Investing Risk

Allocation Advice for Betterment Portfolios Unlike the risk questionnaires, our algorithm weights investment time horizon and downside risk more heavily, and allows you to deviate from our advice if you want to deviate. TABLE OF CONTENTS We start with your goals How we balance risk and time How we manage downside risk The result? Betterment's glide path Including customer risk preference If you have ever worked with a traditional investment manager or have a 401(k) 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, can be 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 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. ...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 spend your Major Purchase goal savings at a specific point in time. You might withdraw your entire 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 spend 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 General Investing goal. It has a similar spending 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 an optimal risk level for your investment horizon. We do this by assessing the possible outcomes for your time horizon across a wide variety of bad to average markets. Getting to an 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 designed 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 select a level of risk that aims to minimize potential downside risk at every investment horizon. By some standards, we have a fairly conservative allocation model—but as we mentioned above, our mission is to help you get 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, 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 If the graph above shows an example of 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 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 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). 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 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 Our advice doesn’t only consider the bad outcomes. We seek to 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 Our goal is to provide the best possible expected returns. That means aiming to provide you with 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 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 help 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 recommendation. In investing, a glide path is the formula used for asset 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.) At Betterment, we adjust the recommended allocation and portfolio weights of the glide path based on your specific goal and time horizon. This means Betterment glide path recommendations are more personalized to your specific goals and investment horizons. For example, in our Major Purchase goals, shown below, the recommended glide path takes a more conservative path than a recommended 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 we recommend 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. Learn how this advice varies by goal type. Mixing bonds and stocks across percentiles The bottom line: Our allocation advice is designed at a goal level to help 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. Including customer risk preference How should we modify this analysis for a conservative or aggressive approach? The glidepath derived above is downside optimized because it gives equal weight to each percentile outcome from the median down to the first percentile over a given time horizon. To tailor this guidance to a more conservative or aggressive approach, we’ll change the weights to reflect the degree to which investors care about the worse outcomes versus median average outcomes. A quantitative approach We’ll define a ‘conservative’ approach as giving the median (50th percentile outcome) about 40% of the weight of the 5th percentile outcome. Conversely, the ‘aggressive’ approach gives the 5th percentile outcome about 40% of the weight of the median. Weight Given to Outcome for Different Approaches The result is a set of optimal aggressive and conservative glidepaths, as shown below for a major purchase goal. Deviation from the Recommended Approach This approach does allow for deviation by risk level, which produces a non-linear guidance range. It is wider at moderate allocations, and tighter at the bottom and top of the risk range. Optimal Stock Allocation One reason is simply mechanical: at higher risk levels, you can’t deviate up very much. At lower risk levels, you can’t deviate down much. Taken across the entire range our outcomes, we have determined that ± 7% is a reasonable deviation. We believe a stable range across recommended levels is easier to understand and follow, and there is sufficient noise in the more extreme tails of these estimates to justify allowing a higher range at the tails. We therefore give guidance that the acceptable range of deviation is -7% for customers wanting a conservative approach, and +7% for customers wanting an aggressive approach to that goal. Very conservative More than 7% beneath recommendation Appropriately Conservative Between 3% and 7% beneath recommendation Moderate Within 3% of recommendation, inclusive. Appropriately Aggressive Between 3% and 7% above recommendation Too aggressive ✢ More than 7% above recommendation Unknown When lack of information regarding significant external assets means it’s not possible to reach a conclusive opinion ✢  Betterment for Advisors customers see ‘Very aggressive’ instead. Goal-term guidance Our quantitative approach above allows us to establish a set of recommended risk ranges given our goals. However, an investor may choose to deviate from our risk guidance if they see fit, and there may be appropriate reasons for those deviations. That being said, we provide investors with feedback regarding the potential implications of such deviations and, in doing so, we treat upwards and downwards deviations differently. If an investor decides to take on more risk than we recommend, we communicate the fact that we believe their approach is “too aggressive” given their goal and time horizon. We flag this because even in a setting where an investor cares about the downsides less than the average outcome, it still isn’t rational to take on more risk (viewing this particular goal in isolation). If the investor is unlucky with returns over that period, the losses in a portfolio flagged as “too aggressive” will be very difficult to recover from. In contrast, if an investor chooses a risk level lower than our “conservative” band, we'll communicate that their choice is “very conservative.” This is because the downside of taking on a lower risk level in a moderate outcome scenario is simply needing to save more. And we believe investors should choose a level of risk which is aligned with their ability to stay the course through the short term. Aligning risk level with short-term risk tolerance An allocation cannot be optimal if the investor is not comfortable committing to it in both good markets and bad ones. As a point of reference, our 70% stock portfolio would have lost 46% from Nov. 2007 to Mar. 2009, and been in the red until 2011. While this performance would have been very disappointing, it is important to remember we only recommend 70% stock allocations for goals expected to be held eight years or longer. To ensure that investors understand and feel comfortable with the short term risk in their portfolios, we present them with both extremely good and extremely poor return scenarios for their selection over a one-year time period.

