Behavioral Finance

Betterment Customers Stay the Course, Steer Clear of Behavior Gap Research from Betterment’s behavioral team shows that most investors with Betterment achieve full investment returns and do not attempt to time the market. Betterment strives to help customers reach Behavior Gap Zero—a way of saying that bad behavior doesn’t interfere with achieving optimal returns.1 To help our customers reach that goal, we’re always seeking to understand their motivations and decisions, and how those actions can make an impact on their investment returns. However, measuring that impact is a multifaceted task, so we are starting with one simple question: How do allocation changes, or changing the weight of stocks to bonds in a goal, affect returns? Under what circumstances are customers making allocation changes, and are customers improving or reducing their returns with these changes? Key Finding: Market Timing Hurts Returns After sifting through the data, we found these key points: In 78% of accounts, customers made less than one allocation change per year, consistent with occasional changes in financial circumstances. Across all accounts, 67% of customer accounts have Behavior Gap Zero. Account holders who are more active appear to make allocation changes in reaction to the market, and underperform as a result. We observe an average behavior gap of 22 basis points across all accounts; however, we noted a skewed distribution, and 74% of accounts are better than this average. Below, we first detail the ways our smarter technology is making allocation selection easier than ever for investors. Second, we review the results of our behavioral research. Together, these illustrate the unique ability and dedication we have at Betterment to understanding and assisting with the behavioral components of investing. What makes this data unique? Most existing studies of the behavior gap in investing look at cash flows into and out of different funds. This is a necessity because most investing platforms require that an investor move funds from one vehicle to another to adjust risk. Existing studies generally show that those cash flows mistime the market, on average: rushing in after periods of success and retreating when returns are down. But cash flows are a muddy measurement of risk preferences. Investors may move assets because of fees, manager reputation, to consolidate investments, or because they need the money to spend. For investors, adjusting risk allocation at Betterment is as simple as dragging a slider to change the proportion of stocks and bonds within the portfolio. As a result, we can focus on how investors change allocations while filtering out other confounding changes, which allows us to measure the resulting impact on returns with great clarity. Automated Allocation: A New Paradigm We understand the reality of changing financial circumstances and accordingly, we make our allocation change as easy and efficient as possible. Adjusting portfolio allocations has traditionally been full of frictions: phone calls to advisors, fees for trades, and uncertain tax consequences. Betterment customers experience none of those frictions, and as a result, have a new level of freedom and power to adjust their allocation to meet their financial needs. Imagine a career change that pushes plans to buy a house back by three to five years, or a family change, such as a divorce or death, that makes retiring a few years later seem like the right decision. These changes in the time horizon of the investing goal mean that stock allocation should be increased accordingly. On the other hand, if an investor needs the money sooner than originally expected, more bonds are appropriate to minimize uncertainty around the withdrawal date. Betterment reduces certain costs and barriers to allocation changes (e.g., fees, fund choices, taxes) so that our customers always have the right portfolio for their financial situation. What we don’t want to encourage, however, are allocation changes in response to market movements or guesses about what the market will do in the future. As long-time Betterment customers know, we discourage market timing at every turn. With this research, we wanted to answer two questions: Are customers trying to time the market? If so, how is that affecting their returns? Examining Customer Behavior The data below shows allocation changes as they coincide with market performance (dark blue line) during just the last two quarters of 2014. Each bar shows the average direction and magnitude of allocation changes over the previous seven days. Note that these averages include only the small number of customers who made a change over the 7-day period— typically five out of every 1,000. When focused on the tiny subset of customers who were active, we do see some behavior that looks like market timing. How do we know this? If these investors were making allocation changes purely in response to idiosyncratic changes in their financial circumstances, the average change would stay close to 0% and we wouldn’t see any correlation with market performance. Allocation Changes and Market Performance Data Shows Subset of Active Users Only   We see that changes followed the market to some degree in the second half of 2014, but what about a more systematic trend? If we use all of our data since 2010, we can look for such systematic patterns.2 The plot below shows the proportion of allocation changes moving toward