Markets

Deriving an Assumption on Inflation While our assumption on inflation comes down to a judgment call in the end, we take a thoughtful approach to balancing the information coming from what we believe to be the best sources of data. Expected annual inflation is a key assumption used by our retirement savings and withdrawal advice, which help you plan for the future. To make these calculations, we must assume a specific growth rate for investments, but the rate of return that really matters is the “real” rate of return—i.e. the return adjusted for inflation. This is because the prices of everything that you buy tend to increase over time, so if you want to maintain the same ability to spend, your plans must take into account the fact that goods and services will cost more in the future. An example from Investopedia (that we have revised a bit) helps to illustrate this concept. Say you have $20,000 and want to buy a car that costs this same amount. Instead of purchasing the car now, you could decide to wait and invest the money for 1 year so as to have a cash cushion after buying the car. Assuming that you can earn 5% interest over a 12-month period, you will have $21,000 in one year. So it seems as if you can generate $1000 in savings by delaying your purchase for one year. But say inflation on car prices over the same one-year period is 2%. That same car will cost $20,400 in one year. The actual amount of money that remains after you purchase the car will be $600, i.e., 3% of your initial investment of $20,000. Your purchasing power due to investing only increases by $600 instead of $1000. 3% is indeed your real rate of return as it accounts for the effects of inflation. Multiple factors can drive the inflation rate including economic growth, public policy, and monetary policy. As a result, no one knows with certainty how the prices of the broad set of goods and services that you purchase will increase in the future. There are many different, credible sources of data for developing views on how inflation will evolve over time. No one source is necessarily going to give you the “right” answer so it is important that you use the multiple sources of information that will help you filter signal from noise. While our assumption on inflation comes down to a judgment call in the end, we take a thoughtful approach to balancing the information coming from what we believe to be the best sources of data. These sources include: Forward guidance from the Federal Reserve Market expectations derived from the pricing of US Treasuries and Treasury Inflation Protected Securities (TIPS). Customers with differing views on inflation can also override our assumption via the Edit Assumptions panel, which can be found on the Plan tab of a Retirement goal. We discuss each of these sources as well as our overall thought process in more detail below, but our broad conclusions based on the present state of the data are as follows: The Federal Reserve explicitly aims for an annual inflation rate of 2% over time and has proven credible in keeping inflation anchored to this level. Macroeconomic projections from the Fed also indicate that long-term inflation forecasts remain near 2% if not below this level. As of May 2, 2017, almost all inflation expectation measures derived from market prices suggest that the market expects inflation to be below 2% across multiple short- and long-term horizons. Since these measures are volatile, we will be keeping a close eye on how market expectations evolve going forward, but inflation expectations seem to be well- contained at the moment. Based on all of these sources, we assume a 2% rate of inflation in our financial planning calculations. The Target Inflation Rate The Federal Reserve explicitly states that an inflation rate of 2 percent is most consistent with their mandate for price stability and maximum employment over the long-run.1 But what data are Fed officials using to evaluate ongoing inflation trends? While they monitor multiple measures of inflation, it is widely recognized that the Fed prefers to use the core Personal Consumption Expenditures (PCE) index.2 This core measure strips out volatile components such as food and energy, allowing the Fed to better gauge long-term trends. Note that the monthly, year-over-year percent change in core PCE, a commonly used measure of inflation, has been strongly anchored to 2% since the early 1990s. Through its implementation of monetary policy—the process of raising or lowering the costs of borrowing through the U.S. federal funds rate—the Fed has proven to be effective in anchoring the long-term inflation rate to 2%.3 Accordingly, at Betterment we account for this trend and model inflation to remain stable for the foreseeable future. PCE Core Inflation Source: Federal Bank of St. Louis FRED, author's calculations However, we recognize that inflation target changes are possible as a result of macroeconomic conditions, political climate, public policy and Fed policy. Indeed, the 2% explicit inflation target itself is relatively new (introduced by Ben Bernanke in January of 2012).4 To address this possibility and help ensure our inflation expectations remain as accurate as possible, we monitor both forward inflation projections and implied inflation rates from the fixed income securities markets. Forward Fed Projections The Fed distributes their macroeconomic projections to the public on each FOMC meeting date (just hours after). These reports include information about the distribution of projections across all 17 Federal Open Market Committee (FOMC) participants for real GDP growth, the overall inflation rate, overall PCE inflation, core PCE inflation and the Fed Funds rate. The median and central