Performance

How Much Are You Losing To Idle Cash? Uninvested cash may feel more readily available compared to when it's invested, but there can be better ways to manage your funds. Find out how. So far, we’ve told you about the consequences of having uninvested cash in your investment portfolio. But cash is king, and so even the most savvy investors still keep money in places like checkings and savings accounts in order to have easy access to those funds, which then can be used for day-to-day expenses. Here at Betterment, we want you to do better. What Is “Idle Cash”? Idle cash is money that is not invested in anything and is therefore not earning investment income. It’s money that is not actually participating in the economy-- not being spent on anything and not increasing in value. Therefore, it can’t earn you anything. Ultimately, keeping idle cash on hand is simply not as beneficial as you may think. In fact, these funds are frequently considered wasted, as they typically cannot keep up with the effects of inflation. In the U.S., the inflation rate that the Federal Reserve targets is 2% annually-- given that your idle cash likely does not increase in value, its purchasing power actually decreases as time passes. That’s right—uninvested funds gradually lose value, since they are unable to keep up with the rate of inflation, which means that as time goes on, the $100 under your mattress can eventually only buy $98 worth of things, then $96, then $94, and so on. And that’s just inflation—the opportunity cost of keeping cash that you otherwise could invest in the market is even worse. Why do people keep uninvested cash? Despite the fact that keeping idle cash can be detrimental to a successful, long term savings plan, there are still plenty of reasons for people to keep cash on hand. Accessibility and liquidity are huge factors—investors want to be able to pay their bills from their checking accounts with the click of a button, for example—as is safety and security, and the fact that savings accounts from member banks are FDIC-insured. The current reality is that among the checking and saving accounts out there, the return on deposited funds is very low. In fact, the FDIC announced that as of February, the average yield on a savings account is 0.09% APY—in a 2% inflation environment, this is still a purchasing power losing investment. The yield on checking accounts is even worse—most of these products have very low interest rates. How much uninvested cash can I get away with keeping? While a small portion of uninvested cash may seem insignificant, it can be disadvantageous for at least two reasons: Preventing it from keeping up with inflation rates means your cash loses value over time, and You fail to benefit from money that can compound over time and garner even higher returns. Typically you shouldn't reinvest cash if it costs you more to actually invest it than what you would earn, due to, for example, broker commissions. However, at Betterment, the absence of trading commissions, as well as our ability to support fractional shares, help ensure that every last cent of your cash is being put to work for you. If we assume an average trading cost of $7 per trade (typical of discount brokerages) and you don’t want to reduce your returns by more than 1%, then you should have, at most, $700 of cash. Even though we recommend having no cash at all because any amount may reduce your returns, for practical reasons we believe portfolios have too much cash when they exceed $700 in cash. How should I manage the rest of my cash instead? There are many schools of thought as to how cash can be managed, but the most common objectives are the following: Yield (without meaningful risk) and liquidity-- simultaneously making sure that your cash does not waste away due to the effects of inflation while mitigating potential high risk. That you are able to access your cash within a reasonable amount of time. At Betterment, we spend a lot of time thinking about how to help you make the most of all your money. Idle cash results from cash dividends which are not reinvested. When you use Betterment, your dividends are automatically reinvested, resulting in zero idle cash and zero cash drag from your accounts. In addition, we provide you with a holistic picture of all your investment accounts from a cash management perspective, from idle funds in external accounts to the cash inside the funds you purchase. We highlight each portfolio’s total idle cash, along with a simple projection of how much potential returns could be lost by holding that cash amount long-term.

