Performance

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Allocation Advice for Betterment Portfolios
Unlike the risk questionnaires, our algorithm weights investment time horizon and downside ...
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 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 Keys to Understanding Investment Performance
Ignore the headlines, think global, and crunch these three often-overlooked numbers.
The Keys to Understanding Investment Performance Ignore the headlines, think global, and crunch these three often-overlooked numbers. In 10 seconds Knowing how to evaluate your investment performance and interpret market news can help you avoid costly mistakes. Don’t make decisions based on headlines. Focus on progress toward your goals and compare your performance to suitable benchmarks. In 1 minute As an investor, you want to make wise financial decisions. Naturally, a lot of people follow financial news to stay informed about what’s happening in the market. But if you’re chasing headlines, you might wind up making some common investment mistakes. You might compare your portfolio to the wrong benchmarks. Or assume the market is performing better or worse than it actually is. If you have a globally diversified portfolio, most financial news is just noise—and you’re better off tuning it out. Constantly buying and selling stocks may seem like the best way to beat the market, but a diversified portfolio will often perform better over a longer time. Frequent trading can leave you stuck paying short-term capital gains taxes that cut into your after-tax return. Want to know how your portfolio is really doing? Instead of comparing your investments to a local benchmark like the Dow, S&P 500, or Russell 3000, consider using a global benchmark like the MSCI All Country World Index. In 5 minutes In this guide we’ll: Highlight the problems with reacting to financial news Explore a simulation about short-term investment decisions Explain a better way to evaluate your performance As an investor, it’s easy to get caught up in the noise about the US market. But constantly reacting to the news and attempting to time the market will probably hurt your performance. Want a better shot at reaching your financial goals? Don’t make decisions based on headlines. And if you have a globally diversified portfolio—like one with Betterment—avoid the trap of using US stocks as a baseline. Caution: following financial news can lead to bad decisions You can’t completely avoid news about the financial markets. The challenge is to know when to react and when to leave your investments alone. As you follow the buzz, here are three fallacies to avoid. 1. The Dow Fallacy Benchmarks like the Dow Jones Industrial Average are popular, but they don’t actually tell you much about the stock market. The Dow only represents 30 US stocks. And even larger benchmarks like the S&P 500 don’t give you a full picture of the US market—let alone the global market. 2. The Points Fallacy It’s common to hear reporters and investors talk about how many points a benchmark has dropped. Headlines like “Dow loses 500 points” sound pretty unsettling. And they’re meant to be. But points alone don’t tell you much. It’s far more valuable to look at the percentage. If the Dow is at 35,000 points, a 500 point drop is less than 2 percent. That’s not something long-term investors need to worry about. 3. The Urgency Fallacy News writers often use overly urgent and dramatic language to grab your attention. Headlines like “Dow Jones Plunges” or “The Five Hottest Stocks to Invest in Today” may get more views, but they won't necessarily help you make good financial decisions. It’s true: the market changes quickly. But if you do what every headline seems to tell you, odds are you’ll actually see worse performance. Can you beat the market with better timing? News headlines would often have you believe that with the right timing, you can beat the market. But is it true? Can savvy market timing beat a buy-and-hold strategy with a diversified portfolio? Market timing almost never works in your favor, especially based on headlines. Instead of trying to time the market, you’re better off trying to maximize your time in the market. Even if you manage to get a win now and then, a globally diversified portfolio and a buy-and-hold strategy typically makes more consistent gains that pay off over time. Not to mention, when you sell stocks you’ve held for less than 12 months, you have to pay short-term capital gains taxes. These eat into your margins fast, reduce the impact of compound interest, and can dramatically change your total returns. When you consider after-tax returns, market timing will almost always lose to a hands-off approach with a diversified portfolio. How to evaluate your investment performance Whether you’ve been trying to time the market or maximize your time in the market, you want to know how your portfolio is actually doing and if you’re on track to reach your goals. Unfortunately, you can’t just look at your earnings. Accurately measuring your progress means adjusting for three crucial variables: Dividends Inflation Taxes The Federal Reserve publishes inflation data, so you can adjust your total returns based on annual inflation. Reinvested dividends can make a big impact over time. And taxes vary by individual and account type. These factors make a big difference when it comes to measuring performance. But what if you want to know how you’re performing relative to the market? Instead of falling into The Dow Fallacy, your best bet is to benchmark against the MSCI All Country World Index. It’s a much better representation of how the entire market is doing, so you can get a clearer picture of how your portfolio has performed. -
How Does Betterment Calculate Investment Returns?
Understanding and using time-weighted and money-weighted returns within your Betterment ...
How Does Betterment Calculate Investment Returns? Understanding and using time-weighted and money-weighted returns within your Betterment dashboard. Investors often want a simple answer to a seemingly simple question: how is my money doing? While it’s relatively easy to calculate any one performance figure, understanding it and knowing how to use it can be more of a challenge. When you log in to Betterment, we calculate the following return metrics under “Performance” for each of your goals: A time-weighted return Two money-weighted returns: simple return and internal rate of return Here, we try to help you better understand each way of looking at returns, when you should use each measure, how to compare them, and the dangers of misunderstanding them. We even provide an interactive calculator (see below) that you can use to test with the different calculations. Time-Weighted Return Time weighted returns are the most common way investors will see a return communicated. A time-weighted return can be thought of as the return on the initial balance of an investment over a certain period. For example, investing $1 in the S&P 500 for one year. Common indices, such as the S&P 500, are reported in time-weighted returns. Time weighted returns can refer to a price-only return, or a total return (price and income/dividends). Price returns reflect only the change in price of the asset, while total returns reflect both price and reinvested income. By default, Betterment displays total returns. If you have an investment account in which you, the investor, control the cash flows into and out of the portfolio, and you want to judge the performance of the investments without the distortion introduced by your cash flow timing, you should use a time-weighted return. For that reason, it is the only method you should use to compare the performance of different investments or of a single investment against a benchmark, making it the industry standard return methodology for financial advisors. Money-Weighted Returns: Two Measures 1. Internal rate of return If you want to judge the overall performance of an investment including both investment returns and timing of cashflows, then you should use a money-weighted return. This is true if you use an investment manager who controls when cash is invested, or if you are managing cash flows yourself and wanted to check your performance. The math gets more complicated here, but the concept is simple: When there is more money in the account, its performance is given more weight than when there is less. That way, an investment that has a lot of your money invested when your portfolio is appreciating, and then only a little when it is depreciating, will have that good timing (or good luck!) reflected in a money-weighted return. It almost never makes sense to compare internal rates of return across accounts or managers, since it includes differences resulting from both your cashflows and differences in investment performance. 2. Simple Return The return on an investment is most simply defined as the amount you gained as a percentage of the amount you invested. The simple return is a good back-of-the-envelope calculation that can work perfectly when you’ve only made a single investment, but in most common circumstances will not be a good judge of the growth of your portfolio. If you invested $100,000, and after a year you have $110,000, you can safely describe your return as 10%. But, consider what happens if you were to invest an additional $400,000 at the end of that year. Using the same calculation, you’d now find your simple return to be 2%. Did your investment performance suddenly drop by 8%? Thankfully, no. That is the major limitation of a simple return—it treats all of the deposits into an investment account as having happened at the same time as the first deposit. For more information on Betterment's approach to designing how your investment returns appear in our digital advice, read about our principled display approach.
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How Much Are You Losing To Idle Cash?
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. -
How Betterment Helps Keep You on Track Through Tough Markets
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
The Right Way to Gauge Investment Returns Of course you know what your portfolio earns. Or do you? 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. 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. 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. 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%.
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