tendency5 forecasts for one, two, and three years ahead as well as longer-term are provided. The ranges on the forecasts one, two, and three years ahead are also provided. An example of the Fed report from the March 2017 FOMC meeting is shown below. We monitor these reports closely and focus on any significant changes in projections for PCE and core PCE inflation in particular for any indication that we need to be adjusting our views accordingly. At present, inflation projections are tame with the relevant inflation statistics all near 2% and below this level in many cases. Forward Fed Projection Table Source: Federal Reserve Board Inflation Breakeven Rates Given pricing in the TIPS and US Treasury markets, we can derive the market's expectation for inflation at different horizons. This expectation is often referred to as the breakeven inflation rate. For a given maturity, the breakeven inflation rate is the difference between the yield on a US Treasury note (bond) and the yield on an inflation-protected US Treasury security (also known as TIPS) with the same maturity. If we perform this calculation for a 5-year maturity, for example, we get the market's expectation for inflation over the next five years. How does this make sense as an expectation for inflation? The cash flows on TIPS are tied to the Consumer Price Index (CPI), another common gauge for inflation. The principal on TIPS rises with CPI while the coupon rate represents a real return (i.e., return above inflation). To the extent that the semi-annual coupon payments and the final redemption value of TIPS track increases and decreases in CPI, investing in TIPS serves as a perfect hedge against inflation. In contrast, US Treasury bonds are fully exposed to inflation risk. Thus, the yield spread of a US Treasury bond over TIPS with the same maturity—often referred to as the TIPS spread—represents the premium an investor demands for being subjected to the risk of inflation in the future. The markets, in fact, give us a term structure of inflation expectations as shown below. Term Structure of Expected Inflation Rates Source: US Treasury; author's calculations This gives us the market's expectation for future inflation over 5-year, 7-year, 10-year, 20-year, and 30-year horizons. We see that only the breakeven inflation rate for the  30-year horizon is just north of 2% as of 2017-05-02. Since breakeven inflation rates are based on a pricing measure that changes regularly, they can provide an early indicator of meaningful increases in inflation. But as appealing as these market-based measures might be, they are not without their drawbacks and therefore cannot serve as the sole basis for formulating our inflation assumptions. For one, breakeven inflation rates reflect factors that may have nothing to do with long-term inflation expectations. For example, TIPS are not as liquid as plain vanilla US Treasuries and their yields may, therefore, have an embedded liquidity premium. Changes in risk appetite which cause nominal Treasury yields to rise and fall can also influence the TIPS spread. Additionally, regardless of maturity, whether 5-year, 7-year, 10-year, 20-year or 30-year, inflation expectations based on the TIPS spread are volatile as clearly shown below. Our goal is to forecast long-term inflation and we do not want to get whipped around by transitory changes in market expectations. We would need to see sustained and persistent increases in breakeven inflation rates above 2% across the term-structure before we would consider an increase in our long-term expected inflation assumption. Expected Inflation Rates Across All Available Maturities Source: US Treasury 5-year, 5-year Forward Inflation Expectations Rate Another long-term measure of the market's expectations for inflation expectations is the 5-year, 5-year forward inflation expectations rate. This is a measure of what the market expects inflation to be over a 5-year period five years from now. In other words, it is an inflation breakeven rate that, as shown in the figure below, applies to the five-year period starting five years from the respective dates in the x-axis. This market-based measure of long-term inflation expectations is preferred by the Fed as it is less sensitive to cyclical factors like energy prices. It, therefore, gives a better indication of whether the market thinks that the Fed is meeting its goal of long-term price stability. Currently, this measure suggests an expected inflation rate of under 2%. This market-based measure is also volatile and is just one additional source of information about inflation rates that we watch. 5-year, 5-year Forward Inflation Expectations Rate Source: Federal Bank of St. Louis FRED Conclusions Long-term historical trends suggest that the Fed has been very effective at keeping the long-term inflation rate anchored at 2%. Current Fed projections show that policymakers are not anticipating that this will change anytime soon. Furthermore, almost all market-based measures currently indicate that inflation expectations fall below the Fed’s 2% target and we would need to see more sustained deviations above this target level before changing our expected inflation assumption. For all these reasons, we assume a 2% inflation rate in our financial planning models and research. 1 See https://www.federalreserve.gov/faqs/economy_14400.htm 2 See https://www.federalreserve.gov/faqs/economy14419.htm and https://en.wikipedia.org/wiki/Coreinflation for more on this preference. 3 See https://research.stlouisfed.org/publications/review/12/01/65-82Thornton.pdf for a historical perspective on this. 4  https://en.wikipedia.org/wiki/Inflation_targeting 5 The sample mean, excluding the three highest and three lowest projections.