When Is the Best Time to Invest in the Stock Market? The media would have you think there are dozens of reasons to buy into or sell out of the market, but what the hard data shows is that most of the time, you should stick to a long-term investment strategy. There’s a saying we at Betterment love: Stock market pundits have successfully predicted 20 out of the past two market crashes. If you listen to the media, they’d have you think that there are dozens of potential reasons to buy into or sell out of the market—to tweak your portfolio—but, what the hard data shows is that most of the time, you should just stick to a solid strategy of investing in a globally diversified portfolio with tax optimization for the long term. Whether you’re a first-time investor getting started and have no clue where to begin, or an experienced investor with a nagging feeling that you could be doing better, the question “Is now the right time to invest?” (or its close cousin, “When should I withdraw?”) often comes up. At Betterment, our customer support team gets these types of questions a lot. People are constantly looking for advice on when to get into the market and when to get out. But the truth is, you don’t have to be a financial advisor to know that nobody can predict the best time to invest. If you message our team of licensed experts, they’d likely tell you that as advisors, they can’t predict the market any better than you can. Whether we analyze the market by asset class, by industry, or by recent events, the truth of the matter is that there is no best time to invest or stay out of the market; and those who try to time their investing strategy usually underperform a long-term investment approach. One of our senior customer support specialists Joe Wang says that he hears a wide range of reasons for why customers want to stop or start their investing strategy. Here are a few examples: “The market has gone up recently, so it must be due for a correction.” “The market is overvalued/at an all time high, so it isn’t safe to buy now.” “I’m expecting interest rates to go up/down, so I’m adjusting my allocation in increase stocks.” “Bonds are a bad bet right now.” “I’m anticipating a stock market crash in the near future.” As humans, our natural tendency is to worry about things that will harm us, and we often feel driven to do something about it. When it comes to investing, this often unconscious motivation can lead you to change your investment allocation to avoid an unpleasant scenario. But unfortunately, making allocation changes—as good as it feels in the moment—actually reduces returns, on average. Even “Experts” Have Difficulty with Their Emotions Human tendencies don’t disappear when you become a professional either. One member of our licensed experts team shared a past advisory experience working with portfolio managers on their personal investments: Even portfolio managers that are data-driven with their clients’ money tend to act differently with their personal dollars. When you have balance sheets north of $10 million, you’d think fund managers—who are experts in the space—would be calculated and judicious when it comes to investing. But even they can let their emotions get the best of them. They’d tell me, "I believe that valuations are high and I have invested through this before. I already know I’m not supposed to react, but I feel better moving to cash." There are any number of messy or insolvable worldly concerns that might have an affect on your portfolio. But most worries become irrelevant on their own, given enough time. The graph below illustrates historical “worries” that many investors have had, and how they correlated to market performance. In every case, investors anticipated these events would impact the market and their portfolio in some way, but as you can see, charted against that index’s actual performance, there’s no clear sign that led to change at all. Crashes often happen with no clear associated news on the day of, but when you step back to look years worth of data, the market went right on doing its thing, trending upward over time. Were there periods where the market dipped? Yes, of course. However, they didn’t last long enough to trouble the savvy long-term investor. Customer Worries Against a Total Market Index (W5000) Wilshire 5000 Total Market Full Cap Index© So what does that mean for the average investor? Even if you happen to “guess correctly” and avoid some downswings in the market, how much was plain luck and how much was solid prediction? Would you be able to replicate a prediction when even experts, with the advantage of time and information, get it wrong too? Let’s say you cash out at a fortuitous time and avoid a crash. Now you face the question of when to get back in. Can you guess correctly a second time, risking a re-entry into the market when it’s “too high?” At Betterment, we are strong proponents of the buy-and-hold strategy, because we know that over the long term with market timing, even if you win, you lose (hint: taxes). In other words, how much of your time and energy is it worth to frequently track your investments, make adjustments for a few percentage points in gains, then get hit with taxes? The Hidden Costs of Worrying, and What To Do Instead It’s easy for us to say, “Don’t freak out about what you can’t predict.” That’s a logical consolation. But when it’s your money, it’s not always easy to be logical. While you can know investing outcomes aren’t truly within our control, that doesn’t make it any easier to stop worrying. To hack into your own worry, you often have to go deeper than your rational mind. Here’s one way to think about it, borrowed from Stoic philosophy. According to Epictetus, it’s important to distinguish things that are under our control and things that are not. He advises to continually divide our moment-to-moment concerns into two buckets: the things we can control, and the things we cannot. Epictetus offers a reminder not to get upset by things we can’t influence, such as other people and external events, and to instead only focus on ourselves and our own behavior. When you worry, if the future situation you worry about comes true, you effectively live the bad experience twice. It is safe to say that worrying about a thing happening before it actually happens doesn’t make the experience any more pleasant. By reclaiming your energy every day from your sphere of concern (the range of things that appeal to your emotions) to your sphere of influence (the range of things you can affect) you are continually developing the essential Stoic skill of learning to let go of that which you cannot influence and accept things as they are. Every choice we make is an expenditure of some sort of time, energy, patience, or well-being. Over time, these expenditures add up to make us better or worse off. We’ve previously outlined some potential investing actions you can take to avoid knee-jerk reactions to market conditions. But here we’d like to offer additional approaches to how you can redirect your energy: Reach out to and spending time with friends (friendships compound beautifully, if you invest in them) Invest in your physical and mental health (being strong of body, and equanimous in temperament pays tremendous dividends later) Develop new skills or sharpen those that are out of practice (gains founded on steady progress, pursuit of meaning, and achievement last longer, and are more gratifying. Quality of life compounds, even better than money does. Your time and energy will be best spent on activities within your control that can improve your quality of life. Why worry endlessly about politics, world events, and market movements so much that it affects your ability to lead a happy life? You could be missing out on living a more fulfilling, better life. That result, in our opinion, would be a far more tragic loss than any market crash.

