In the realm of investment management, the construction of portfolios significantly influences financial outcomes. Betterment, a leader in the online investment space, adopts a systematic approach that is grounded in empirical evidence and strategic decision-making. This article explores the key elements of Betterment’s methodology, highlighting its aim to maximize returns for clients while aligning with their individual financial goals.
Table of Contents:
Key components of Betterment’s portfolio methodology
At the core of Betterment’s strategy lies the Core portfolio, which serves as the foundational model for all client investment portfolios.
This Core portfolio is globally diversified, and subsequent portfolios are tailored through specific adjustments that reflect varied investment objectives. These adjustments may involve increasing allocations to value stocks, innovative companies, or adhering to Socially Responsible Investing (SRI) criteria. Understanding the underlying principles of asset selection and optimization is essential to grasping Betterment’s comprehensive approach.
Global diversification and asset allocation strategies
A critical goal in constructing an effective portfolio is achieving optimal asset allocation, which refers to how investments are distributed across various asset classes. Betterment utilizes concepts from Modern Portfolio Theory, pioneered by economist Harry Markowitz, emphasizing that the performance of an asset should be evaluated in the context of a cohesive portfolio. This theory advocates for maximizing returns while managing risk, quantified through volatility.
To formulate a well-rounded portfolio, Betterment begins with a broad spectrum of investable assets, envisioned as a global market portfolio. This involves analyzing a range of exchange-traded funds (ETFs) that represent distinct asset classes, allowing for a diversified and balanced approach. The portfolios typically encompass U.S. stocks, international developed market stocks, and bonds of varying types, including U.S. treasury bonds and municipal bonds.
Portfolio optimization techniques
Once the asset classes are selected, Betterment employs advanced techniques to optimize portfolios for clients. This process is not merely about creating a few generic investment options; instead, it enables customization across 101 distinct risk levels. By leveraging Capital Asset Pricing Model (CAPM) principles, Betterment aims to achieve the best possible return for the amount of risk an investor is willing to accept.
Understanding risk and expected returns
The essence of Betterment’s optimization strategy revolves around estimating various financial parameters, including expected returns and covariance among assets. This enables the determination of portfolio weights that strike an appropriate balance between risk and reward. Instead of relying solely on historical averages, which can be misleading, Betterment uses CAPM to assess anticipated returns based on the asset’s contribution to overall portfolio risk.
Moreover, the firm has evolved its methodology by integrating a custom benchmark into its portfolio optimization process. This benchmark, derived from a combination of global stock and bond indices, ensures that portfolios remain aligned with market expectations while enhancing potential for diversification. By establishing clear benchmarks, Betterment can effectively manage the risk of performance divergence between its portfolios and market indices.
Exclusion of certain asset classes
While the objective of modern portfolio theory is to include a wide range of asset classes, Betterment strategically excludes certain types. For instance, commodities and natural resources are omitted due to their limited contribution to a balanced risk-adjusted return. Similarly, while real estate investment trusts (REITs) are often championed as a separate asset class, Betterment incorporates real estate exposure within its stock allocations, thereby avoiding an over-concentration in this sector.
Through this methodical approach, Betterment is able to craft portfolios that not only aim for maximum returns but also consider the inherent risks associated with various investments. This attention to detail and research-driven decision-making shapes how clients can engage with their financial futures.
Betterment’s portfolio construction process showcases a thoughtful blend of diversification, asset allocation, and optimization techniques that aim to provide clients with robust investment strategies. By adhering to proven financial theories and continuously refining their methodologies, Betterment empowers individuals to invest with confidence and clarity.
