Investing always involves some degree of risk. However, you should always be able to control how much risk you take.
When your goals are decades away, it's easier to invest in riskier assets. The closer you get to achieving your goals, the more you may want to play it safe.
Betterment's tools help you manage risk and stay on track with your goals.
In this guide you will:
- Explain how Betterment provides assignment advice
- Talk about determining your personal risk level
- Learn about some of Betterment's automation tools to help you manage risk.
- Take a look at our low-risk portfolio
Key to risk management: asset allocation
Investing involves risk, and some risk is good. High risk, high reward, right? What matters is how you manage risk. You want to expand your investment as the market changes. One of the main ways investors manage risk is by Diversification.
You've probably heard the old cliché, “Don't put all your eggs in one basket.” This is the same reason investors use it. We diversify our investments and put our eggs in different baskets, so to speak. That way, if one investment fails, you don't lose everything.
But how do you choose a basket to put your eggs in? And how many eggs would you put in those baskets?
Investors give this process names such as: asset allocation.
Asset allocation involves dividing investment funds between multiple types of financial assets (such as stocks and bonds). Together, these investments form a portfolio.
A good portfolio puts your investment money in the right baskets. This means you are protected against extreme losses when the market is underperforming, but open to windfall profits when the market is strong.
If that sounds complicated, we have good news. Betterment automatically recommends how to allocate your investments based on your personal goals.
How Betterment Provides Allocation Advice
Here are Betterment's recommendations: your financial goals. Each financial goal, such as a vacation or retirement, has its own allocation of stocks and bonds.
Next, let's look at the investment period. This is a fancy term that means “when you need money and how to withdraw it.” It's like a timeline. How long will you invest? Do you release it all at once or little by little?
If you have a down payment goal, you can also withdraw your entire investment after 10 years once you reach your savings amount. But when you retire, you'll probably take gradual withdrawals from your retirement account over many years.
What if you don't have a clear goal?
If you are investing without setting a schedule or goal amount, set your investment period based on your age, with a default goal date of your 65th birthday. Assume that you'll be withdrawing it like a retirement account, but since you don't know when you'll liquidate your investment, you'll need to maintain a slightly riskier portfolio even if you reach your target date.
But you are not the “default” person. So why do we need a default investment plan?
That's why you should have goals. Once you know your goals and time horizon, you can determine the optimal risk level by evaluating possible outcomes ranging from bad to average markets. Our predictive models include many possible futures, each weighted by how likely we believe it to be.
Depending on the criteria, we may be erring on the side of caution because we have a fairly conservative allocation model. Our mission is to help you achieve your goals through steady savings and appropriate allocation, not taking unnecessary risks.
how many Should I take the risk?
The investment horizon is one of the most important factors in determining the risk level. The longer it takes to achieve your investment goals, the more risk you can safely take. Therefore, generally speaking, the closer you are to achieving your goals, the less risk your portfolio will be exposed to.
This is why we use Betterment Auto Adjust. This is a glide path (aka formula) used for asset allocation that becomes more conservative as the target date approaches. We adjust glide path recommended allocations and portfolio weights based on your specific goals and time horizon.
Would you like to take a more aggressive approach or be more conservative? No problem at all. You are in control. You always have the final say regarding assignments and we can show you the expected results.
Our quantitative approach helps us establish a set of recommended risk ranges based on your goals. If you choose to deviate from our risk guidance, we will provide you with feedback on the potential impact.
Take more risks than we recommend. I would like to inform you that your approach seems “too aggressive” considering your goals and time frame. Even if you care more about the downside than the average outcome, it can be very difficult to recover from losses in a portfolio flagged as “too aggressive,” so you may want to take more risk. I warn you not to injure yourself.
On the other hand, if you choose a risk level lower than the “Conservative” band, your choice will be labeled “Very Conservative.” The downside to lower risk levels is that you may need to save more. You should choose a level of risk that matches your ability to stay the course.
Allocation is only optimal if you can commit to both good and bad markets. To give you peace of mind about the short-term risks of your portfolio, we present both very good and very bad return scenarios for your selections over a one-year period.
How Betterment automatically optimizes risk
The benefits of investing with Betterment include: Our technology works behind the scenes Automatically manage risk in a variety of ways, including automatically adjusted allocation and rebalancing.
Auto-adjusted allocation
For most goals, the ideal allocation changes as you get closer to your goal. Our automated tools aim to make these adjustments as efficiently and tax-efficiently as possible.