The Recommended Allocation To Keep Up With Inflation Has Changed For funds that seek to match or beat inflation, like a Safety Net goal or Emergency goal, we seek to take on minimal risk while allowing your portfolio the potential growth needed to keep up with inflation. Learn about our updated portfolio allocation recommendations for your emergency funds. At Betterment, we are routinely evaluating our investment strategies to help you achieve your financial goals. As part of that routine evaluation process, we have recently updated our recommended portfolio allocation for goals that seek to keep up with inflation. Goals like our Safety Net goal or an emergency fund are designed to be an account you can withdraw from in the case of an unexpected financial situation, such as a large medical bill or the loss of a job. If your emergency money is sitting out of the market and it’s not invested, it runs the risk of losing buying power over time because of inflation. A key risk to this money is that it loses purchasing power as time goes on. A key aim for such goals is to match—or beat—inflation, so that your dollars can keep as much buying power over time as possible. We updated our recommended allocation for goals that seek to keep up with inflation from 15% stocks to 30% stocks. Based on updated analysis below that considers the current yield curve and inflation expectations, our recommendation is that a 30% stock portfolio is the appropriate allocation for your emergency funds. The chosen allocation is designed to match our assumptions regarding long term inflation. We revisit these assumptions annually, and our assumption for long term inflation is still 2%. As interest rates have moved lower, the yield on low asset assets has also gone down. Now, an investor must take slightly more risk to achieve a return that may beat inflation. Just as they have in the past, these economic conditions could change again in the future—which is why we routinely evaluate our strategies over time. Keeping Inflation At Bay In order to determine the right level of portfolio risk, we need two key pieces of information: The expected return of the portfolio The expected rate of inflation Our current inflation assumption is 2% per year. We review our inflation assumptions annually to make sure they reflect the current economic environment, which is always changing. The expected return of the portfolio has two key components: the risk-free rate and the expected return on risky assets. Yield on U.S. Treasury bonds determines the risk-free rate. Since U.S. Treasury bonds are backed by the U.S. government, they are considered to be virtually risk-free. We also estimate how much additional return we might expect from holding risky assets, such as stocks or corporate bonds. Putting these two pieces together gives us the total expected return for the portfolio. As of January 2021, short-term U.S. Treasury bonds were expected to have a 0.10% annual yield. This means that holding these bonds until they mature will produce about a 0.10% annualized return, which is less than the 2% we need in order to combat inflation, based on our current inflation assumptions. By taking slightly more risk, Betterment seeks to improve on the 0.10% risk-free investment return. Based on our asset class return assumptions, we expect that the total returns for our 30% stock portfolio could potentially be 2.1% after fees*, which is slightly higher than our inflation expectations. We Recommend A Buffer Unfortunately, we can’t predict the future, so the actual performance of our 30% stock portfolio may turn out to be different than our projected assumptions. We can use history to help us understand the range of potential outcomes. Our 30% stock portfolio’s worst performance in a historical backtest would have been -22.9%, during the Great Financial Crisis.