Long-Term Returns Have a Cost, and It’s Well Worth the Price We’re investors in the stock market because it has a long, time-tested history of generating big returns for those patient enough to let compound interest work its magic. Take a look at this chart. I’m always amazed by it, no matter how many times I’ve seen it. It’s the value of $1 invested in the S&P 500 index since 1950. One buck turned into $1,216, without any input, skill, or decisions from the investor who owned it. 1 Dollar in the S&P 500 Source: Robert Shiller, Yale University, author’s calculations. Includes reinvested dividends. You can call this chart The Reason We’re All Here. We’re investors in the stock market because it has a long, time-tested history of generating big returns for those patient enough to let compound interest work its magic. But ask yourself: Why are these returns even possible? Why are we so lucky to enjoy these returns? The Giant Bill You Never See but Pay Every Day Almost everything in the economy has a price tag. The nicer the thing, the higher the price. And the stock market, over time, is a pretty darn nice “thing.” Why doesn’t enjoying these big returns have a price tag? In fact, there is a big price tag on these returns. It’s just hard to keep track of. Everyone knows the stock market is volatile. But a chart like the one above doesn’t do a good job depicting how much chaos and misery investors had to endure to capture the full long-term return. This chart -- over the same time period as the one above -- shows how much the S&P 500 was below its previous all-time high on any given day (periods at 0% are when the market is at a new all-time high): S&P 500: Percent Below Previous All-Time High Source: S&P Capital IQ, author’s calculations. It’s a mess. Total chaos. During this period, when the S&P 500 increased more than 1,200-fold, the index spent just 6.2% of trading days at a new all-time high. Here’s how the rest of days fared: Percent of Total Trading days, 1950-June 2017 New all-time high 6.2% 0%-10% below previous all-time high 34.8% 11%-30% below previous all-time high 35.6% 31%+ below previous all-time high 23.4% Earning excellent long-term returns required putting up with having less money in your account than you did at some point in the past 93.8% of the time. That’s the cost of long-term returns in the stock market. Checking your account, wondering what happened. Remembering how much more money you used to have. Kicking yourself for not doing something different. Agonizing over whether the pursuit of long-term investing is actually worth it. Watching your net worth decline, sometimes by a lot, and fairly often. You don’t pay this cost in dollars and cents. Its currency is stress hormones. But it’s a very real cost. Bang for Your Buck A smart way to defray the cost of long-term stock returns is through diversification into less volatile assets, like bonds or cash. But the cost of long-term returns in the stock market will always send you a bill, no matter how much or little you own. There are two ways to view that cost. Consider it a fine, like something you should try to avoid and feel guilty for paying. Consider it the cost of admission, like something you are happy to pay because it’s worth the price. Many investors probably fall into the first camp. They trade in an out of the market, trying to avoid any declines. They consider a losing month, quarter, or year as a sign that they did something wrong or were cheated with bad advice, changing their investment strategy to avoid paying another fine. Fewer investors fall into the second camp. But it is, for most investors, the wisest way to invest. The long-term history of market growth even in the face of constant drawdowns is why. View market volatility as a fine, and you’ll spend your life jumping in and out of your investments, likely missing some of the best returns as you fret about paying the bill. View it as the cost of admission and you will likely realize over the course of many years that you may have purchased tickets to one of the greatest shows capitalism has ever produced, with encores for those who stay through the end.