With Market Timing, Even If You Win, You May Lose (Hint: Taxes) When you’re actively trading, short-term capital gains taxes will cripple your take-home returns. Let’s take Joe, a hypothetical investor, who thinks he is really good at trading. In the past year, he has been fiddling with his portfolio on a quarterly basis, buying low, selling high, usually after reading something online. And he’s doing well—the market is up, so he is making money. Then let’s take another investor, who strives to be like The Dude in The Big Lebowski. He dumped some money into his investments in January and has since ignored them. And knowing him, he won’t do a thing with it for at least another decade. Who’s the better investor? Year over year, after all is said and done, it’s likely The Dude. You can probably guess that this is not really a story about personality types—but about the invisible cost of active trading. When you market time, no matter how well you do, you’re probably going to get stung on taxes. If you’re moving between securities quickly, chances are, you never hold them for longer than a year, so even if you’re successful (a big if!), you will owe short-term capital gains tax on your gains. This one is a killer—siphoning up to nearly 45% of your returns to Uncle Sam, when including state tax. Outperforming an index is hard, and doing it year after year is even harder, but that’s not enough. You actually need to substantially outperform the index to wind up with better returns, because the tax code is set up to discourage speculative trading. To observe this effect, you need to focus on after-tax returns. A Quick Review on Tax Rates You incur taxes on short-term capital gains when you sell an appreciated security that you’ve held for a year or less. Any longer, and the gain will be long-term. When you pay the short-term rate, instead of waiting for the long-term rate, you effectively reduce your own investor rate of return. At the time of this article’s publication, the federal tax rate on long-term capital gains goes up to as much as 23.8%, while short-term capital gains get taxed up to 43.4%. Rates are subject to change. See the current short-term and long-term capital gain tax rates. The $100,000 Case Study To get a sense of how taxes from active trading can drag down a portfolio’s returns, we backtested the performance of two $100,000 investments, from Jan. 1, 2000, to Oct. 31, 2014. Both initially started with a Betterment portfolio allocated to 50% stocks. Portfolio A remained passive for the term, maintaining the target 50% stock allocation. Automated rebalancing kicked in any time the allocation drift exceeded 5%. After 14 years, the portfolio was worth $282,000 upon full withdrawal, after all taxes. Portfolio B began at 50% stocks, but every quarter it rebalanced to a different (random) stock allocation. This means that every time the allocation was reduced, stocks were sold. This simulation mimics investors who attempt to anticipate market movements, or chase trends. The portfolio was worth $240,000 upon full withdrawal, after all taxes. How to explain the difference? Even though the average stock allocation of Portfolio B was 50%, constantly altering the allocation will, of course, result in different exposures over the period, making meaningful comparisons difficult. But there is one distinction which likely had a massive effect: not including the ultimate liquidation, Portfolio B paid nearly $30,000 in short-term capital gains taxes over the period—on average more than $2,100 per year. Meanwhile Portfolio A paid about $3 in short-term capital gains tax, as part of a rebalance in 2000, and never after that (subsequent to Year 1, long-term lots were always available when rebalancing kicked in.) The Hidden Taxes in Actively Managed Funds This effect can be particularly costly inside mutual funds, which can obfuscate their tax-inefficiency by parading their pre-tax returns. Meanwhile, the after-tax adjustment can be dramatic. Inside every actively managed fund is a professional Joe—making stock picks, and realizing short-term gains on your behalf. You have to dig a little to appreciate the capital gains problem inside an actively managed mutual fund. All funds are obligated to distribute any realized capital gains to their investors at the end of the year. Here is a list of mutual funds that are expected to distribute lots of such gains this year. At the top of the list is Eaton Vance Large-Cap Value. Let’s look at its performance compared to the large-cap value index fund VTV, that we use in the Betterment portfolio: Taking a look at the chart, where the Eaton ETF is represented by the blue line and VTV is represented by the red line. They’re both up about the same, year-to-date, and seem to track very closely. So seemingly no difference, right? But when it comes to investing, you should care about your investor returns—not the fund’s returns. Let’s look at more detailed info at Morningstar for both. Eaton’s Pre-Tax YTD return: 9.48%. After-tax: 