Behavioral Finance

How To Avoid Common Investor Mistakes People often make financial decisions based on impulses and market shifts In 10 seconds Want to invest wisely? Start with why you’re saving and investing: A goal. Don’t overreact to short-term gains and losses. And keep your cost-of-living low, even when your income increases. In 1 minute Even savvy investors can let their impulses get the best of them. By understanding how our natural tendencies can cause poor financial decisions, we can teach ourselves to make wiser choices. Goal-based investing means identifying what you need money for in the future, and aligning investments around a tangible outcome. Having a goal helps you decide:  Where to invest How much to invest How long to invest Short-term losses are part of the process. If you constantly check your portfolio’s performance and react to short-term losses, you’ll likely hold yourself back. Instead, focus on the process that can yield long-term gains, and give your investments time to grow. “Lifestyle creep” can easily throw off your plans for the future. As your income increases, try to keep your cost of living about the same. If your regular spending increases, you’ll need to save and invest more to maintain your new lifestyle. That’s the short version. Learn more about common investor mistakes below. In 5 minutes In this guide we’ll: Explain how biases lead to bad financial decisions Look at common mistakes investors make Show you how to avoid these investing mistakes The source of common investor mistakes. Investing mistakes are often rooted in our natural reactions. Let’s face it: We don’t always react the right way to information. And when enough investors have poor reactions, it can affect the entire market.  Behavioral finance is a field of study that looks at how psychology affects financial decisions. It helps us understand why investors make common mistakes, so it’s easier to avoid them. But don’t worry—it doesn’t have to be complicated. Some of the most important lessons from this field are surprisingly simple. Try to invest with a goal in mind. Investing is one of the smartest financial decisions you can make. But a lot of investors start without knowing what they’re working toward—and that’s, well, less smart. When you don’t know why you’re building a financial portfolio, it’s a lot harder to know things like: What account types to use  How much risk to take on How much to invest each month How much you can spend without feeling guilty How much total money you’ll need to save How long you need to invest Instead, start with why. What do you want to be able to spend money on in the future? When are you going to use that money? These aren’t just stocks and bonds. Your investment is a future downpayment on a house. Your dream car. Retirement. College. Real things and experiences you want to be able to afford. Having a goal takes the guesswork out of investing. You can calculate exactly how much you need to invest based on the range of potential outcomes. It’s also easier to decide where to put your investments. Retiring in 40 years? Take more risk and put more in stocks. Hitting your goal next year? Play it safe. When you know how much you need to invest, break it into monthly chunks and automate your deposits. With recurring deposits, you're basically “paying yourself first” before worrying about other expenses. That way, you won’t talk yourself into skipping a month. (Which turns into two months, then three, and—oops, it’s been a year.) Focus on the long-term. When you invest, you’ll have short-term losses here and there. It’s inevitable. And most times, it’s a mistake to make adjustments when your portfolio loses value. You can’t predict tomorrow’s performance based on yesterday’s. Even during the last ten years of steady growth, investors had to endure short-term losses at some point every year. Given enough time, the market trends upwards. And investments that perform poorly one day can easily make up for it the next. But that’s not what most people think about when they see their portfolio lose 15% of its value. They panic. They make sweeping changes, reinvesting in funds and stocks that had short-term gains. And those big emotional decisions often do more harm than good. Investing is about long-term gains. Short-term losses are simply part of the process. Don’t panic every time there’s a loss, and you’ll likely see bigger long-term gains. Watch out for “lifestyle creep.” You don’t have to live frugally to be a successful investor. It helps, but the bigger issue is making sure that as your income increases, you stay in control of your lifestyle and spending. Most people see small pay increases over the course of their lives. 3% here. 8% there. When your regular spending increases with your income, it’s known as “lifestyle creep.” It can easily get in the way of saving enough to achieve your goals. If you have a lower income, it makes sense that more of your money goes toward basic necessities. But lifestyle creep happens when you gradually spend more on things you don’t need. Entertainment. Hobbies. Take out.  Every time you increase your regular spending, your lifestyle costs more to maintain. You’ll likely need to save more for retirement. Your emergency fund may need to grow, too. Lifestyle creep is an even bigger problem if you started investing with the expectation that you’d invest more later. Some people feel intimidated by their goals, so they plan to increase the amount they invest when they start making more money. That’s fine—as long as you actually do it. Temporary increases in spending are OK. But as you make more money, don’t let a more extravagant lifestyle sabotage your goals. Mistake-free investing You want to invest because you want to use your money wisely. At Betterment, we help you do that by building your portfolio around your goals and setting you up to play the long-game. Right from the start, you’ll know our suggested allocation for your portfolio, how much to invest each month, and what outcomes you can expect based on your input. Schedule recurring deposits to help you stay on track, check your progress, and make adjustments at any time.

