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Three ways to put your bonus to work Feb 9, 2024 9:15:00 AM Cash windfalls can have the power to supercharge your savings goals. Year-end bonuses are a blessing. And while there’s no guarantee you’ll get one—just ask Clark Griswold—if you do, they can have the power to supercharge your savings goals. So while you wait for that bonus cash, read up on three ways to handle small cash windfalls such as these. Go 50/50: Treat yourself now and save for the future Let’s address the elephant in the room: A lot of us spend the bulk of our bonuses. But there’s a psychological workaround to this temptation: Think of yourself as two people. There’s “present-day” you, flush with cash and eyeing a few items on your wish list. Then there’s “future” you and all of their dreams for major purchases or financial freedom. Since both of you can rightly lay claim to your bonus, the only fair thing to do is split it 50-50. So go ahead: Splurge guilt-free with one half of your bonus, and save the other half. Tax-savvy saving: Use your bonus to get a tax break A lot of companies withhold taxes on bonuses at the IRS-recommended rate of 22%. Less commonly, some companies lump it in with your regular paycheck, and your regular withholding rate applies. Either way, and contrary to popular belief, bonuses aren’t taxed at a higher rate. But seeing your bonus shrink due to any amount of taxes is still rough. Thankfully, you may able to minimize your tax hit with the help of a tax-advantaged retirement account: Boost your 401(k) contributions. In some cases, companies allow employees to make 401(k) contributions with their bonuses. If that’s the case for you, consider funneling “future” you’s half of your bonus into your traditional or Roth 401(k), up to the IRS limits. Traditional for a tax break now, Roth for a tax break later. Max out your IRA. Depending on how much income you make, you may be eligible to deduct traditional IRA contributions from your taxes and/or contribute after-tax dollars to a Roth IRA for a tax break later. Better yet, you have until Tax Day of 2024 to max out your 2023 IRA! Stash the cash: Start earning interest today Tax breaks aren’t the end-all, be-all, of course. In some scenarios, saving your bonus in a high-yield cash account like our Cash Reserve account might take priority. If you lack an emergency fund, for example, or if you’re planning for a major purchase in the near future. However you save or invest your bonus, rest easy knowing you’re striking a good balance between today and tomorrow. Unless your bonus came in the form of jelly, in which case you’re on your own, Clark.

Are bonds right for you? Q&A with Betterment Investing Feb 6, 2024 2:57:06 PM We sat down with Betterment Director of Investing Mindy Yu to have her explain what bonds are and if they are right for your investing goals. Question 1: What's the difference between bonds and stocks? Mindy: A stock represents a share of ownership in a company. Depending on how a company performs, the stock value can rise and fall. A bond is like a loan that you provide to an entity such as a business or government. The entity issuing the bond promises to pay your money back by some specified date (called the bond’s maturity), plus interest that is typically distributed to you on a consistent schedule, such as on a monthly, quarterly, semi-annual, or annual basis. Question 2: Are there risks to investing in bonds? Mindy: First, all investing involves risk. However, bonds have historically been less risky than stocks—but keep in mind with less risk typically comes a lower return on your investment over time. Two common risks associated with bonds are credit risk, the likelihood of a bond issuer paying you back, and interest rate risk, a bond’s sensitivity to changes in interest rates. Bond prices and interest rates historically have moved in opposite directions, as one rises the other falls. Question 3: What are the different types of bonds? Mindy: Some common types of bonds that can be used to create a portfolio include: Investment-grade bonds: These are bonds issued by relatively more creditworthy (less risky) entities. Because they are less risky, these bonds typically have lower interest rates and thus lower income potential. High-yield bonds: These are bonds issued by relatively less creditworthy issuers and