How Betterment Helps Keep You on Track Through Tough Markets Historical data suggests that customers who follow our advice will stay on track to reach their goals, even in a market downturn as bad as the 2008 crisis. Imagine going for a weekend upstate New York. You rent a car, load your destination into your phone’s GPS. It lets you know that you have about a two-hour journey ahead of you, and it suggests that you take the highway. About an hour and a half into your drive, your GPS notices that there is an accident on the highway up ahead. It knows that it will slow you down, so it reacts by advising you to take a different route, using back roads, in order to get to your destination as quickly as possible. Because of the accident, it's going to take a bit longer (not much—just 20 minutes or so)—but you're back on track.  This example is very similar to Betterment’s goal-based advice; just as the GPS recommends the best route to take to reach your destination, we recommend the smart path to take to reach your financial goals. And just as the GPS updates its recommended route based on road conditions and accidents, we update our advice based on various circumstances, such as a shorter time horizon as you approach your target date, or a market downturn.   Because our advice is constantly taking these factors into account, you’re always taking on the right level of risk and saving the right amount (if you’re following our advice). Historical data suggests that customers who follow our advice will stay on track to reach their goals, even in a market downturn as bad as the 2008 crisis. How Our Advice Works At the beginning of your journey with Betterment, we’ll recommend your starting risk level. We’ve chosen this risk by considering what stock allocation would be appropriate in a bad-market scenario. That means that even in a worse-than-expected market, you’ll be taking on the right level of risk for the goal you want to achieve, and you’ll be set up to ultimately reach your goal. Second, we’ll estimate how much you need to save, and adjust that not for average returns, but, to be conservative, slightly below-average returns (the 40th percentile, if you’re being precise). So we’ve built in some degrees of conservatism from the outset. From that point, you’re on your way but not on your own. As you get closer to your goal, making your time horizon shorter, we’ll update our advice for your recommended risk level and suggested monthly savings amount. While you might experience interim losses or market drops before your goal’s target date, subsequent positive returns are likely to offset them. Close to your target date, your portfolio will be designed to take on less risk, as you will have less time to recover. As a result, you won’t take on significant goal risk, which is the chance you’ll miss your goal by a large amount of money or time. In the case of a really big market drop, we might advise you to do something about it, such as make a deposit, which will help keep your goal on track. But if it’s early on in a long-term goal, it’s unlikely you’ll need to change anything significantly, because you still have a lot of saving to do. Historical Performance of Our Advice To see how this advice plays out, let’s review a scenario that many people worry about: a goal that has two pretty unpleasant market drawdowns over its term. We’ll use a hypothetical investor who opens a Betterment Major Purchase goal with $100,000 on Jan. 1, 2000. The goal has a target date of March 2009, and a target balance of $150,000. We’re using a Major Purchase goal because the investor intends to completely liquidate that goal at the target date (as opposed to a Retirement goal that wouldn’t be liquidated all at once). This time period (January 2000 to March 2009) was one of the worst times to invest. The investor would have had to contend with both a market drop from 2000 to 2004, and the fact that the market would have dropped right at the end of her investing period, in 2008-09. Recommended Asset Allocation Because this was a Major Purchase goal (where the funds are liquidated at the target date), Betterment would have recommended a high stock allocation early on, but decreased that significantly as the goal date approached. When the goal has roughly one year left, our advice would have been to have 27% stocks, with 18% of the portfolio in cash. The graph below depicts our allocation advice over the term of the goal. Recommended Asset Allocation, 2000-2009 Portfolio Weight in Stocks and Bonds as the Investor Nears Goal Portfolio Returns Below we show the cumulative returns of the portfolio. This investor would have seen two large drawdowns over her investing period, in 2001 and 2008. Compared with keeping the initial allocation, the allocation takes on less risk over