Investing Philosophy

Goal-Based Investing: A Decade In Review As we all look forward to and plan for the future, let’s stop and take a look at the past decade to see what we can learn from it. I’ve never been particularly good at New Year’s Resolutions. Coming up with a shiny new list of resolutions is always fun, but as we all know—the challenge is sticking to them. But this year, things feel different. A new decade is a fantastic opportunity to reflect on what I want for my life for the next ten years, and set goals to match my vision. Here at Betterment, we take goals seriously. Our entire investing platform was built from the ground up on the idea of goal-based investing. Research has shown that separating your investing dollars based on the actual goals you want to reach is more effective for not just one reason, but for nine reasons. The turn of the decade has sparked my curiosity, so I’ve set out to learn how investing goals at Betterment might have fared over the past ten years. If I had set aside my emergency fund in Betterment’s Safety Net goal, would my portfolio have outpaced inflation? If I had used a Major Purchase goal to save and plan for a down payment on a house, would I have reached my goal? If I had followed Betterment’s contribution advice within the Retirement goal, how would my retirement accounts be looking right now—sunny or bleak? First, some caveats... Our portfolio and advice changes over time, so let’s investigate the answers to these questions acting as if Betterment’s current portfolio and advice had been around in and since 2010. Before I jump into the analysis, I want to be very explicit with some of the simplifying assumptions I’ll be making here. While Betterment launched near the beginning of this decade, our product has in no way been static. One of our core principles is iteration, and so the Betterment of today is very different than it was in 2010. Though it would have been interesting to analyze the growth and improvement of our advice over time, I chose instead to use the goal types and advice of the current Betterment platform and apply them retroactively. The historical return data is, of course, historical, as are inputs into the model such as risk-free rate assumptions—but the actual code is what currently powers our platform. Betterment’s recommendations and models update throughout the lifetime of our customers’ goals in order to give them better advice, and I tried to account for this throughout the analysis. Betterment’s advice for Retirement plans is adjusted for inflation and taxes, whereas other goals are projected at a pre-tax, nominal basis. Lastly, the scenarios I present below are purely hypothetical, and do not represent actual investor returns. They are certainly not promises or guarantees of future returns. Safety Net Goal Setting aside cash for emergencies is one of the most important components of a solid financial plan. At Betterment, our recommendation is that you keep your emergency funds invested in our Safety Net goal. With this specific goal, we invest in low-volatility assets to ensure that your portfolio isn’t at risk of a major drawdown1. But there is also another risk to consider: inflation. If you were to keep your emergency funds in cash, the post-inflation value of the cash would naturally erode over time. In order to try to maintain your portfolio’s value while also trying to beat inflation, we invest Safety Net funds at the lowest possible risk level that still has higher expected returns than inflation—15% stocks and 85% bonds. Let’s assume that at the beginning of the decade, we had already saved up $10,000 in cash for emergencies, and we had invested it all into Betterment’s current Safety Net portfolio of 15% stocks. Would we have outpaced inflation? For the most part, yes, the analysis below indicates that we would have outpaced inflation. Our balance (the blue line) temporarily dips below inflation (the red line) a few times through the projection, but remains above inflation for 92% of the entire time period. The maximum drawdown during this period is 3%, which is well below our recommended buffer of 15%. Overall, we end up with $12,900 in our Safety Net goal, which comes out to around $10,850 after adjusting for inflation. Hypothetical Safety Net "Balance Versus Inflation"—Over the Last Ten Years Source: Returns data from Xignite. Inflation data from the Federal Reserve. Calculations by Betterment. Major Purchase Goal Our Major Purchase goal is designed to help our customers plan for larger, planned expenses that we all encounter throughout our lifetimes. By setting an amount that you’d like your goal to reach by a specific target date, we can give advice on how much you’ll need to save and invest, either as a one-time deposit or through regular deposits over time. We’ll also automatically de-risk the portfolio over time to ensure that a market downturn near the end of the goal term is less likely to