because they are less creditworthy, these issuers’ bonds typically carry higher interest rates and enhanced levels of potential income. Treasury bonds: These are bonds issued by the U.S. government which is considered to be one of the most creditworthy issuers. Treasury bonds include T-bills (0-1 years to maturity), Treasury notes (1-10 years to maturity), and Treasury bonds (10-30 years to maturity). Question 4: How do I know if I should invest in bonds? Mindy: There are a few financial goals that bonds may be suited for: Diversification: If you own stocks, bonds could help reduce volatility. This is because the values of stocks and bonds have historically moved in opposite directions. When one rises, the other typically falls. Consistent income: If you are looking for income, bonds may be able to help. This is because the entity issuing a bond typically pays the bondholder interest on some regular schedule. Putting cash to work: If you are looking to preserve the value of your savings, while potentially earning some return over a traditional savings account or CDs, bonds, especially short-maturity bonds, may be a viable option. Question 5: Betterment offers the BlackRock Target Income portfolio. How does it work? Mindy: The BlackRock Target Income portfolio offered by Betterment is built with a diverse set of bond ETFs. Let’s break down what that means: A bond ETF may contain hundreds, sometimes thousands of bonds, and offer broad or targeted exposure to various areas of the bond market without the investor needing to invest in the bonds directly. The BlackRock Target Income portfolio includes a diverse set of bond ETFs with a range of risk levels, helping to mitigate exposure to volatility in the stock market, aiming to preserve wealth, while seeking to generate income. All interest payments, also called dividends, are automatically reinvested to help grow the portfolio’s value. Question 6: Who is the portfolio best suited for? Mindy: Because the BlackRock Target Income portfolio is 100% invested in bond ETFs, it may be better suited for investors with a relatively lower risk tolerance and shorter investment time horizon. This could include investors closer to retirement or with short-term goals. As you decide which investments are right for your goals, keep in mind that while bonds are a lot less volatile than stocks, investing in them is not without risk.

Backdoor Roths and beyond: The four camps who can benefit Feb 6, 2024 10:41:21 AM Roth IRA conversions can unlock serious savings, especially if you find yourself in one of these scenarios. Roth IRAs and their tax-free perks are pretty great—so great that in some scenarios, it can make sense to convert pre-tax dollars from traditional retirement accounts into post-tax dollars in a Roth IRA. This is what’s known as a Roth conversion. You’re effectively taking those pre-tax funds and telling Uncle Sam you’d rather pay taxes on them now in exchange for the benefit of tax-free and penalty-free withdrawals in retirement. And if you need the money earlier, the IRS requires only that you wait five years before withdrawing each conversion to avoid a 10% penalty. So who do Roth conversions appeal to in particular? Four types of people: High earners and the “backdoor” Roth conversion Recent retirees and unwelcome RMDs Early retirees and the Roth conversion “ladder” People experiencing temporary income dips High earners and the “backdoor” Roth conversion Did you know the IRS restricts access to Roth IRAs based on income? Shut the front door! Yes, if your income exceeds these eligibility limits, you can’t contribute directly to a Roth IRA. But as the saying goes, when one door closes, another door opens. A “backdoor,” more specifically. So if you make too much money, fear not – you can contribute indirectly to a Roth IRA via a Roth conversion widely known as a “backdoor” Roth. This entails contributing post-tax dollars first to a traditional IRA, then converting those funds to a Roth IRA. If you’ve never contributed to a traditional IRA before, pulling off a backdoor Roth can be simple, especially if you use Betterment. Open both a traditional and Roth IRA with us, fund the traditional, then convert those funds to your Roth IRA once they’ve settled. Done! If you have any existing traditional IRA funds, however, things get a little more complicated due to something called the