Many investors consider low-cost, globally-diversified total market funds for long-term wealth accumulation. However, adopting a more nuanced approach that includes a variety of funds may yield better results while requiring less mental effort. Platforms like Betterment utilize advanced technology to enhance investment outcomes, beginning with essential tax optimization.
A key strategy to explore is tax-loss harvesting. This technique involves selling an asset at a loss and replacing it with a similar but distinct asset.
The challenge with total market funds is that these investments typically require the entire fund to depreciate to realize a loss. If only a segment of the fund declines, the investor cannot isolate and trade that portion, resulting in the need to sell everything or nothing at all.
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Benefits of a diversified fund approach
In response to these limitations, Betterment has moved from a single fund for U.S. stocks to three distinct funds representing small, mid, and large-cap U.S. companies. This transition enables more flexible investment management, allowing investors to capitalize on harvesting opportunities within specific market segments.
Strategic asset location
Another significant advantage of employing a broader range of funds is the concept of asset location. This refers to the strategic allocation of assets across various account types, such as traditional, Roth, and taxable accounts. For example, assets with high growth potential are often best suited for traditional accounts, where they can appreciate in value without immediate tax implications. This deferral allows investors to postpone taxes until retirement, potentially falling into a lower tax bracket.
Betterment’s unique methodology, termed Tax Coordination, facilitates this strategy. By organizing various account types and following a straightforward process, investors can effectively manage their tax burdens and retain a larger portion of their earnings.
Exploring target date funds
Among the simpler investment options for retirement savings are target date funds. First introduced in the 1990s, these funds gained popularity as default options in many 401(k) plans by the late 2000s. Their introduction has been beneficial, steering the industry toward lower-cost and more automated investing solutions.
However, target date funds also have limitations, particularly regarding choice. For instance, if an individual born in 1988 plans to retire at 62, their investment options are typically limited to one fund—the 2050 fund. In contrast, Betterment offers a more extensive range of portfolio choices, including socially responsible and innovation-focused options.
Managing risk through diversification
A broader selection of funds enhances risk management across various market conditions. For example, rising interest rates can negatively impact bond-heavy portfolios. A diversified approach allows an investor to increase exposure to short-term corporate debt and U.S. Treasuries, which can serve as a hedge against potential losses.
While costs associated with target date funds have decreased, many total market funds can be accessed for less than 0.1% in expense ratios. By segmenting a portfolio and actively seeking the best deals, investors can achieve even greater savings. For example, a total world stock fund costing 6 basis points (0.06%) can be significantly reduced by dividing the U.S. stock allocation into three separate funds, as demonstrated by Betterment’s Core portfolio.
Considering Betterment’s collective $20 billion in U.S. stocks, this strategy could result in approximately $7.6 million in annual savings. While a simple portfolio provides a solid foundation, it may not maximize investment potential. By diversifying funds, investors can enhance tax efficiency, optimize account types, and unlock additional cost savings, all supported by automated processes. This approach combines simplicity with technology managing the complexities behind the scenes.