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 seek 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 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.

Women and Money: Bridge The Gap It’s no secret that women fight more of an uphill battle than male peers in their efforts to reach personal financial goals. $430,480. That’s what it costs to be a woman, according to the National Women’s Law Center. It’s the wage gap that results from a lifetime of being paid less than men. It’s no secret that women fight more of an uphill battle than male peers in their efforts to reach personal financial goals. That nearly half-million dollar wage disparity may be the best known financial hurdle that a number of women face today, but it’s not the only one. Let’s take a look at what other financial hurdles women face, issues they should reconsider, the opportunities they should take advantage of, and what it will take to bridge the gap. The Hurdles You Should Pay Attention To Earning Money The wage gap women face starts with lower pay for comparable work. More time out of the workforce (15% of working years vs. 2% for men), primarily for family caregiving, compounds the problem. On top of that, when women are fired from their role, they tend to take an average 24% pay cut at their next job, as compared to the 1.3% increase men see. Spending Money: The “Pink Tax” Not only do women often earn less for comparable work, they also tend to pay more for comparable goods and services. This so-called “pink tax” is levied on everything from hair care to healthcare. In some cases, it extends to financial products such as mortgages, business loans, and annuities. The Issues You Should Reconsider How confident are you? A mere 9% of women think they are better investors than men, per a recent study. Traditional gender roles had them showing up late to the party on this, so a case of newbie nerves is to be expected. The problem is that this confidence gap results in reduced risk tolerance. Women wait longer to invest and, when they finally do, they tend to stash larger portions of their money in safer, but low earning, accounts. Compounded over time, this more conservative approach can exact a big toll on women’s net worth. Are you considering your life expectancy as much as you should? According to 2017 Center for Disease Control data, the life expectancy for American women is 81.6 years. This means, on average, women get 5 more years than men to enjoy the good life, whether that’s globe hopping, playing golf, or spending time with the grandkids. But it’s also 5 extra years of living expenses to fund. And some of those additional years can be extra costly as healthcare expenses soar in later life. Thanks to the hurdles faced en route to retirement, women are forced to cover these higher costs with a comparatively smaller pool of resources. That can include: Lower Social Security benefits Reduced pension payouts Smaller nest eggs The Opportunities You Should Take Advantage Of Behavioral Finance Is On Your Side On the plus side, some gender differences work in women’s favor as do demographic trends. For starters, studies show that women are better savers than men.  In particular, they have higher 401(k) participation rates and those that do participate, contribute a higher percentage of pay. Furthermore, behavioral finance research has found that women are also better long-term investors. That’s primarily because, once invested, they are more inclined to “stay the course” regardless of market conditions. Not only does this reduce unprofitable panic selling, it minimizes fees and capital gains taxes. Additional data suggests that this may ultimately result in generally higher rates of return. Shifting Gender Roles Shifting gender roles are affording women more opportunities to leverage those inherent advantages. With 2/3 now acting as primary or co-breadwinner, it’s not surprising that women, and the men in their lives, want to make the most of that hard-earned money. Accordingly, many are eager to learn about financial planning—92 percent according to one study. This hunger for information has spawned a treasure trove of resources. That includes a burgeoning cadre of role models of all stripes, from finally-debt-free millennial bloggers to women CFOs. Watching these prominent women in finance talk openly and confidently about money is inspiring others to overcome cultural barriers and do the same. The cost of ignoring women is finally dawning on the historically male-centric financial services industry. The push to better serve women remains in its infancy, but an estimated $800 billion missed market opportunity is driving it forward. Bridging the Gap When it comes to gender and money, things are moving toward parity with increasing momentum, and there’s a few steps women can take to accelerate the process even more. Here’s how. Just start. Fear of making mistakes often prompts women to delay important financial decisions until fully versed in the matter at hand. While it’s smart to look before you leap, losing out on the magic of compound interest can be just as costly as imperfect execution. Get smart. Financial education is one of the few investments that comes with little to no risk. These days, it’s easily accessible via a startling assortment of seminars, blogs, podcasts, videos, forums, and more—many free or low cost. Take part. Splitting up your money management “To Do” list with a spouse or financial planner makes good sense,  but women should stay intimately involved to ensure their interests are represented. The journey to women’s financial parity is far from over, but the progress has been impressive. And with the collective impact of more and more women taking control of their money, maybe someday “the gender gap” can be relegated to the dustbin of history.