time. This means it goes down slower when markets fall, but also up slower when they rally. Over this period, the investor would have seen a cumulative return of 28.6%, which averages out to 2.7% per year. Even in a pretty unlucky environment, still positive returns. Growth of First $1 Invested, 2000-2009 At the very end it avoids the crash a bit, not because we saw it coming, but because it wasn’t appropriate to take on lots of risk so close to the goal date. Note that the portfolio still experienced drawdowns along the way, in fact, for most of the first three years. Would you have stuck with Betterment through that period? Savings Advice In the beginning, it seems possible the investor would hit her target with no savings, given the $100,000 starting balance. Of course, we realize markets rarely deliver average returns: It bounces up and down around the average. Early on in this goal, market returns are below average (global stock markets measured by the ACWI ETF dropped nearly 50%), and so the probability of achieving her goal dips below 50%. Probability of Success, 2000-2009 This causes our advice to change: Our response is to do the one thing that’s guaranteed to improve the investor’s odds—increase her monthly savings amount. Starting in late 2001 (during the crash) through mid-2003, we’d recommend an increasing savings amount—up to $250 a month. At that point, the market starts increasing rapidly. Recommended Monthly Savings Amount, 2000-2009 Rather than reduce savings, we view this as a chance to increase the probability of the investor achieving her goal. Results: Portfolio Value But, here is the key graph—the portfolio value. In this case, the investor was aiming for a final value of $150,000. As you can see, even with savings, the portfolio value was flat for the first three years. That would have been a long time to stick with an investment manager, even if this was just what global markets were doing. Starting in 2003, the stock market takes off, and the combination of savings plus returns gets us to our goal in 2007, two years early. However, if the investor had stayed invested, she’d have experience a pretty dramatic, significant drawdown toward the end. But because Betterment was recommending decreasing risk, it’s not a big deal. And, even despite the 2008 crisis, she reaches her goal. Portfolio Value, 2000-2009 Even better than probability of success is projected shortfall in a bad market, given the current balance and savings rate. We can see below that while the crash in 2008-09 definitely hits the balance, the expected shortfall from our goal is relatively minor. Shortfall Amount, 2000-2009 As time time horizon reduces, and the portfolio risk reduces, we decrease the uncertainty of the outcome. The graph below depicts, for any point in time looking forward, the expected range of outcomes at the target date. The range does follow portfolio returns and savings paths, but is always decreasing at the effects of time and portfolio risk reduce. Uncertainty Reduces Over Time, 2000-2009 A good financial advisor is always updating advice to take into account your current situation and goals. This might mean adapting to setbacks and unlucky outcomes, but being proactive about what clients need to do in order to get back on track. It’s almost guaranteed you’ll have losses in your portfolio at some point in time, so it’s critical to plan for how those setbacks impact your plan. While Betterment can’t guarantee risk-free high returns, we can guarantee we’ll always be giving you advice that’s personalized to your goals and circumstances, and completely up to date. A word about backtested performance data: These results are hypothetical and past performance does not guarantee future results. The Betterment portfolio historical performance numbers are based on a backtest of the ETFs or indexes tracked by each asset class in a Betterment Taxable portfolio. All percentage returns include the Betterment fee (0.15% for $100,000 or more, charged quarterly), standard rebalancing, reinvesting dividends and the expenses of the underlying ETFs. All values are nominal. Monthly contributions are assumed to be made at the beginning of the month. Performance returns are calculated using the time-weighted rate of return methodology that ignores cash flows. We've updated our pricing structure since this article was published. Learn more at betterment.com/pricing. Data and performance returns shown are for illustrative purposes only. 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 individual investor performance has and will vary depending on the time of the initial investment, amount and frequency of contributions, and intra-period allocation changes and taxes. Please see additional details at: https://www.betterment.com/returns-calculation/.