pro rata rule. In short, you need to move any pre-tax dollars out of your traditional IRA(s) into an employer-sponsored retirement account like a 401(k) before you can use the account as a backdoor. This gets even more complicated if you have both pre- and post-tax dollars mixed together in your traditional IRA(s). Before going down the road of a backdoor Roth conversion, or any Roth conversion really, we highly recommend seeking the advice of a financial advisor, as well as a tax advisor in certain cases. They can help assess both your current situation and future projections. Recent retirees and unwelcome RMDs The IRS doesn’t let you keep funds in your traditional retirement accounts indefinitely. They’re meant to be spent, after all. So starting at age 73, annual required minimum distributions (RMDs) from these accounts kick in. RMDs aren’t inherently a bad thing, but if your expenses can already be covered from other sources, RMDs will just raise your tax bill unnecessarily. You can get ahead of this and lower your future amount of RMDs by converting traditional account funds to a Roth IRA before you reach RMD age. That’s because Roth IRAs are exempt from RMDs. And as an added benefit, you’ll minimize taxes on Social Security benefits and Medicare premiums later on in retirement. Just make sure you convert those funds before you turn 73, because once RMDs kick in, those amounts can’t be converted. Early retirees and the Roth conversion “ladder” If you want to retire early, even by “just” a few years, you very well might encounter a problem: Most of your retirement savings are tied up in tax-advantaged 401(k)s and IRAs, which slap you with a 10% penalty if you withdraw the funds before the age of 59 ½. A few exceptions to this early withdrawal rule exist, the biggest for early retirees being that contributions to a Roth IRA (i.e., not the gains you may see on those contributions) can be withdrawn early without taxes or penalties, in this specific order: “Regular” contributions made directly to a Roth IRA. As an aside, you can always withdraw these funds tax-free and penalty-free without waiting five years. Once you’ve burned through regular contributions, the IRS allows you to withdraw contributions that were converted from traditional 401(k)s and traditional IRAs! You won’t pay any additional taxes on these withdrawn contributions because taxes have already been paid. But withdrawn conversions (item #2 above) typically are still subject to a 10% penalty if withdrawn before 5 years. Think of this rule as a speed bump in an otherwise swift shortcut. So what does all of this mean for early retirees? Starting five years before they plan on retiring, they can create a “ladder” looking something like the table below (note: dollar amounts are hypothetical). They convert funds each year, pay taxes on them at that time, then withdraw them five years later 10% penalty-free and sans any additional taxes. Time Amount converted Amount withdrawn Source of withdrawal 5 years pre-retirement $40,000 $0 N/A 4 years pre-retirement $40,000 $0 N/A 3 years pre-retirement $40,000 $0 N/A 2 years pre-retirement $40,000 $0 N/A 1 year pre-retirement $40,000 $0 N/A Retired early! 🎉 Year 1 of retirement $40,000 $40,000 5 years pre-retirement Year 2 of retirement $40,000 $40,000 4 years pre-retirement Year 3 of retirement $40,000 $40,000 3 years pre-retirement Year 4 of retirement $40,000 $40,000 2 years pre-retirement Year 5 of retirement $40,000 $40,000 1 year pre-retirement Etc. Etc. Etc. Etc. People experiencing temporary income dips Say you find yourself staring at a significantly smaller income for the year. Maybe you lost your job. Maybe you work on commission and had a down year. Or maybe you had a big tax writeoff. Whatever the reason, that dip in income means you’re currently in a lower tax bracket, and it may be wise to pay taxes on some of your pre-tax investments now at that lower rate compared to the higher rate when your income bounces back. Watch out for potential Roth conversion pitfalls Each of these scenarios requires careful tax planning, so again, we recommend working with a trusted financial advisor and/or tax advisor. They can help you avoid the most common Roth conversion mistakes and take full advantage of this post-tax money maneuver. Our CERTIFIED FINANCIAL PLANNER™ professionals are here to offer on-demand guidance.

