Investing for long-term wealth can be a challenging endeavor. However, it does not have to be overwhelming. Focusing on low-cost, globally diversified total market funds can help establish a stable financial foundation. Moreover, sophisticated strategies may yield even better results while minimizing the time and effort required from investors.
One effective strategy involves integrating technology into the investment process through automated investing platforms, such as Betterment. These platforms streamline investment decisions and emphasize tax optimization, a crucial element often overlooked by traditional investing methods.
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Understanding tax-loss harvesting
Tax-loss harvesting is a valuable technique that can significantly benefit taxable investment accounts. This process entails selling an asset that has lost value to offset gains from other investments, thereby reducing taxable income. Traditional total market funds limit this strategy, as losses can only be harvested when the entire fund declines, preventing action on individual asset fluctuations.
Benefits of diversified funds
To address this limitation, Betterment has shifted from a single fund model to employing three distinct funds representing small, medium, and large U.S. companies. This diversification facilitates strategic asset swapping, maximizing opportunities for tax-loss harvesting whenever a specific portfolio segment underperforms.
Strategic asset location
Another area where complex fund lineups demonstrate superiority is in asset location. This strategy allocates various assets across different account types—such as traditional, Roth, and taxable accounts—depending on their growth potential. For example, assets anticipated to appreciate significantly are often better suited for traditional accounts, allowing them to grow tax-free until retirement, when the investor may fall into a lower tax bracket.
Tax coordination for optimized investments
At Betterment, the platform implements a method known as Tax Coordination. This mathematically driven approach to asset location helps investors retain more earnings by ensuring that each asset is placed in the most advantageous account type to minimize tax liabilities. To begin, investors simply need to open a combination of the aforementioned account types and follow the provided instructions.
Target date funds and their limitations
Since their introduction in the 1990s, target date funds have gained popularity, particularly as default options in many 401(k) plans. While they have positively impacted the investment landscape by promoting lower-cost, automated investing, they have notable drawbacks. A significant limitation is the lack of customization. For instance, an individual born in 1988 intending to retire at 62 typically has access to only a single 2050 fund.
Enhanced flexibility with multiple funds
In contrast, Betterment provides a range of portfolios tailored to diverse goals, including those centered on social responsibility and innovation. This expanded selection not only allows for greater customization but also introduces additional avenues for effective risk management. For example, as interest rates rise, the value of bond-heavy portfolios may decline, prompting a strategic increase in exposure to short-term corporate debt and U.S. Treasuries to mitigate risk.
Despite the decreasing costs associated with target date funds—often available at expense ratios below 0.1%—Betterment aims to maximize savings further. By analyzing a portfolio and seeking better fee structures, investors can achieve even lower costs. For instance, instead of paying 6 basis points (0.06%) for a total world stock fund, diversifying into three separate funds may result in significant savings.
For example, considering Betterment’s customers’ collective $20 billion investment in U.S. stocks, this strategy could yield approximately $7.6 million in savings annually. A straightforward portfolio serves as a solid starting point, but by adopting a more nuanced approach, investors can enhance tax efficiency, optimize asset allocation, and possibly unlock additional savings—all automatically. This allows investors to concentrate on building wealth without excessive effort.