Deposits, withdrawals, and dividends help guide your portfolio toward your target allocation without having to sell assets. If you need to sell your investments, our tax-friendly technology is designed to minimize potential tax consequences. First, look for stocks with losses. These can offset other taxes. Then sell the stock with the lowest embedded gain (and lowest potential taxes).
rebalance
Over time, the value of individual assets within a diversified portfolio rises and falls, moving away from the target weights that help achieve appropriate diversification. The difference between the target allocation and the actual weights of the current ETF portfolio is called portfolio drift. We define portfolio drift as the sum of the absolute deviations of each super asset class from its target divided by two. These super asset classes are U.S. bonds, international bonds, emerging market bonds, U.S. equities, international equities, and emerging market equities.
A large drift may expose you to more (or less) risk than you intended when you set your target allocation. Betterment automatically monitors your account for rebalancing opportunities to reduce drift. There are several different methods, depending on your situation.
- First, Betterment buys underweight stocks and sells overweight stocks, depending on cash flows such as deposits, withdrawals, and dividend reinvestment. Cash flow rebalancing typically occurs when cash flows are already occurring in and out of the portfolio. We use inflows (such as deposits and dividend reinvestment) to purchase underweight asset classes. This reduces the need to sell and reduces potential capital gains taxes. They then take advantage of outflows (such as withdrawals) by first trying to sell their overweight asset classes.
- Second, if cash flow is not sufficient to maintain the client's portfolio drift within the applicable drift tolerance (Betterment's Form ADV), automatic rebalancing moves your portfolio closer to your target allocation by selling overweight holdings and buying underweight holdings. A buy/sell rebalance reshuffles assets already in the portfolio and requires a minimum portfolio balance (clients can see estimated balances) www.betterment.com/legal/portfolio-minimum). The rebalancing algorithm is also tuned to avoid frequent small rebalancing transactions and pursue tax benefits such as preventing wash sales and minimizing short-term capital gains.
- Allocation change rebalancing occurs when you change the target allocation. Although this may result in the sale of the security and a capital gain, we still utilize tax minimization algorithms to reduce the tax impact. We will notify you of the potential tax implications before confirming any allocation changes. Once you've confirmed that, rebalance to the new target with minimal drift.
If you are an advised client, rebalancing in your account may function differently depending on the customizations your advisor chooses for your portfolio. We recommend contacting your advisor for more information.
Click here for more information. Rebalancing disclosures.
How Betterment reduces risk in your portfolio
Investments like Treasury bills can help reduce risk in your portfolio. However, at some point, including such assets in your portfolio no longer improves your return relative to the amount of risk you take. Better yet, this point is 60% of our stock portfolio. Portfolios with equity allocations of 60% or higher do not incorporate these exposures.
We include a U.S. Ultra Short Income ETF and a U.S. Treasury Bond ETF in our portfolios with less than 60% equity allocation in both the IRA and the taxable version of the Betterment Core Portfolio Strategy.
If you have no stocks in your portfolio (i.e., 100% fixed income allocation), you can take a hint. you probably don't want to worry market volatility. In that case, we recommend investing your entire money in these ETFs.
The Betterment Core Portfolio, which is 100% bonds and 0% stocks, consists of 60% U.S. Treasury bills, 20% U.S. short-term high-grade bonds, and 20% inflation-protected bonds. Increasing the equity allocation within a portfolio reduces the allocation to these exposures. Once the 60% equity allocation threshold is reached, these funds are removed from the recommended portfolio. That allocation reduces the expected return given the desired risk of the entire portfolio.
Short-term U.S. Treasuries generally have low volatility (very moderate price fluctuations) and low drawdowns (losses are short-lived and less severe). The same goes for short-term, high-quality bonds, but with slightly more volatility.
Also note that these asset classes don't always fall at exactly the same time. By combining these asset classes, you can create a portfolio with higher potential yields while maintaining relatively low volatility.
As with any asset, returns on assets such as high-quality bonds include both price return potential and earnings yield. Generally, price returns are expected to be minimal, with the primary form of return coming from income yields.
The yield you receive from Betterment's 100% Fixed Income Portfolio ETFs is the actual yield of the underlying asset, minus fees. We invest directly in funds that pay prevailing market interest rates, so you can rest assured that the yield you receive is fair and in line with prevailing interest rates.