The racial wealth gap, and how your investments can help narrow it Feb 6, 2024 8:00:00 AM In celebration of Black History Month, we turn our focus toward the topic of Black wealth. Our goal at Betterment is to make people’s lives better through investing. We believe that wealth-building is one of the most powerful tools to live a better life and lay a path for generations to come. So each February, in celebration of Black History Month, we turn our focus toward the topic of Black wealth. The reality of the racial wealth gap and the path ahead We can’t fully appreciate the importance of building wealth for Black people without acknowledging our collective past and examining its lasting impact. Rising out of slavery did not create equality for Black Americans in 1865. Many factors have created and sustained a substantial wealth gap, including housing discrimination, credit inequality, mass incarceration, inaccessible healthcare and education, and lower-paying jobs. The domino effect of these factors has been powerful over the last century and a half. There are still enormous wealth disparities between Black and non-Black households. According to the 2022 Survey of Consumer Finances, the wealth of the typical Black family ($44,900) was roughly 15% of the typical White family. But all is not lost, and progress can be seen. Housing and business equity were key drivers in the 28% growth of Black wealth between 2019 and 2022. Black businesses employed 1.3 million workers and created 48,000 new jobs in 2020 alone. And while stock equity emerged as the largest disparity in wealth growth across racial groups during the same period, Black Americans make up the fastest-growing group of stock investors. So what now? The racial wealth gap is clearly not just a Black problem, nor can it be solved by individual actions alone. Organizations like the National Advisory Council on Eliminating the Black-White Wealth Gap are at the forefront of developing proposals to address the issue systemically. Other organizations are also making meaningful strides toward progress: Black Girls Code fights to establish equal representation in the tech sector. The National Fair Housing Alliance works to eliminate housing discrimination. The National Urban League works to provide economic empowerment, educational opportunities, and the guarantee of civil rights for the underserved in America. How you can join the movement right now Here at Betterment, we’re committed to supporting individuals through our investing products and our voices. In that spirit, we’ve created two ways for customers to make a difference through their investing: Donate eligible shares from your taxable investing accounts to the NAACP, which advocates for economic policies that support Black entrepreneurs and workers. Invest in companies actively working toward minority empowerment through our Social Impact portfolio.

How much cash is too much cash to be in savings? Jan 4, 2024 12:23:57 PM Cash is great. But can you have too much? And what should you do with it? Let’s find out. The main point: If you have too much cash in savings, you may be missing out on growth from stock or bond investments. Consider having cash in savings for short-term needs and putting the rest into investing accounts. Facts about cash in savings: Cash in savings is liquid, meaning it is easy to access when you need to withdraw it for spending. Cash in savings is also low risk, meaning your money should not decrease in value like stocks if you stay with FDIC insurance limits. But—cash in savings does not have the opportunity to grow compared to cash in stocks and bonds, especially when savings rates are not keeping up with inflation. Finding a balance: To strike the right balance between cash and investments for different needs, consider the following: Cash is a secure option for your emergency fund. Most experts recommend having three to six months of living expenses saved. Cash is the lowest-risk option but you can use a mix of bonds and stock too. Take a close look at your situation and save what feels right for you. After that, take a look at your extra cash. Cash and investments can also be right for your short-term goals. Having cash in savings can be wise for short-term goals (we consider anything under 12 months short-term). But depending on how you’re defining short-term and your risk tolerance, you may consider putting some cash for shorter-term goals in bonds and stocks. Investments can support your long-term goals. For most goals longer than 12 months, consider putting your cash into stock and bond investments. While investing involves more risk, stocks have had greater long-term gains historically than leaving your cash in savings. We have options for you: Open a Cash Reserve account if you’re looking for a secure way to save. It’s a high-yield cash account that helps grow your savings while offering FDIC insurance† up to $2 million ($4 million for joint accounts) through our program banks. Open an investing account for your long-term goals. We’ll help assess your risk tolerance, provide investment recommendations, and make it easy to access expert-built portfolios to get you closer to your goals.