affect the outcome. One possible use-case for a Major Purchase goal is for saving for a down payment on a house. My colleague Nick Holeman recently wrote a research report on the economics of buying a home, so I’ll pull some figures from there. Nick found that the average down payment on a home is around $32,500, plus an additional $5,000 of closing costs, so the target balance for our hypothetical Major Purchase goal will be $37,500. Let’s assume that we started saving for the down payment on January 1st, 2010, and we wanted to spend the down payment funds exactly ten years later, on January 1st, 2020. If we feed these values into Betterment’s algorithm that recommends the appropriate savings amounts to reach our goal, we end up with a target savings rate of $230 per month. Let’s also assume that we log in once per year to update our recurring deposits to match Betterment’s advice. With those assumptions in mind, we can explore how the balance of our Major Purchase goal would have evolved over time. The chart below plots the hypothetical balance over the course of the past decade (blue line), compared to the desired end target amount (red line) and the cumulative deposits into the Major Purchase goal (green line). We see that we do end up reaching our goal, and even slightly early—in early 2019, rather than at the end of 2019. Hypothetical Major Purchase Goal Balance—Over the Last Ten Years Source: Return data from Xignite. Calculations by Betterment. Another way to assess the outcome of following the Major Purchase advice is to look at how much we cumulatively had to deposit in order to reach the target amount. If we had chosen not to invest our cash at all and given up the opportunity to potentially receive investment returns, our total cumulative deposits would of course be a flat $37,500—the original target amount for our Major Purchase goal. With the Major Purchase goal, the total cumulative deposits necessary to reach our goal would have been $29,804, which is around 21% less than if we hadn’t invested at all. In other words, committing to Betterment’s deposit advice over the ten year period would have earned us enough returns to allow us to save less towards our down payment, yet end up with the same target amount. The chart below shows the effect investing through the past decade would have had on our goal. The bar in red is the sum of all deposits into the goal over the past decade based on Betterment’s recommendations, and the blue area shows the additional balance gained from investing. Hypothetical Final Major Purchase "Balance Versus Total Deposits" Source: Returns data from Xignite. Calculations by Betterment. In total, we need about $7,700 less to reach our target amount when using the Major Purchase goal as opposed to not investing it at all. That’s not a bad outcome for the five minutes of work per year that it takes to log in and check up on your deposit advice within your Betterment account. Retirement Goal Saving for retirement is one of the most common ways that our customers use Betterment, and we have a wide range of tools to make that journey easier. These include advice on how much to save, how to choose the right accounts, and how much predicted spending power you’ll have in retirement based on our projections. For the Retirement goal, I was curious to see the effect that market conditions of the past decade would have had on the retirement-readiness of a customer nearing their retirement date. I assumed that the customer was 55 years old at the start of the decade, and planning on retiring at age 65. I also assumed the customer wants to be able to withdraw enough money from their account to have $20,000 per year (after paying a 15% long-term capital gains tax) for 20 years after their retirement date to supplement their social security. Based on these inputs and an estimated inflation of 2%, Betterment estimates that the customer would need around $382,000 at retirement, according to the customer’s projection graph. I further assumed that our customer had saved 2/3 of that desired balance at the start of the decade, and that the customer logs in once per year to update their automated deposits according to Betterment’s advice, as the balance in the account changes. Based on these assumptions and market data from the past decade, we can calculate the actual amount that the customer could withdraw in retirement. The chart below shows that due to favorable market conditions, our customer is actually able to withdraw around $20,500 per year in retirement, which is roughly 2.5% more than they initially planned. Hypothetical Retirement "Spending Power Versus Target Spending Power" Source: Betterment data. If 2.5% seems like a very small increase after what has been a historically strong decade for markets, you are not alone—I was also initially surprised. The answer lies in the U.S. Treasury yield markets. Treasury securities are often seen as being some of the