2.76% VTV's Pre-Tax YTD return: 10.16%. After-tax 9.36% Eaton’s capital gains exposure is 3x that of VTV. In investor take-home returns, that is ~6.5% negative alpha. That stinks. Note that the figure above is year-to-date (YTD) as of Nov. 13, 2014, which means the data represents Jan. 1, 2014 through Nov. 13, 2014. Viewing Morningstar for the Eaton ETF or VTV will be YTD as of the current year in which the data is being viewed. The Bottom Line Unless you plan to never liquidate your assets, taxes on gains are inevitable, and you should not have an irrational aversion to them. But you should have healthy aversion to the most costly of them—the short-term capital gains tax. In all but a few rare situations, you can and should avoid it. Tax Impact Preview shows you the amount and type of capital gains you may be about to incur, before you commit to a trade. Surfacing the hidden cost of active trading in this way makes you think twice about impulsive decisions, and encourages you to stick to your long-term plan. It’s no accident that a Fidelity study actually found that investors who forgot they had accounts did best. This is one of the beauties of being a buy-and-hold investor—you do less, and as a reward, you also hand over less of your money to the government. This article originally appeared on Forbes.com. 

How to Adjust Your Investments During Market Highs Nervous about the stock market being at record highs? Instead of making short-sighted knee-jerk decisions, consider these five investing actions instead. We’re having a darn good run. Since its low point in March 2009, the S&P 500 has returned over 300%. This recovery is the second longest bull market on record, lasting over eight years. And with a CAPE ratio of about 29, U.S. stocks are historically expensive relative to their corporate earnings. Given all of this information, it is entirely understandable that some investors are getting a little nervous about the market’s future potential. So, what lies ahead? John Maynard Keynes famously said that “markets can stay irrational longer than you can stay solvent.” Much as interest rates have stayed low for a very long time, markets can stay expensive for a very long time, negating any value to trying to time when to invest. Despite this viewpoint—and abundant evidence that market timing probably won’t make you better off in the long run—as investors, it’s difficult to be rational about the market’s irrationality when faced with tough news—or even the potential of tough news. At Betterment, we understand this. Though we don’t recommend trying to time the market, we know that worse things may happen when investors hold a portfolio they aren’t comfortable with. So rather than just saying, "don't do anything, folks," we’ve developed five concrete steps you can take now to get ahead of market volatility and stick with your long-term plan. 1. Decrease your risk moderately, but don’t ignore taxes. Once you’ve decided you think the market holds less potential for growth in the short term, it’s tempting to whipsaw your portfolio down to zero stock exposure. Unfortunately, we have found the more you change allocations, the more likely it is you’ll underperform. And not just because of subsequent market returns; each time you trade, the market takes a tiny bit out of the value of what you trade. So while you might get lucky, the odds are against you over time. Also, if you’re trading in a taxable account, ignoring taxes when making investment decisions is one of the biggest mistakes you can make. You may think a market downturn is on its way, but, in truth, you can never know for sure exactly when it will happen. Look back at old broadcasts of financial television from 2016 or 2015; there were plenty of pundits predicting the market would face a major correction before the end of the year. And yet, here we are—no downturn yet. Many an investor has missed more in gains than they’ve avoided in losses by trying to time a dip. What is certain is that you will owe taxes on any net capital gains you incur from selling out of stocks and going into less risky investments like bonds or cash. That’s why we built Tax Impact Preview—to help you see how much in taxes you could owe before finalizing your trade. Our technology allows us to analyze each specific investment you hold and calculate the estimated capital gains/losses you could incur from selling it. It’s okay to slightly decrease the risk in your portfolio if it helps you sleep at night. Each investor has his/her own tolerance for risk. That is why Betterment is personalized to provided recommended ranges of risk for each goal. If you are nervous about the market, you could slide down from “Moderate” to “Conservative.” Just be aware of the tax impact it could cause. 