The Betterment Core portfolio strategy Jan 2, 2024 11:30:00 AM We continually improve our portfolio construction methodology over time in line with our research-focused investment philosophy. TABLE OF CONTENTS Introduction Global Diversification and Asset Allocation Portfolio Optimization Tax Management Using Municipal Bonds The Value Tilt Conclusion Citations I. Introduction Betterment builds investment portfolios designed to help you make the most of your money so you can live the life you want. Our investment philosophy forms the basis for how we pursue that objective: Betterment uses real-world evidence and systematic decision-making to help increase our customers’ wealth. In building our platform and offering individualized advice, Betterment’s philosophy is actualized by our five investing principles. Regardless of one’s assets or specific situation, Betterment believes all investors should: Make a personalized plan. Build in discipline. Maintain diversification. Balance cost and value. Manage taxes. To align with Betterment’s investing principles, a portfolio strategy must enable personalized planning and built-in discipline for investors. The Betterment Core portfolio strategy contains 101 individualized risk levels (each with a different percentage of the portfolio invested in stocks vs. bonds, informed by your financial goals, time horizon and risk tolerance), in part, because that level of granularity in allocation management provides the flexibility to align to multiple goals with different timelines and circumstances. In this guide to the Betterment Core portfolio strategy construction process, our goal is to demonstrate how the methodology, in both its application and development, embodies Betterment’s investing principles. When developing a portfolio strategy, any investment manager faces two main tasks: asset class selection and portfolio optimization. Fund selection is also guided by our investing principles, and is covered separately in our Investment Selection Methodology paper. II. Global Diversification and Asset Allocation An optimal asset allocation is one that lies on the efficient frontier, which is a set of portfolios that seek to achieve the maximum objective for any given feasible level of risk. The objective of most long-term portfolio strategies is to maximize return for a given level of risk, which is measured in terms of volatility—the dispersion of those returns. In line with our investment philosophy of making systematic decisions backed by research, Betterment’s asset allocation is based on a theory by economist Harry Markowitz called Modern Portfolio Theory.1 A major tenet of Modern Portfolio Theory is that any asset included in a portfolio should not be assessed by itself, but rather, its potential risk and return should be analyzed as a contribution to the whole portfolio. Modern Portfolio Theory seeks to maximize expected return given an expected risk level or, equivalently, minimize expected risk given an expected return. Other forms of portfolio construction may legitimately pursue other objectives, such as optimizing for income, or minimizing loss of principal. Asset Classes Selected for Betterment’s Core Portfolio Strategy The Betterment Core portfolio strategy’s asset allocation starts with a universe of investable assets, which for us could be thought of as the “global market portfolio.”2 To capture the exposures of the asset classes for the global market portfolio, Betterment evaluates available exchange-traded funds (ETFs) that represent each class in the theoretical market portfolio. We base our asset class selection on ETFs because this aligns portfolio construction with our investment selection methodology. Betterment’s portfolios are constructed of the following asset classes: Equities U.S. equities International developed market equities Emerging market equities Bonds U.S. short-term treasury bonds U.S. inflation-protected bonds U.S. investment-grade bonds U.S. municipal bonds International developed market bonds Emerging market bonds We select U.S. and international developed market equities as a core part of the portfolio. Historically, equities exhibit a high degree of volatility, but provide some degree of inflation protection. Even though significant historical drawdowns, such as the global financial crisis in 2008 and pandemic outbreak in 2020, demonstrate the possible risk of investing in equities, longer-term historical data and our forward expected returns calculations suggest that developed market equities remain a core part of any asset allocation aimed at achieving positive returns. This is because, over the long term, developed market equities have tended to outperform bonds on a risk-adjusted basis. To achieve a global market portfolio, we also include equities from less developed economies, called emerging markets. Generally, emerging market equities tend to be more volatile than U.S. and international developed equities. And while our research shows high correlation between this asset class and developed market equities, their inclusion on a risk-adjusted basis is important for global diversification. Note that Betterment excludes frontier markets, which are even smaller than emerging markets, due to their widely varying definition, extreme volatility, small contribution to global market capitalization, and cost to access. The Betterment Core portfolio strategy incorporates bond exposure