** To help protect against a temporary market drop, we recommend that you hold an additional buffer that’s 30% of your target amount—which generally represents at least three months of normal expenses—to insulate against down markets. For example, if three months of expenses is $10,000, we recommend that you hold $13,000 in our goal. Why not just hold cash? Finally, you might be wondering, “Why not just use a bank account for my emergency funds?” It’s a valid question. After all, money in a checking or savings account isn’t subject to market volatility. Most traditional bank accounts don’t pay a high enough interest rate to keep up with inflation. The national average interest rate is 0.04%, which is far below the 2% annual return we need in order to simply match inflation. This means that even though the amount of cash you’re holding is stable, its buying power is still declining over time. We’ll help keep you on track while keeping you informed. Having funds set aside for emergencies is the cornerstone of any financial plan, since it provides an important cushion against unforeseen circumstances—circumstances that might otherwise require you to dip into a long term account, such as retirement. In fact, our advisors routinely recommend that the first investing goal our customers set up should be a goal to protect oneself against unexpected costs, like a medical bill, or loss of income. If you currently have a goal that’s set to the target allocation of our old recommendation—15% stocks—we’ll alert you that your allocation is now considered conservative, and that a more appropriate target allocation for your goal is now 30% stocks. While we won’t adjust your target allocation for you, you’ll be able to adjust your target allocation within your goal either on a web browser or on your mobile app. Before making this update, please note that there may be a tax impact. We’ll show you the estimated tax impact before you complete the change inside of your account. As the economic environment changes, we will continue to review our recommendations. Because we believe in transparency, we’ll keep our customers updated if economic condition shifts lead to a chance in our advice and recommendations. We calculate expected excess returns for the assets in our portfolio by applying a Black-Litterman model, as described in “Computing Forward-Looking Return Inputs” of our . By multiplying these expected returns by our portfolio weights, we can calculate the gross expected excess returns for the portfolio. We can then calculate the expected total return of the portfolio by adding to the expected excess return our estimate of the forward-looking risk-free rate. In this example, we used the lowest point on the US Treasury yield curve as our assumption. The expected returns are net of a 0.25% annual management fee and fund level expenses, and assumes reinvestment of dividends.This expected return is based on a model, rather than actual client performance.  Model returns may not always reflect material market or economic factors. All investing involves risk, and there is always a chance for loss, as well as gain. Actual returns can vary. Past performance does not indicate future results. ** The Betterment portfolio historical performance numbers are based on a backtest of the ETFs or indices tracked by each asset class in Betterment’s portfolio as of January 2021. Though we have made an effort to closely match performance results shown to that of the Betterment Portfolio over time, these results are entirely the product of a model. Actual client experience could have varied materially.  Performance figures assume dividends are reinvested and daily portfolio rebalancing at market closing prices. The returns are net of a 0.25% annual management fee and fund level expenses. Backtested performance does not represent actual performance and should not be interpreted as an indication of such performance. Actual performance for client accounts may be materially lower. Backtested performance results have certain inherent limitations. Such results do not represent the impact that material economic and market factors might have on an investment adviser’s decision-making process if the adviser were actually managing client money. Backtested performance also differs from actual performance because it is achieved through the retroactive application of model portfolios designed with the benefit of hindsight. As a result, the models theoretically may be changed from time to time and the effect on performance results could be either favorable or unfavorable.  See additional disclosure https://www.betterment.com/returns-calculation/.

