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Wednesday, November 29, 2023

The Recommended Allocation To Keep Up With Inflation Has Changed

At Betterment, we are routinely evaluating our investment strategies to help you achieve your financial goals. As part of that routine evaluation process, we have recently updated our recommended portfolio allocation for goals that seek to keep up with inflation.

Goals like our Safety Net goal or an emergency fund are designed to be an account you can withdraw from in the case of an unexpected financial situation, such as a large medical bill or the loss of a job. If your emergency money is sitting out of the market and it’s not invested, it runs the risk of losing buying power over time because of inflation. A key risk to this money is that it loses purchasing power as time goes on. A key aim for such goals is to match—or beat—inflation, so that your dollars can keep as much buying power over time as possible.

We updated our recommended allocation for goals that seek to keep up with inflation from 15% stocks to 30% stocks.

Based on updated analysis below that considers the current yield curve and inflation expectations, our recommendation is that a 30% stock portfolio is the appropriate allocation for your emergency funds. The chosen allocation is designed to match our assumptions regarding long term inflation. We revisit these assumptions annually, and our assumption for long term inflation is still 2%. As interest rates have moved lower, the yield on low asset assets has also gone down. Now, an investor must take slightly more risk to achieve a return that may beat inflation.

Just as they have in the past, these economic conditions could change again in the future—which is why we routinely evaluate our strategies over time.

Keeping Inflation At Bay

In order to determine the right level of portfolio risk, we need two key pieces of information:

  • The expected return of the portfolio
  • The expected rate of inflation

Our current inflation assumption is 2% per year. We review our inflation assumptions annually to make sure they reflect the current economic environment, which is always changing.

The expected return of the portfolio has two key components: the risk-free rate and the expected return on risky assets.

Yield on U.S. Treasury bonds determines the risk-free rate. Since U.S. Treasury bonds are backed by the U.S. government, they are considered to be virtually risk-free. We also estimate how much additional return we might expect from holding risky assets, such as stocks or corporate bonds. Putting these two pieces together gives us the total expected return for the portfolio.

As of January 2021, short-term U.S. Treasury bonds were expected to have a 0.10% annual yield. This means that holding these bonds until they mature will produce about a 0.10% annualized return, which is less than the 2% we need in order to combat inflation, based on our current inflation assumptions.

By taking slightly more risk, Betterment seeks to improve on the 0.10% risk-free investment return. Based on our asset class return assumptions, we expect that the total returns for our 30% stock portfolio could potentially be 2.1% after fees*, which is slightly higher than our inflation expectations.

We Recommend A Buffer

Unfortunately, we can’t predict the future, so the actual performance of our 30% stock portfolio may turn out to be different than our projected assumptions.

We can use history to help us understand the range of potential outcomes. Our 30% stock portfolio’s worst performance in a historical backtest would have been -22.9%, during the Great Financial Crisis.**

To help protect against a temporary market drop, we recommend that you hold an additional buffer that’s 30% of your target amount—which generally represents at least three months of normal expenses—to insulate against down markets.

For example, if three months of expenses is $10,000, we recommend that you hold $13,000 in our goal.

Why not just hold cash?

Finally, you might be wondering, “Why not just use a bank account for my emergency funds?” It’s a valid question. After all, money in a checking or savings account isn’t subject to market volatility.

Most traditional bank accounts don’t pay a high enough interest rate to keep up with inflation. The national average interest rate is 0.04%, which is far below the 2% annual return we need in order to simply match inflation. This means that even though the amount of cash you’re holding is stable, its buying power is still declining over time.

We’ll help keep you on track while keeping you informed.

Having funds set aside for emergencies is the cornerstone of any financial plan, since it provides an important cushion against unforeseen circumstances—circumstances that might otherwise require you to dip into a long term account, such as retirement.

In fact, our advisors routinely recommend that the first investing goal our customers set up should be a goal to protect oneself against unexpected costs, like a medical bill, or loss of income.

If you currently have a goal that’s set to the target allocation of our old recommendation—15% stocks—we’ll alert you that your allocation is now considered conservative, and that a more appropriate target allocation for your goal is now 30% stocks. While we won’t adjust your target allocation for you, you’ll be able to adjust your target allocation within your goal either on a web browser or on your mobile app. Before making this update, please note that there may be a tax impact. We’ll show you the estimated tax impact before you complete the change inside of your account.

As the economic environment changes, we will continue to review our recommendations. Because we believe in transparency, we’ll keep our customers updated if economic condition shifts lead to a chance in our advice and recommendations.

* We calculate expected excess returns for the assets in our portfolio by applying a Black-Litterman model, as described in “Computing Forward-Looking Return Inputs” of our Portfolio Strategy article. By multiplying these expected returns by our portfolio weights, we can calculate the gross expected excess returns for the portfolio. We can then calculate the expected total return of the portfolio by adding to the expected excess return our estimate of the forward-looking risk-free rate. In this example, we used the lowest point on the US Treasury yield curve as our assumption. The expected returns are net of a 0.25% annual management fee and fund level expenses, and assumes reinvestment of dividends.This expected return is based on a model, rather than actual client performance.  Model returns may not always reflect material market or economic factors. All investing involves risk, and there is always a chance for loss, as well as gain. Actual returns can vary. Past performance does not indicate future results.

** The Betterment portfolio historical performance numbers are based on a backtest of the ETFs or indices tracked by each asset class in Betterment’s portfolio as of January 2021. Though we have made an effort to closely match performance results shown to that of the Betterment Portfolio over time, these results are entirely the product of a model. Actual client experience could have varied materially.  Performance figures assume dividends are reinvested and daily portfolio rebalancing at market closing prices. The returns are net of a 0.25% annual management fee and fund level expenses. Backtested performance does not represent actual performance and should not be interpreted as an indication of such performance. Actual performance for client accounts may be materially lower. Backtested performance results have certain inherent limitations. Such results do not represent the impact that material economic and market factors might have on an investment adviser’s decision-making process if the adviser were actually managing client money. Backtested performance also differs from actual performance because it is achieved through the retroactive application of model portfolios designed with the benefit of hindsight. As a result, the models theoretically may be changed from time to time and the effect on performance results could be either favorable or unfavorable.  See additional disclosure https://www.betterment.com/returns-calculation/.

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