because, historically, bonds have a low correlation with equities, and they remain an important way to dial down the overall risk of a portfolio. To promote diversification and leverage various risk and reward tradeoffs, the Betterment Core portfolio strategy includes exposure to several asset classes of bonds. Asset Classes Excluded from the Betterment Core Portfolio Strategy While Modern Portfolio Theory would have us craft a portfolio to represent the total market, including all available asset classes, we exclude some asset classes whose cost and/or lack of data outweighs the potential benefit gained from their inclusion. The Betterment Core portfolio construction process excludes commodities and natural resources asset classes. Specifically, while commodities represent an investable asset class in the global financial market, we have excluded commodities ETFs because of their low contribution to a global stock/bond portfolio's risk-adjusted return. In addition, real estate investment trusts (REITs), which tend to be well marketed as a separate asset class, are not explicitly included in the Core portfolio strategy. Betterment does provide exposure to real estate, but as a sector within equities. Adding additional real estate exposure by including a REIT asset class would overweight the exposure to real estate relative to the overall market. Incorporating awareness of a benchmark Before 2024, we managed the Core portfolio strategy in a “benchmark agnostic” manner, meaning we did not incorporate consideration of global stock and bond indices in our portfolio optimization, though we have always sought to optimize the expected risk-adjusted return of the portfolios we construct for clients. The “risk” element of this statement represents volatility and the related drawdown potential of the portfolio, but it could also represent the risk in the deviation of the portfolio’s performance relative to a benchmark. In an evolution of our investment process, in 2024 we updated our portfolio construction methodology to become “benchmark aware,” as we now calibrate our exposures based on a custom benchmark that expresses our preference for diversifying across global stocks and bonds. A benchmark, which comes in the form of a broad-based market index or a combination of indices, serves as a reference point when approaching asset allocation, understanding investment performance, and aligning the expectations of portfolio managers and clients. In our case, we created a custom benchmark that most closely aligns with our future expectations for global markets. The custom benchmark we have selected is composed of (1) the MSCI All Country World stock index (MSCI ACWI), (2) the Bloomberg Global Aggregate Bond index, and (3) at low risk levels, the ICE US Treasury 1-3 Year Index. Our custom benchmark is composed of 101 risk levels of varying percentage weightings of the stock and bond indexes, which correspond to the 101 risk level allocations in our Core portfolio. At low risk levels (allocations that are less than 40% stocks), we layer an allocation to the ICE US Treasury 1-3 Year index, which represents short-term bonds, into the blended benchmark. We believe that incorporating this custom benchmark into our process reinforces the discipline of carefully evaluating the ways in which our portfolios’ performance could veer from global market indices and deviate from our clients’ expectations. We have customized the benchmark with 101 risk levels so that it serves clients’ varying investment goals and risk tolerances. As we will explore in the following section, establishing a benchmark allows us to apply constraints to our portfolio optimization that ensures the portfolio strategy’s asset allocation does not vary significantly from the geographic and market-capitalization size exposures of a sound benchmark. Our benchmark selection also makes explicit that the portfolio strategy delivers global diversification rather than the more narrowly concentrated and home-biased exposures of other possible benchmarks such as the S&P 500. III. Portfolio Optimization As an asset manager, we fine-tune the investments our clients hold with us, seeking to maximize return potential for the appropriate amount of risk each client can tolerate. We base this effort on a foundation of established techniques in the industry and our own rigorous research and analysis. While most asset managers offer a limited set of model portfolios at a defined risk scale, the Betterment Core portfolio strategy is designed to give customers more granularity and control over how much risk they want to take on. Instead of offering a conventional set of three portfolio choices—aggressive, moderate, and conservative—our portfolio optimization methods enable the Core portfolio strategy to contain 101 different risk levels. Optimizing Portfolios Modern Portfolio Theory requires estimating variables such as expected-returns, covariances, and volatilities to optimize for portfolios that sit along an efficient frontier. We refer to these variables as capital market assumptions (CMAs), and they provide quantitative inputs for our process to derive favorable asset class weights for the portfolio strategy. While we could use historical averages to estimate future returns, this is inherently unreliable because historical returns do not necessarily represent future expectations. A better way is to utilize the Capital Asset Pricing