The Right Way to Gauge Investment Returns Of course you know what your portfolio earns. Or do you? Here’s the best way to gauge your returns, so you always make the smartest choices. Did you know that most investors don't know their own returns?1 It’s not because they don’t read the numbers, but because there’s a widespread misunderstanding about how to calculate your true net returns. Studies have shown, for example, that most people care more about raw returns than anything else. Unfortunately, this isn't actually the return you should care about, and it can lead you astray. Only looking at the raw return can skew your perceptions about your portfolio and lead you to make bad choices—such as taking on an inappropriate level of risk or misplacing expectations—which can impede your investing goals. In fact, there are several important factors to consider when evaluating how your portfolio has performed. This guide will help you reach the right conclusions when judging historical investment returns. By following these steps, you’ll avoid the errors many investors make, and you will correctly infer how well your portfolio has performed, and how it compares to others. The steps outlined in this detailed primer can be read in order, or you can click down to the topics that are most relevant: Use the Right Returns Total returns, not price returns Real returns, not nominal returns After tax, not pre-tax returns Adjust for Risk Market risk (beta) Manager risk (negative alpha) Adjust for cash flows Adjust for Time Ignore short-term returns Annualize returns before comparing them Adjust for Costs Transaction fees Expense ratios Bid-ask spreads Entry/exit fees Trading costs 1. Use the Right Returns Total returns, not price returns One of the most common errors investors make is to consider price returns, not total returns. The total return includes not only the change in price of your securities, but also the dividends or coupons they’ve paid out over the time you’ve held the investment. Figuring out total returns can be a challenge to individual investors, as most news reports and brokerage return figures are based on price returns only. For example, over the past year the S&P 500 has had a price return of 29.7%, but a total return of 32.3%. This implies a dividend return of 2.6%, which is just slightly above historical averages. Not using the total return when assessing performance means that you could incorrectly penalize investments which have a higher proportion of their total return due to dividends. And remember, reinvested dividends experience the power of compound growth as well. The graph below depicts the total return and price-only return of the S&P 500 since 1993. The total return growth of a $100,000 portfolio is $514,237 as of January 2, 2014, while the price-only growth is $316,294—a difference of 63%. Put into annual return figures, the price-only return is 8.2% while the total return is 10.2%. There are six months over this time period when the price return was negative, but the dividends pushed the total return into positive territory. Thus dividends can make the difference between what appears to be a negative return and a positive return. Just as important, the total return gives you a more accurate sense of how risky or not certain assets were. Real returns, not nominal returns To get the most accurate returns, you also have to factor in the bite of inflation, especially when comparing returns from different time periods (or different geographies). A stock that returned 20% in 1920 Weimar Republic, for example, still wasn’t as good an investment as a loaf of bread or a shovel. More relevantly, in 2011 when inflation was an average of 3%, investment returns had to be higher in order to increase wealth in real terms when compared to 2013, with inflation at 1.2%. In other words, inflation can affect the risk/return profile of any asset, including cash. Money stashed under the bed is virtually certain to lose value over time. Savings accounts seem to provide a certain guarantee that equities and bonds don’t. In reality, while savings accounts may guarantee your nominal investment, they are also guaranteed to steadily erode your real wealth over time. By including inflation, you can pinpoint real returns, which is a more accurate gauge of growth than nominal returns. After tax, not pre-tax returns Finally, most investors care about the growth in wealth which they (as opposed to the government) actually benefit from. But estimating your net-of-tax return can be tricky, as the short-term capital gain you realize in February won’t be taxed till the following April—but it will be taxed. As such, you should consider your portfolio’s returns after you’ve deducted the amount of tax you’ll have to pay on it. (Note that this only applies for taxable portfolios.) There are generally three sources of tax-drag on your portfolio: Ordinary income tax vs. capital gains tax: Although qualified dividends (generally from large, U.S. companies) are taxed at a reduced rate, other income generated by your portfolio, be it bond interest or non-qualified stock dividends, will be taxed at your highest marginal income tax rate. Given that your income tax rate will generally be the same as, or higher than, your capital gains tax rate, it’s important to bear in mind that the same dollar return is likely to give you a higher after-tax return if it comes from capital gains rather than other investment income. Short-term capital gains vs. long-term capital gains: Capital gains on investments which you’ve sold after holding for a year or less (short-term) are taxed at a higher rate than those you’ve held for more than a year (long-term). Strategies which