most risk-free assets in U.S. markets. At the beginning of the decade, 30-year Treasury rates were around 4.63%2, meaning investors could lock in very high risk-free rates by investmenting in those instruments, or other instruments whose rates are primarily driven by Treasury rates. As of December 2nd, 2019, the 30-year Treasury rate is 2.28%, so investors have a much lower rate on their risk-free investments. The chart below shows the yield curve at the beginning of the decade (blue) and at the end of the decade (red). Yield Curve at the Beginning and End of the Decade The decrease in long-term rates has a large effect on retirees with a fixed-income heavy portfolio. Luckily, Betterment’s advice updates with changes in not just the equity and bond markets, but also because of Treasury rates—so our hypothetical investor did not lose any spending power in retirement due to activity in the Treasury rate markets. On To The Next Decade While no one will ever be able to predict what the markets will do over the next decade, and future market returns are unlikely to match the past, looking backwards can often help us feel empowered to plan for the future. As we usher in the new decade, I hope you’ll join me in thinking about what your goals are for the next ten years, and start planning for how you can make them a reality. 1 Drawdown is an investing term that measures how much an investing balance decreases from its all-time high. In simple terms, you can think of maximum drawdown as the largest loss you might have endured during a period if you invested at exactly the worst time. 2 Data from the Federal Reserve. Please note that clicking the previous link will download a CSV file of historical rates to your computer.

Drivers of Investing: Time Value and Compound Interest When it comes to investing, the longer you let your money grow and compound, the more money you can likely earn in returns. Have you ever wondered why banks pay an interest rate? Perhaps the most obvious answer is to entice you to keep your money with them. But, how are they able to pay an interest rate in the first place? And why do they want to hold your cash? The answer is the time value of money, or the fact that money you have today is more valuable than the same amount in the future because of its potential earning capacity. It may sound simple, but money that you have onhand today is valuable because you can do things with it. Of course, you could use it to buy something. But if you don’t need it immediately, you could also loan it out to someone, particularly to someone who wants to do something productive with it, and earn a return on it. Funding The Next Great Idea Imagine your friend is running a small business, say a coffee shop. Things are going well, and she wants to open another location. To do that she needs store space, new coffee-making equipment, and perhaps advertisements to announce the new location. This will be a big cash outlay. Cash that she doesn’t have onhand. You happen to have extra cash and agree that her plan to expand is a good idea, so you loan her money to grow the business, keeping in mind that all investing involves some financial risk. In this case, she agrees to pay you back the original loan in three years plus some interest. Now she has the funding she needs to grow and you have converted your unused cash into something that can generate more money for you.   The demand for money, sometimes called capital, is exactly why money has time value. You can use cash that you have onhand to fund many productive activities -- like a friend’s coffee shop (a personal loan), a large established company (corporate bonds), or even theU.S. government (U.S. Treasury bills). The revenue generated from these activities can allow you to earn a return on your capital invested. Ultimately, it’s important to determine the level of risk you are comfortable with by weighing the potential consequences and returns. How Banks Pay Interest Now, let’s go back to the interest that you earn at the bank. Banks are able to pay you this interest because they are taking a portion of your money and loaning it out. In turn, they earn interest and pass a portion-- sometimes an exceedingly small portion-- along to you. Whether it’s you or your bank doing the lending, the dynamics are always the same: money is given to those in need of capital, and those people (or companies or governments) in need of capital, in turn, compensate the lender. It’s the need for money itself that gives money time-value. In other words, the sooner you have money the more valuable it is because you can start earning more money on it. What’s the right amount of interest? Now that we understand the underlying mechanics of why and how interest is earned on money, we might find ourselves asking, “Ok, but who decides what the interest rate is anyway?” At the most fundamental level, interest rates are set by the demand for capital compared to the supply