How Portfolio Rebalancing Works to Manage Risk Portfolio rebalancing, when done effectively, can help manage risk and keep you on track to pursue the expected returns you want to reach your goals. What is rebalancing? Over time, the value of individual ETFs in a diversified portfolio move up and down, drifting away from the target weights that help achieve proper diversification. Over the long term, stocks generally rise faster than bonds, so the stock portion of your portfolio will likely go up relative to the bond portion—except when you rebalance the portfolio to target the original allocation. The difference between the target allocation for your portfolio and the actual weights in your current portfolio (e.g. your actual allocation) is called portfolio drift. Measuring Portfolio Drift At Betterment, we define portfolio drift as the total deviation of each asset class (put in positive terms) from its target allocation weight, divided by two. Here’s a simplified example, with only four assets: Target Current Deviation (±) U.S. Bonds 25% 30% 5% International Bonds 25% 20% 5% U.S. Stocks 25% 30% 5% International Stocks 25% 20% 5% Total 20% Total ÷ 2 10%   A high drift may expose you to more (or less) risk than you intended when you set the target allocation, and much of that risk may be uncompensated—meaning that the portfolio isn’t targeted higher expected returns by taking on the additional risk. Taking actions to reduce this drift is called rebalancing, which Betterment automatically does for you in several ways, depending on the circumstances, and always with an eye on tax efficiency. Cash Flow Rebalancing This method involves either buying or selling, but not both, and generally occurs when cash flows into or out of the portfolio are happening anyway. Cash flows (deposit, dividend reinvestment or withdrawal) can be used to rebalance your portfolio.  Fractional shares allow us to allocate these cash flows with precision to the penny. Inflows: You may be rebalanced if you make a deposit, including when you auto-deposit or receive dividends in your account. We use the inflow to buy the asset classes you are currently under-weight, reducing your drift. The result is that the need to sell in order to rebalance is reduced (and with sufficient inflows, eliminated completely). No sales means no capital gains, which means no taxes will be owed. This method is so desirable that we’ve built it directly into our application. Whenever your drift is higher than normal (approximately 2% or higher), we calculate the deposit required to reduce your drift to zero, and make it easy for you to make the deposit. Although we show the deposit amount needed to bring drift back to 0%, smaller deposits also help reduce drift. In fact, the first dollars deposited have the largest impact on reducing drift. This means, for example, that depositing half the amount recommended to reduce drift to 0% will generally reduce drift by more than half. Portfolio Drift vs. Deposit Size The chart above is a hypothetical, illustrative example of the relationship between portfolio drift and deposits needed to rebalance without selling any assets. The blue line in the chart demonstrates the general relationship between deposit size and drift. As you can see, the first dollars of a deposit reduce drift by more than the last dollars. The dotted grey line shows what a linear relationship between drift and deposits would look like. Withdrawals (and other outflows) are likewise used to rebalance, by first selling asset classes that are overweight. (Once that is achieved, we sell all asset classes equally to keep you in balance.) We employ a sophisticated ‘lot selection’ algorithm called TaxMin within asset classes to minimize the tax impact as much as possible in taxable accounts. Sell/Buy Rebalancing In the absence of cash flows, we rebalance by selling and buying, reshuffling assets that are already in the portfolio. When cash flows are not sufficient to keep your portfolio’s drift within a certain tolerance, we sell just enough of the overweight asset classes, and use the proceeds to buy into the underweight asset classes to reduce the drift to zero. Sell/Buy rebalancing is triggered whenever the portfolio drift reaches or exceeds 3%. Our algorithms check your drift approximately once per day, and rebalance if necessary. Note: In addition to the higher threshold, we built in another restriction into the rebalancing algorithm for taxable accounts. As with any sell trade, our tax minimization algorithm selects the lowest tax impact lots, but stops before selling any lots that would realize short-term capital gains. Since short-term capital gains are taxed at a higher rate than long-term capital gains, we can achieve higher after-tax outcome by simply waiting for those lots to become long-term before rebalancing, if it’s still necessary at that point. As a result, it’s possible for your portfolio to stay above the 3% drift if we have no long-term lots to sell. Almost always, it’s because the account is less than a year old. In this case, we recommend rebalancing via a deposit to avoid taxes. The Portfolio Tab will let you know how much to deposit, as described above. Please note that for advised clients on our Betterment For Advisors platform, the drift threshold is 5% for portfolios that contain mutual funds. Allocation Change Rebalancing Changing your target allocation by moving the allocation slider and confirming the change will also cause a rebalance. Because you have chosen a new target allocation, Betterment will rebalance to the new target with 0% drift.  This sells securities and could possibly realize capital gains. Moreover, if you change your allocation even by 1%, you will be rebalanced entirely to match your new desired target allocation, regardless of tax consequences. As with all sell trades, we will utilize our tax minimization algorithm to help reduce the tax impact. Additionally, before you confirm your allocation change we will let you know the potential tax impact of the change with Tax Impact Preview. Transaction Timelines If you’d like to turn off automated rebalancing so that Betterment only rebalances your portfolio in response to cash flows (i.e., deposits, withdrawals, or dividend reinvestments) and not by reshuffling assets already in the portfolio, please contact Customer Support. Our team will be happy to help you do this.