realize short-term capital gains are therefore penalized up to an additional 20% on such gains, versus strategies that favor holding for more than 12 months. This is a major reason why frequent trading can lose any lustre once returns are calculated on an after-tax basis. Those costs may be invisible until next April, but they are there. Taxes now versus taxes later: In general, the longer you defer taxes, the longer that money you’ll eventually part with can work for you in the meantime. Even long-term capital gains are taxed when you realize them, and so avoiding realizing capital gains has its own benefit—greater tax-deferred growth. Strategies which defer taxation can therefore be better, all else being equal, than those which realize capital gains. If you realize your gains at a point when you have a relatively low marginal tax rate (if you take a year off, or in retirement), you could owe as little as zero capital gains tax, meaning you pay zero tax on that portion of your returns. 2. Adjust for Risk When comparing two different investments, you must consider how much risk you took on to achieve the returns of each. Consider two investors, Jake and Debbie. Jake achieved a return of 7% this year, and Debbie achieved 6%. You might say that Jake performed better than Debbie, but Jake had a very risky portfolio, in which he had a chance of losing more than 50% of his investment, and had to endure a bumpy ride throughout the year. Meanwhile, Debbie had a zero-risk investment with no drawdowns. In other words, Jake bore a lot of risk and stress to earn a 1% higher return. So in fact Debbie’s portfolio performed better—i.e. had higher risk-adjusted returns—than Jake’s did. There are generally two sources of risk you should consider—market risk, and idiosyncratic manager risk. Market risk (beta) Market risk is uncertainty and volatility due to the financial markets as a whole. Most stocks are all fairly correlated with each other—whether or not expectations for the world economy are positive or negative. This single source of risk—or market beta—drives the vast majority of stock returns, and most stocks are subject to it. Thus, the amount of stocks in your portfolio will determine how sensitive it is to beta. So the first thing you should do is consider how much of your portfolio’s return was due to beta. It’s not correct to compare a portfolio with a beta of 90% to a portfolio with a 70% beta unless you adjust for the fact that one has a higher risk exposure than the other. To compare returns with different levels of risk, econometricians use a metric called a Sharpe ratio, defined as the excess return2 of the portfolio divided by the standard deviation of the return (the volatility). Thus, if two portfolios receive the same return in a given time period, the one with the lower volatility will be awarded the higher Sharpe ratio—it has achieved the higher return with greater certainty. Manager risk (negative alpha) While investing in a well-diversified market portfolio means that you have a controlled exposure to market risk, many investors use managers who actively deviate from holding a market portfolio. This often means you hold a subset of stocks or bonds which reflect the manager’s views. As a result, they are taking on idiosyncratic manager risk, i.e. the greater variance in outcomes associated with using an active manager. This risk is independent of the beta in your portfolio. As we discussed above, you should only take on more risk when you expect higher returns in exchange. Unfortunately, as we found in our white paper with Rick Ferri, A Case for Index Fund Portfolios, the expected return of bearing manager risk is negative. Active mutual funds are riskier, and have lower expected risk-adjusted returns than a passive portfolio. Another key insight from this white paper is that the time frame matters. Over a shorter period, you may conclude that a given manager has skill. But over a one-year period, odds are just over 50% that an active manager will underperform the index. Over five years, that rises to 77%, and over 15 years, 83%. So one year of good performance is a weak indicator that the manager is a long-term winner. When assessing your portfolio’s performance, and comparing to an active manager, it’s important to consider this manager risk factor. You took an extra chance by using a manager—you should be consistently rewarded with above-average returns for that risk. If your manager doesn’t outperform consistently, it’s probably not worth the risk. Adjust for cash flows Finally, we should mention that you, the investor, are also a manager. You could be making deposits and withdrawals over the course of the year, and these cash flows mean that you may experience different overall returns than a buy-and-hold portfolio. Significant amounts of cash flows may result in a positive or negative behavior gap, i.e. the difference between the returns of the market (assuming a buy-and-hold strategy), and the actual returns you the investor received, based on your behavior. Research has shown that the riskier the fund, the greater the behavior gap. While we can’t completely prevent bad behavior, Betterment’s customers have the lowest measured behavior gap we know of. 3. Adjust for Time The period of time you’ve been invested is perhaps one of the trickier but more important adjustments to be made. The two things to keep in mind are to not trust short-term returns, and always annualize returns to compare like-for-like. Ignore short-term returns A very liberal definition of “short-term” means anything less than three years of monthly return data (36 observations) just to look at an investment on its own. A conservative definition is about 