of people willing to lend it. A good starting point for evaluating interest payments is to consider the amount you would get paid by someone who will almost certainly pay you back, for example, the U.S. government. In fact, the U.S. government holds auctions every week asking for loans—U.S. Treasury auctions. Yields for U.S. treasury debt are set during these auctions. These rates can serve as a good benchmark for other interest rates that you might see, like a certificate of deposit (CD) at a bank for example. Don’t settle for average. Knowing that yields on U.S. government debt are a good starting point for comparing interest rates, we can look at a couple of practical examples. If you are considering a one-year CD from a bank, you would want to compare its interest rate to the latest yield from one-year U.S. Treasury bills. At the beginning of February, the national average yield on a one-year CD was 0.64%, compared to 2.56% for Treasuries of the same maturity. This means that the average rate on a CD is not very good. As a smart investor, you know to use Treasury yields as a baseline to compare other interest rates and not to settle for yields that are substantially worse. If you were to compare your savings account rate, you would want to use the federal funds rate as a benchmark. This is the rate at which banks lend money to each other overnight. At the beginning of February, the effective federal funds rate was 2.4%. Compare that to the national average interest rate on a savings account of 0.09%. Again, as a smart investor, you know to compare your savings account rate to the federal funds rate and not settle for a meaningfully lower rate. Compounding, Or Why Rates (And Time) Are Important A key reason to pay attention to the interest rate you are receiving is the effect that compounding can have over time. Compounding happens when you earn interest not only on your original investment, but also on all the previous interest payments that you have received. It might not sounds like much, but over time compounding winds up having a meaningful impact on our wealth. To illustrate, let’s start with a simple example. Imagine you start with a penny, and every day it doubles in value for a month. So, on the second day you have 2 cents, on the third day you have 4 cents, then 8 cents, and so on. But before reading any further, how much would you expect to have at the end of those 30 days-- perhaps $100, $10,000, maybe even $100,000? Starting with 1 cent and doubling it every day would leave you with over five million dollars after 30 days! Take a look at the table below to see how your initial penny grew. Magic Penny: Growth of 1 cent over 30 days As you can see from above, the balance does not even break $100 until halfway through the month, and doesn’t reach $1mm until the third to last day. This extreme example illustrates the power of compounding over time. Returns start off slowly, but increase more and more as time goes on. Compounding in the real world. Of course, you would be hard pressed to find any investment that doubles every year, let alone every day. However, the impact on compounding is still profound. Below, you can see the growth of $10,000 over 30 years at a 5% annual interest rate. You’ll notice in the first few years the account grows at nearly a constant rate. However, after about five years you start to see the power of compounding kick in. In fact, by the final year you would earn over $2,000 from your original $10,000 investment and have an ending balance of over $43,000, compared to $25,000 if you earned the same interest rate with no compounding. Growth of $10,000 with 5% interest rate This figure represents the growth of a $10,000 investment with a 5% annual interest rate over the course of 30 years, based on whether compounding did or did not occur. Please note, the calculations assume a hypothetical annual interest rate of 5%. The hypothetical yield on this investment is not based on, and should not be interpreted to reflect, any Betterment portfolio, or any other investment or portfolio, and is purely an arbitrary number. Further, the results are solely based on the calculations mentioned in the preceding sentences. These figures do not take into account any dividend reinvestment, taxes, market changes, or any fees charged. The illustration does not reflect the chance for loss or gain, and actual investment returns can vary from those above. The time value of money is a fundamental concept for investing. As an investor, you should expect to earn money on your excess cash. You should also ensure that the amount you are earning is appropriate by comparing it to relevant benchmarks. Earnings from interest are particularly powerful as they compound over time. Compound growth affects all investments and is especially pronounced in retirement investments because of the long investment horizon. Investing early allows more time for your money to grow on itself.

