Betterment is dedicated to helping individuals optimize their investments through a carefully designed portfolio construction methodology. This comprehensive guide sheds light on the principles that shape the portfolios Betterment curates for its clients, emphasizing systematic decision-making grounded in empirical evidence.
The cornerstone of all portfolio strategies at Betterment is the Core portfolio, which serves as the base for tailored portfolios aimed at achieving specific investment objectives. Adjustments to this foundation include allocations toward value stocks, innovative technology companies, or adherence to Socially Responsible Investing (SRI) principles.
Table of Contents:
Global diversification and asset allocation
An effective asset allocation strategy lies on the efficient frontier, a concept representing portfolios that aim for maximum returns at a given risk level. The primary goal of many long-term investment strategies is to enhance returns while managing risk, defined through volatility, or the variability of returns.
Betterment’s approach to asset allocation is rooted in Modern Portfolio Theory, proposed by economist Harry Markowitz. This theory posits that assets should be evaluated not in isolation, but based on their contribution to the overall portfolio’s risk and return dynamics. The aim is to either maximize expected returns for a specified risk or minimize risk for a targeted return.
Asset class selection
Our asset allocation process begins with a wide array of investable assets, conceptualized as the global market portfolio. We prioritize exchange-traded funds (ETFs) that effectively capture the characteristics of each asset class. The key asset classes in Betterment’s portfolios include:
- Stocks: U.S. stocks, international developed market stocks, and emerging market stocks
- Bonds: U.S. short-term treasury bonds, inflation-protected bonds, investment-grade bonds, municipal bonds, as well as international and emerging market bonds
U.S. and international developed market stocks form the core of our investment strategy due to their historical performance and ability to provide some protection against inflation. While stock investments can be volatile, long-term data suggests that developed market equities tend to outperform bonds when adjusting for risk.
To achieve global investment exposure, we also incorporate stocks from emerging markets, which, while exhibiting higher volatility, enhance diversification and align with our risk-adjusted return strategy.
Exclusions for optimization
While striving to represent the total market, Betterment consciously excludes certain asset classes where the costs or lack of data outweigh potential benefits. For instance, commodities and real estate investment trusts (REITs) are omitted from our portfolios, as their inclusion could lead to an overemphasis on specific areas of real estate and commodities relative to the overall market.
Portfolio optimization techniques
As an investment manager, Betterment’s goal is to fine-tune client portfolios to maximize returns while respecting individual risk tolerances. Unlike traditional models that offer limited options, our optimization method allows for a range of 101 different stock-bond risk levels, providing clients with enhanced control.
Capital market assumptions
To achieve optimal allocation, we employ established techniques based on Modern Portfolio Theory. This involves estimating key variables such as expected returns, covariances, and volatilities, referred to as capital market assumptions (CMAs). By utilizing the Capital Asset Pricing Model (CAPM), we focus on optimizing the return relative to the risk each investor is willing to accept.
Using the CAPM framework, we can derive expected returns based on the asset’s contribution to the overall portfolio risk. The process involves reverse optimization, where we calculate expected returns based on given weights of the global market portfolio.
Constrained optimization strategies
For the portfolios that are heavily weighted towards stocks, we generate thousands of simulated expected returns using our latest CMAs. Each simulation helps identify optimal asset allocation weights while adhering to constraints derived from a custom benchmark.
For portfolios with a higher bond allocation, our optimization approach shifts to maximize expected returns while keeping in line with volatility targets based on benchmark performance. By implementing these strategies, we ensure that portfolios remain closely aligned with benchmark indices, reducing the risk of disproportionate performance variations.
Conclusion
Through a robust portfolio construction methodology, Betterment aims to create diversified investment strategies tailored to meet various client goals. By embracing a systematic approach backed by research, investors can navigate the complexities of the market and work towards achieving their financial aspirations.