Model (CAPM) along with a utility function which allows us to optimize for the portfolio with a higher return for the risk that the investor is willing to accept. Computing Forward-Looking Return Inputs Under CAPM assumptions, the global market portfolio is the optimal portfolio. Since we know the weights of the global market portfolio and can reasonably estimate the covariance of those assets, we can recover the returns implied by the market.3 This relationship gives rise to the equation for reverse optimization: μ = λ Σ ωmarket Where μ is the return vector, λ is the risk aversion parameter, Σ is the covariance matrix, and ωmarket is the weights of the assets in the global market portfolio.5 By using CAPM, the expected return is essentially determined to be proportional to the asset’s contribution to the overall portfolio risk. It’s called a reverse optimization because the weights are taken as a given and this implies the returns that investors are expecting. While CAPM is an elegant theory, it does rely on a number of limiting assumptions: e.g., a one period model, a frictionless and efficient market, and the assumption that all investors are rational mean-variance optimizers.4 In order to complete the equation above and compute the expected returns using reverse optimization, we need the covariance matrix as an input. This matrix mathematically describes the relationships of every asset with each other as well as the volatility risk of the assets themselves. In another more recent evolution of our investment process, we also attempt to increase the robustness of our CMAs by averaging in the estimates of expected returns and volatilities published by large asset managers such as BlackRock, Vanguard, and State Street Global Advisors. We weight the contribution of their figures to our final estimates based on our judgment of the external provider’s methodology. Constrained optimization for stock-heavy portfolios After formulating our CMAs for each of the asset classes we favor for inclusion in the Betterment Core portfolio strategy, we then solve for target portfolio allocation weights (the specific set of asset classes and the relative distribution among those asset classes in which a portfolio will be invested), with the range of possible solutions constrained by limiting the deviation from the composition of the custom benchmark. To robustly estimate the weights that best balance risk and return, we first generate several thousand random samples of 15 years of expected returns for the selected asset classes based on our latest CMAs, assuming a multivariate normal distribution. For each sample of 15 years of simulated expected return data, we find a set of allocation weights subject to constraints that provide the best risk-return trade-off, expressed as the portfolio’s Sharpe ratio, i.e., the ratio of its return to its volatility. Averaging the allocation weights across the thousands of return samples gives a single set of allocation weights optimized to perform in the face of a wide range of market scenarios (a “target allocation”). The constraints are imposed to make the portfolio weights more benchmark-aware by setting maximum and minimum limits to some asset class weights. These constraints reflect our judgment of how far the composition of geographic regions within the portfolio’s stock and bond allocations should differ from the breakdown of the indices used in the benchmark before the risk of significantly varied performance between the portfolio strategy and the benchmark becomes untenable. For example, the share of the portfolio’s stock allocation assigned to international developed stocks should not be profoundly different from the share of international developed stocks within the MSCI ACWI. We implement caps on the weights of emerging market stocks and bonds, which are often projected to have high returns in our CMAs, and set minimum thresholds for U.S. stocks and bonds. This approach not only ensures our portfolio aligns more closely with the benchmark, but it also mitigates the risk of disproportionately allocating to certain high expected return asset classes. Constrained optimization for bond-heavy portfolios For versions of the Core portfolio strategy that have more than or equal to 60% allocation to bonds, the optimization approach differs in that expected returns are maximized for target volatilities assigned to each risk level. These volatility targets are determined by considering the volatility of the equivalent benchmark. Manually established constraints are designed to manage risk relative to the benchmark, instituting a declining trend in emerging market stock and bond exposures as stock allocations (i.e., the risk level) decreases. Meaning that investors with more conservative risk tolerances have reduced exposures to emerging market stocks and bonds because emerging markets tend to have more volatility and downside-risk relative to more established markets. Additionally, as the stock allocation percentage decreases, we taper the share of international and U.S. aggregate bonds within the overall bond allocation, and increase the share of short-term Treasury, short-term investment grade, and inflation-protected bonds. This reflects our view that investors with more conservative risk tolerances should have increased exposure to short-term Treasury, short-term investment grade, and inflation-protected bonds relative to riskier areas