2. Divert regular savings into a “dry powder” fund. If you believe stocks are overvalued, you may wish to temporarily stop purchasing more of them. However, that doesn’t mean you should stop saving altogether. Instead, redirect your regular monthly savings into an account we often call a “dry powder” fund. Parking money in your dry powder fund will allow you to continue your good savings habits while building a stockpile you can deploy if the market does take a dip. A good dry powder fund should be extremely low risk and very liquid, meaning you can access the money quickly. A traditional savings account could do the trick, but at Betterment, we also created a portfolio for exactly this purpose. It is built entirely of US short-term Treasuries, with AAA credit quality and average maturities of less than six months. Another benefit is that you can transfer money from one Betterment account to another with great speed than processing a deposit from your bank account. The graph below shows how the US Short-Term Treasuries ETF (abbreviated SHV) compares to the World Stock Markets (ACWI) fund. While the latter fund has had plenty of ups and downs, the “dry powder” fund, the SHV, is nearly a flat line—steadily holding its value. While, of course, historical performance is not a reliable predictor of future performance, but, if investing for dry powder, I’d take my chances on a flat line over a hilly line any day. Source: Data provided by XIgnite A dry powder fund can be a great alternative if you are nervous about the market, but be aware of how large your balance gets. Keeping too much cash (i.e. cash equivalents) for too long is a sure-fire way to lose purchasing power due to inflation. 3. Reassess how your investment strategy aligns with your goals. “Most things work—until they don’t.” When you apply such common sense to investing, it means you can get away with an overly aggressive portfolio relative to your goals—even for a long period of time—but eventually, an overly aggressive mentality will likely backfire. Smart investors make sure their investments match their goals and time horizons. The market may be unpredictable, but your goals and plans are far more predictable and under your control. If you have a short-term goal, like purchasing a home, you shouldn’t be taking a lot of risk with that money. If the market does go down, you simply won’t have enough time to recover. A prudent approach is to decrease your portfolio’s risk as your goal approaches. You can see a visual example of a major purchase goal below. Major Purchase Goal 4. Have a game plan. The biggest investment regrets are often from knee-jerk reactions to events beyond our control. The most recent Federal Reserve Survey of Consumer Finances shows that the number of individuals who own stocks has declined by 4.4% since 2007, despite the market recovery. In other words, many individuals exited the market during the Recession, rather than riding the bull market upward from 2009 onward. You cannot control the stock market, but you can control your behavior. When you expect market volatility, it’s best to plan ahead. Ask yourself questions like the ones below, and consider even writing down your responses for your future self. How often should I check my investment accounts? How long of a “cool-off” period will I give myself before executing a withdrawal/trade? What is the maximum number of trades I will make per year? What’s the maximum I’m allowed to deviate from my long-term allocation? Having a personalized rulebook like this should be part of every investor’s game plan, so that rash thinking in the heat of the moment doesn’t lead to later regret. 5. Start tax loss harvesting. Despite your best efforts, no strategy can entirely safeguard you from the short-term ups and downs of the stock market. You can actually use these temporary market downturns to your advantage. Tax loss harvesting can save you money, and it can increase your after tax-tax returns by up to an estimated 0.77% per year through actively realizing short-term losses, and using them to offset taxes. When you sell an investment at a loss, you can use that loss to reduce taxes on other capital gains as well as earned income. Advisors have been using this strategy for decades when assisting wealthy clients, but technology now allows us to do it much more efficiently for Betterment clients throughout the year. Putting It All Together Personal finance is only one part math; the other nine parts are behavior. Betterment stands by our evidence-based investment approach that trying to time the market is not a prudent strategy. But we also understand that, as humans, not taking action during a market downturn is extremely difficult for people. So if you are nervous about what lies ahead with the stock market—now or in the future—try one of the five tips above. Decrease your risk slightly, but be mindful of taxes. Don’t stop saving entirely, just redirect your savings into a dry powder fund. Make sure your investments match your goals. Have a game plan that you are comfortable with, and commit to sticking to it ahead of time. Lastly, take advantage of market volatility with tax loss harvesting. These five tips will help you take control of your portfolio and stick with your long-term strategy.