Personal Investing Strategies Tailored For You We’ve long tailored customer portfolios based on factors like goal type, and risk tolerance. Now, we’re further personalizing our advice at the level of the portfolio strategy itself. We believe that truly optimal wealth management is always personal. A holistically optimal investment recommendation includes the investor’s circumstances, goals, personality, and views. At Betterment, we focus on helping customers achieve higher take-home returns, not just investment returns. Investment returns are the public, pre-cost, pre-tax, pre-behavior investment growth you might read about on a fund’s prospectus. “Take-home” returns make up the growth that individual investors actually achieve once you consider the cost, tax, and behavioral losses they often experience. It’s the additional dollars you actually take home. Our goal is to add value—real dollars—through improved financial planning, risk management, tax management, and behavioral optimization, in addition to offering an appropriate investment strategy for you. We’ve long tailored customer portfolios based on goal type, time horizon, risk tolerance, account type, and the use of asset location. Now, we’re further personalizing our advice at the level of the portfolio strategy itself. In addition to Betterment’s core strategy, we will now offer the following four portfolio strategies to help ensure that your investments are personalized to your preferences: The Betterment Portfolio - A globally diversified mix of exchange-traded funds, chosen to help you earn better returns at each level of risk. Betterment SRI Portfolio - This strategy maintains the diversified, low-fee approach of the Betterment portfolio while increasing exposure to companies that meet SRI criteria. BlackRock Target Income portfolios - A low-risk alternative to the Betterment portfolio, composed entirely of bonds, with different income targets that seeks to provide steady income with low risk. Goldman Sachs Smart Beta portfolios - This strategy is for investors seeking to outperform a market-cap strategy, despite potential periods of underperformance. None of our strategies is “best” when evaluated in a vacuum. We offer these strategies to fit an investor’s goal and personal preferences. In financial planning terms, we understand this fit by measuring individualized investment success in precise ways. We’ll dig into this approach in the next section. Regardless of which strategy you choose, our financial planning advice can continue to work on your behalf when appropriate. Real investment success is personal. A key insight in our approach is respecting the difference between the generic value from using a portfolio strategy and the actual, individual-specific results of doing so. Hypothetically speaking, any two people who invest the same amount of money in the same strategy, at the same time, should earn the same incremental pre-tax return. However, for each individual investor, personal factors like tax rates affect how much of your return you actually take home. Preferences, like how comfortable you are with risk, affect how much you choose to invest, how committed you are in rough markets, and whether or not you feel your earnings are worthwhile. When analysts compare two funds’ returns, they’re typically doing surface-level analysis. They usually aren’t factoring in the individualized cost, tax, and behavioral losses that actual investors realize. Pursuing the highest possible gross returns is a zero sum game. Everybody involved is competing for the same value—the raw gross returns—and almost nobody wins because they’re all largely locked into the same calculus. When you focus on gross returns, you’re liable to end up suffering the Winner’s Curse. In contrast, when we focus on increasing value for individual investors, we can find opportunities that can make all parties involved better off: We see the older investor who wants to reduce risk sell some of her stocks to the younger investor who has a longer time frame on an open exchange. We find an investor wishing to invest in companies with high social responsibility increase demand for better corporate governance. We see the retiree who wants a predictable payout sleep better at night because he holds a portfolio of bonds optimized for income. We see an investor who strongly wants to outperform the S&P 500 accept the pain of potential underperformance in the interim. The more we dig deep into what makes for successful investors, the more we confirm our prerogative to help people grow their personal take-home returns. To help maximize the individualized value you get from investing (and in effect, generate the scenarios above) we’re continually improving Betterment to align with the aspects of life that contribute that value. We can sum up these elements of life in four categories. 1. Personal Circumstances Personal circumstances include facts such as the size of your household, the tax bracket you fall into, and your state of residence. These cold hard data points are part of the foundation for helping to grow your personal take-home returns because they often present specific opportunities. For instance, a high-rate tax payer in New York may personally be better off investing in New York municipal bonds due to the state tax exemption. This would not make sense for a low-rate tax payer in Texas. 