everything from 0% stocks to 100% stocks. To do this, we evaluate stock allocations and look at how they might perform at similar percentiles over a fixed investment horizon. This analysis helps us finely tune the stock-and-bond ratio.

In the example below, we see the 15th percentile outcome for every stock allocation over a 20-year investment horizon. We use the 15th percentile to represent a ‘bad’ outcome, i.e., poor predicted market performance. With shorter-term horizons (seven years and less), our modeling shows a majority bond portfolio beats a majority stock portfolio in this ‘bad case.’  However, by year 12, the same model predicts higher stock allocations begin to overcome bond-heavy portfolios. By year 20 all majority stock portfolios (at least 50.1%) have better outcomes than majority bond portfolios, even though this is still a ‘bad’ outcome in terms of investment performance.

Returns at the 15th percentile, or a ‘bad case’ scenario

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Within this bad outcome scenario let’s focus on the best allocation at each time period. Measured by returns, the best expected outcomes are equivalent to the top of this graph (traced in red).

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Another way to view this best allocation line is to change the y-axis from absolute value in dollars to the stock allocation. If we plot the same 15th percentile best allocation line on a new plot we get the following graph.

Portfolio value as a measure of stock allocation at the 15th percentile

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This new view of the same line clearly shows which allocation would have performed best for a given period. For example, in the ‘bad’ scenario, a 65% stock portfolio would have performed best over a period that lasted 10 years and nine months on the predicted model.

Allocation and time

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Our advice doesn’t only consider the bad outcomes. We find the best stock allocation for outcomes from the expected 50th percentile to the 5th percentile (a ‘worst case’ scenario, but not THE worst case scenario). You can see the result of this exercise in the graph below, which maps investment horizon against best stock allocation, given the percentile chosen.

Percentiles by 5%, from 5th to 50th

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Our goal is to provide the best possible expected returns. That means providing you the best chance of making money and not losing it. To do that, we then must look at the the median outcome—and an average of all the outcomes that are considered bad, which is everything from the 5th percentile to the 50th. (Why 50th? Percentiles over the 50th, the median will always show that 100% stocks are the best allocation.)

The dark blue line represents the average ‘best’ stock allocation across all percentiles. Since we have included more downside scenarios in this average, it weighs the potential for loss more than equivalent upside. But note that over longer time periods, even with a downside risk focus, we predict that it is still better to be in a majority stock portfolio compared to a majority bond portfolio.

Average of all percentiles

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For long-term goals, those with time horizons over 20 years or more, we recommend 90% stocks. For short-term time horizons, we recommend 10% stocks. And for intermediate-term goals, the recommended stock allocation rises very quickly. This is based on a conservative downside-weighted risk measure which accounts for your specific time horizon in each goal to ensure you are taking on the right risk for the level of return you should realize.


The result is Betterment’s glide path

The result is a general framework for the risk allocation advice Betterment uses across all goals, which can supply a goal-specific glide path.

In investing, a glide path is the formula used for allocation that progressively gets more and more conservative as the liquidation date nears. Many retirement-oriented target-date funds are based on a glide path (though every firm has its own formula.)

However, we go further with our glide path. We adjust the recommended allocation and portfolio weights of the glide path based on your specific goal and time horizon.

For example, in our Major Savings goals, shown below, the glide path takes a more conservative path than a retirement glide path—moving to near-zero risk—for very short time horizons. Why is that? This is because we expect that you will fully liquidate your investment at the intended date and will need the full balance.

With Retirement goals, in contrast, the glide path remains at a higher risk allocation even when the target date is reached, as we assume liquidation will be gradual, and you still have years in retirement for your investments to grow before they are liquidated. If you’d like to understand how this advice varies by goal type, you can read more here.

Mixing bonds and stocks across percentiles

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The bottom line: Our allocation advice is designed at a goal level to ensure you’re taking on the right level of risk based on your personal situation, unlike the impersonal and often unexplained glide path offered by target-date funds.