stocks or bonds based on market performance in the preceding week. We see that when the market is up between 0% and 3% in the preceding week, the average change increases the stock allocation by 6%. When the market is down more than 2% in the preceding week, the average allocation change is toward bonds by 5%. Remember, more than 99% of customers do not make an allocation change during a given 7-day period, so this pertains to the decisions of the small number who do make changes. Proportion of Allocation Changes Moving Toward Stocks or Bonds Based on Market Performance   How is this affecting returns? Perhaps these active customers are actually improving their returns by making changes? To measure the effect of allocation changes on a customer’s returns, we compared the returns the customer experienced as a result of actual allocation choices to an individualized benchmark. For the benchmark, we used the average time-weighted allocation chosen by the customer. Then, we compared each customer’s actual returns resulting from actual allocation levels over time to the benchmark: the returns that would have resulted if the customer had been at the average allocation constantly from day one. In both cases, we used time-weighted returns, so cash flows into or out of the account did not have an effect. As an example, imagine a customer who funds a five-year home-buying goal and sets the allocation to 70% stocks. After one year, the customer increases the allocation to 95% to chase the performance of surging U.S. equity markets. A more volatile second year makes the prospect of losses more salient, and the customer sets the allocation back to 70%. By the end of the third year, the account had earned 18%. In this analysis, we compare that actual 18% time-weighted return to a hypothetical account with a constant 78.33% allocation over the same period (the time-weighted average of 70, 95, and 70). By doing this analysis on every account, we find making allocation changes reduces returns, on average. By doing this analysis on every account, we find making allocation changes reduces returns, on average. Across all Betterment accounts, the mean gap between actual returns and the average allocation returns was 22 basis points. However this includes all the accounts that made no allocation changes, and whose gap would by definition be zero. Looking only at the accounts that made at least one allocation change, the average gap is 41 basis points. The figure below shows that each additional allocation change (up to four) increases the average behavior gap by about 16 basis points. Only 22% of accounts have made more than one allocation change per year. Nearly half have never made even one, so there is no possibility of a behavior gap, as we define it. Overall, two-thirds of customers have no gap, and three-fourths have a behavior gap smaller than the 22 basis point average. Behavior Gap and Allocation Changes   IRAs Are Different Interestingly, we see customers making fewer allocation changes in their retirement goals in IRA accounts, and their returns are closer to the ideal as a result. Betterment customers make 48% fewer allocation changes in their IRA accounts and see 50% smaller behavior gaps, on average. We see two potential explanations for this difference. First, it’s likely that our customers’ retirement horizons don’t change very often, so there are fewer legitimate allocation changes than in many of the shorter-term taxable savings goals. Second, the findings are consistent with prior research showing less activity in retirement accounts, possibly because they are perceived as more “off limits.”3 It’s worth noting that a preference for changing allocation inside a taxable account versus an IRA, all else being equal, is highly tax-inefficient behavior, as investors are not taxed on realized gains inside an IRA. The returns analyzed here are not after-tax, so the findings actually understate the gap that results from frequent trading in a taxable account, which we’ve written about in the past. If an investor is going to market time (and we advise against that!), doing so in a taxable account is particularly ill-advised, as compared to an IRA. How does this apply to individuals? Does this mean that an investor should never make an allocation change? Not at all. If an investor’s financial goals or constraints have changed, an allocation change may be the right thing to do. In that case, we recommend going to the Advice tab in your Betterment account, entering the new time horizon or target balance, and adjusting accordingly. Using allocation changes as a tool to try to time the market, or in reaction to periods of bullish or volatile markets, is where we see trouble. These kinds of changes only make sense if an investor know exactly what the markets will do next, and that is not something most of us should be betting on. 1 The “behavior gap” is a term coined by financial planner and journalist Carl Richards and has become a popular way to refer to the loss of investor returns due to bad timing decisions. 2 While the average market movement has been upward over the period Betterment has been available to investors, it has been marked by drawdowns of up to 20% in the S&P 500 since 2010. 3 Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. The Journal of Finance, 55(2), 773-806.

How 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.

9 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.