2. Your Goals Where do you want to be in the future in regards to your finances? Goals are what you want to accomplish with your money, in a general sense. Two investors with similar circumstances, personalities, and views but with different objectives should have different strategies. Exactly what we intend to spend our money on can have serious implications for the best account type, investment approach, risk level, and ongoing management. Goals may include pro-social activities like funding charities or improving environmental stewardship. Dedicating money toward a charity, an impact investment, or a socially responsible fund may be the best way of attempting to achieve a social impact goal. Thus, it is likely optimal for an investor whose goal is to improve social impact, corporate governance, and disproportionately fund ethically focused companies to invest in an SRI or ESG managed portfolio. In order to achieve their goal, they may need to forego some potential investment returns, but this can comfortably be viewed as “spending” toward their goal. 3. Personality Your personality is who you are and how you behave. Two individuals with the same circumstances, goals, and views may still differ in terms of their personality, especially when it comes to financial or investing matters. Personality traits such as sensation seeking, emotional intelligence, and composure have all been linked to financial and investing behavior. Studies have shown that genes even play a role—the more closely related two individuals are, the more likely they are to take on similar levels of risk. How much absolute loss can you handle before you freak out? How closely do you follow markets? How hands-on do you want to be with your investments? All of these can inform how we help you choose the right portfolio. For example, an investor who is anxious about stock market risk, is comforted by predictable, consistent returns, and has high sensitivity to short-term capital losses might be best served by an income optimized portfolio. Income portfolios seek more predictable returns (in the form of coupons), low correlation to stock market movements, and low daily capital volatility. If an investor is more liable to frequently check his or her portfolio, and is more likely to react adversely to day-to-day losses, a steadier balanced portfolio with less chance of abruptly sharp losses will fit the bill. 4. Views Investors with the same circumstances, goals, and personalities may hold different views about future risk and reward. They may want to feel a sense of involvement and individuality in their investing, or follow an investment strategy that resonates more strongly with them personally. At Betterment, we aim to provide portfolio and allocation advice in your best interest, which means a portfolio must resonate with you. If you don’t have specific views, then we use the other aspects of your life to formulate a financial plan. But if you do have a view, such as a belief that factor-based investing is better than a passive market cap-based approach, our advice will help you express it within your investing strategy. For example, research (Vanguard, Research Affiliates, AQR) has shown that smart beta has historically outperformed market capitalization benchmarks over long holding periods. And many investors may be more comfortable with a strategy that doesn’t rely on market capitalizations to determine its portfolio weights. But, we must be cautious: expressing views can be behaviorally tricky. The pursuit of higher returns can result in lower take-home returns, even in smart beta funds. If the investor is not truly committed to the strategy, their views may be influenced by recent returns, the news, and what they hear from friends and family. Chasing good performance has a strong tendency to lead to lower returns. So when Betterment customers want to express views, our job as an advisor is to request commitment to a strategy—to offer a subtle, yet important, push to think carefully. One way we do this is to make clear that a strategy such as an aggressive smart beta portfolio strategy may very well underperform market benchmarks, especially for shorter time periods. The factors driving our selected smart beta strategy underperformed the S&P 500 in five of the 17 years from 2000 to 2016 (when you compare performance at year end). Yearly returns calculations based on S&P 500 and factor index data from Bloomberg for the period January 1999 to December 2016. Personalized portfolio strategies are just the start. Betterment’s core principles for investing success include helping every customer develop a personalized plan and building in discipline to one’s investing practice. By offering more personalized portfolio strategies that help solve for the important elements of life above, we’re advancing in our goal to fulfill these principles. Now you can access a strategy that seeks predictable, consistent income with our income portfolio strategy. You can invest in a portfolio designed to outperform a market-cap strategy in the long term using our smart beta portfolio strategy. You can express your environmental, social, and corporate governance values by investing in the Betterment SRI portfolio strategy. Offering more personalized portfolio strategies is just one improvement. We’ll continue to add more features, services, and investment strategies to deliver on our mission of helping you make the most of your money, so you can live better.