12 years. And If you want to compare two investments, you may need twice that amount of time. While we can’t completely prevent bad behavior, Betterment’s customers have the lowest measured behavior gap that we know of. Why shouldn’t you trust short-term returns? The shorter the period of time, the higher the chance you have of coming to the wrong conclusion. There is too much randomness in short-term returns to make them reliable. It’s very easy to have a diversified portfolio be beaten by any of its constituents in the short-term—only to beat all its constituents in the long-term. Looking at short-term returns is like performing a statistical test with very little data—you just can’t have any confidence in the results. Annualize returns before comparing them Second, you should always annualize returns. For example, imagine you had a two-year return of 25%, and were comparing it to a three-year return of 30%. Which one is better? Clearly, the 30% is larger, but it’s also had more time to grow. What would the 25% return be equivalent to over three years? If you annualize the returns using the equation below, you’ll find that in this case, the two-year return is equivalent to an annual return of nearly 12%. The three-year return is equivalent to an annual return of 9%. So adjusting for the amount of time you’ve been invested, the two-year actually has better performance. Annual return = ((1 + return / 100)  ^ (1 / years invested) - 1) x 100 Two-year example: 11.8% = ((1 + 0.25) ^ (1 / 2) - 1) x 100 Three-year example: 9.1% = ((1 + 0.30) ^ (1 / 3) - 1) x 100 4. Adjust for Costs Every investment has its own costs that an investor must pay in order to get access to its returns. Therefore, any comparison of returns that fails to account for all costs associated with the relevant investment products is misleading. Let’s take a look at some of the costs most commonly encountered by individual investors: Transaction fees: This is money you pay to trade a security, and you’ll usually pay about $5-$20 for a discount broker, and often $150 or higher for a full-service broker. Given that you’ll sell at some point as well, consider these costs doubled. Moreover, as you accumulate wealth, you’re likely to want to add to your holdings, and $10  every time you want to put a little away can really add up. There are some brokers that offer some free ETF trades, but these carry limitations—typically only a limited number of trades are allowed, and only a limited range of ETFs are available. Expense ratios: This is the total annual amount of a fund’s assets that is used to cover its operating costs—including administrative, management and advertising costs. Both mutual funds and ETFs have expense ratios, but returns are normally stated net of this cost. One thing to remember, however, is that indices, such as the S&P 500, are not actual investable assets. Thanks to great innovations such as Vanguard’s VOO, you can get very close to true S&P 500 returns—but you’ll still have to pay an expense ratio for an index fund that tracks the S&P. Bid-ask spreads: This charge is also a trading cost of sorts; you can think of it as money lost to friction each time you trade. The bid-ask spread is simply the difference between the ‘buy’ and the ‘sell’ price available at market. For the most liquid securities this is normally only a few hundredths of a percent, but can be much higher in extremely volatile or illiquid markets. For micro-cap stocks, for example, the bid-ask spread can be huge, and stocks may have to increase by several percent—or even much more—before they can be sold at a profit. Entry/Exit fees: Also known as sales fees, load fees are particularly nasty charges that are commonly 5% of assets or more. You pay a front-end load when you buy the fund, or a back-end load when you sell it. Here’s the real kicker: Current research shows that mutual funds with a load fee actually underperform those with no load fee, even taking into account the loads themselves. Thus, load fees should be avoided at all costs, and if your advisor or broker recommends one to you, you should think about whether their incentives are conflicting with yours. Other fees to consider are advisory fees, subscription fees, or brokerage maintenance fees that aren’t tied to specific assets and so can’t reasonably be included in returns when those are reported. But if you’re paying those costs, they are nipping into your returns. Remember: any percentage you save in these costs will 100% go towards increasing your returns. Your returns, the full picture When you add up all the points above and calculate how, in concert, they all may have an impact on your returns, you can see why looking at just your portfolio’s raw returns is not an effective way to understand performance. And while it may seem that these numerous factors would mostly eat into your final returns, the more useful perspective here is to remember that your focus—and ours—is to optimize investing returns and inoculate your portfolio’s growth against the potential hits from taxes, idiosyncratic risk, costs, and so on. By being aware of each of these and how they operate you can better protect your returns and feel more confident about reaching your investing goals. Patrick Burns contributed to this post. 1Glaser, Markus and Weber, Martin, Why Inexperienced Investors Do Not Learn: They Do Not Know Their Past Portfolio Performance (November 15, 2007). Finance Research Letters, Vol. 4, No. 4, 2007. 2An excess return is the return above and beyond that achievable from investing in a risk-free asset. For instance, if a portfolio has an 8% return over a period of time when the risk-free rate is 2%, the portfolio’s excess return is 6%.