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 our Safety Net goal.
Our Safety Net goal is 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. The aim of our Safety Net goal is to match—or beat—inflation, so that your dollars can keep as much buying power over time as possible.
Based on updated analysis below that considers the current yield curve and inflation expectations, our recommendation is that a 15% stock portfolio is the appropriate allocation for your emergency funds. The chosen allocation is designed to match our assumptions regarding long term inflation. A 15% stock portfolio is also considered less risky than the previous allocation recommendation of 40% stocks.
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 for our Safety Net goal, 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 08-12-2019, the lowest yielding U.S. Treasury bonds were expected to have a 1.5% annual yield. This means that holding these bonds until they mature will produce about a 1.5% 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 1.5% risk-free investment return. Based on our asset class return assumptions, we expect that the total returns for our 15% stock portfolio could potentially be 2.3% 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 15% 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 15% stock portfolio’s worst performance in a historical backtest would have been -11.4%, between the timeframe of May 2008 and November 2008 (source: Betterment data).**
To help protect against a temporary market drop, we recommend that you hold an additional buffer that’s 15% 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 $11,500 in our Safety Net 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 0.09%, 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.
High-yield savings accounts and savings account alternatives could potentially be a better option since many of them are currently yielding over 2%. However, because of the close relationship between the Federal Funds Rate and interest rates for savings products, it’s likely that interest rates could decline in the near future. This could mean that even high yield savings accounts might underperform against inflation over the long term.
The below graph shows interest rates as of July 2019, along with a forecast of what they might look like in the future. As you can see, rates may drop below the 2% inflation target in the coming years.
This chart shows the hypothetical future Federal Funds Rate in comparison to the hypothetical future national average savings rate, based on one possible path of future changes in the Federal Funds Rate. The forecasted Federal Funds Rate is based on yield curve data as of 7/26/2019. This chart is hypothetical in nature and based on forecasts. Actual interest earned may differ. Source data: Federal Reserve and FDIC.
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 Safety Net goal.
If you currently have a Safety Net goal that’s set to the target allocation of our old recommendation—40% stocks—we’ll alert you that your allocation is now considered too aggressive, and that a more appropriate target allocation for your goal is now 15% stocks. While we won’t adjust your target allocation for you, you’ll be able to adjust your target allocation within your Safety Net goal either on a web browser or on your mobile app.
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.
** Please see https://www.betterment.com/resources/betterment-historical-performance/ and https://www.betterment.com/returns-calculation/ for more details on how we calculate historical performance. Please note that this figure is based on back-tested data. Backtesting is the process of evaluating a strategy, theory, or model by applying it to historical data and calculating how it would have performed had it actually been used in a prior time period. They do not represent the results of actual trading but were achieved by means of the retroactive application of a model designed with the benefit of hindsight. Backtested performance is hypothetical and does not represent actual performance and should not be interpreted as an indication of such performance. All back-tested performance has a chance for loss and/or profit. Furthermore, clients should be aware that the potential for loss (or gain) may be greater than demonstrated in the backtests. This back-test is based on actual data, and includes the application of Betterments 25 basis points management fee and fund level fees. This assumes reinvestment of dividends, and daily portfolio rebalancing.