of fixed income. The lower available risk levels of the Core portfolio strategy demonstrate capital preservation objectives, as the shorter-term fixed income exposures likely possess less credit and duration risk. Clients invested in the Core portfolio at conservative allocation levels will likely therefore not experience as significant drawdowns in the event of waves of defaults or upward swings in interest rates. Inflation-protected securities also help buffer the lower risk levels from upward drafts in inflation. IV. Tax Management Using Municipal Bonds For investors with taxable accounts, portfolio returns may be further improved on an after-tax basis by utilizing municipal bonds. This is because the interest from municipal bonds is exempt from federal income tax. To take advantage of this, the Betterment Core portfolio strategy in taxable accounts is also tilted toward municipal bonds because interest from municipal bonds is exempt from federal income tax, which can further optimize portfolio returns. Other types of bonds remain for diversification reasons, but the overall bond tax profile is improved by tilting towards municipal bonds. For investors in states with some of the highest tax rates—New York and California—Betterment can optionally replace the municipal bond allocation with a more narrow set of bonds for that specific state, further saving the investor on state taxes. Betterment customers who live in NY or CA can contact customer support to take advantage of state specific municipal bonds. V. The Value Tilt Portfolio Strategy Existing Betterment customers may recall that historically the Core portfolio strategy held a tilt to value companies, or businesses that appear to be potentially undervalued based on metrics such as price to earnings ratios. The latest iteration of the Core portfolio strategy, however, has deprecated this explicit tilt that was expressed via large-, mid-, and small-capitalization U.S. value stock ETFs, while maintaining some exposure to value companies through broad market U.S. stock funds. We no longer favor allocating to value stock ETFs within the Core portfolio strategy in large part as a result of our adoption of a broad market benchmark, which highlights the idiosyncratic nature of such tilts, sometimes referred to as “off benchmark bets.” We believe our chosen benchmark that represents stocks through the MSCI ACWI, which holds a more neutral weighting to value stocks, more closely aligns with the risk and return expectations of Betterment’s diverse range of client types across individuals, financial advisors, and 401(k) plan sponsors. Additionally, as markets have grown more efficient and value factor investing more popularized, potentially compressing the value premium, we have a marginally less favorable view of the forward-looking, risk-adjusted return profile of the exposure. That being said, we have not entirely lost conviction in the research supporting the prudence of value investing. The value factor’s deep academic roots drove decisions to incorporate the value tilt into Betterment’s portfolios from the company’s earliest days. For investors who wish to remain invested in a value strategy, we have added the Value Tilt portfolio strategy, a separate option from the Core portfolio strategy to our investing offering. The Value Tilt portfolio strategy maintains the Core portfolio strategy’s global diversification across stocks and bonds while including a sleeve within the stock allocation of large-, mid-, and small-capitalization U.S. value funds. We calibrated the size of the value fund exposure based on a certain target historical tracking error to the backtested performance of the latest version of the Core portfolio strategy. Based on this approach, investors should expect the Value Tilt portfolio strategy to generally perform similarly to Core, with the potential to under- or outperform based on the return of U.S. value stocks. With the option to select between the Value Tilt portfolio strategy or a Core now without an explicit allocation to value, the investment flexibility of the Betterment platform has improved. VI. Conclusion After setting the strategic weight of assets in the Betterment Core portfolio strategy, the next step in implementing the portfolio construction process is Betterment’s investment selection, which selects the appropriate ETFs for the respective asset exposure in a generally low-cost, tax-efficient way. In keeping with our philosophy, that process, like the portfolio construction process, is executed in a systematic, rules-based way, taking into account the cost of the fund and the liquidity of the fund. Beyond ticker selection is our established process for allocation management—how we advise downgrading risk over time—and our methodology for automatic asset location, which we call Tax Coordination. Finally, our overlay features of automated rebalancing and tax-loss harvesting are designed to be used to help further maximize individualized, after-tax returns. Together these processes put our principles into action, to help each and every Betterment customer maximize value while invested at Betterment and when they take their money home. VII. Citations 1 Markowitz, H., "Portfolio Selection".The Journal of Finance, Vol. 7, No. 1. (Mar., 1952), pp. 77-91. 2 Black F. and Litterman R., Asset Allocation Combining Investor Views with Market Equilibrium, Journal of Fixed Income, Vol. 1, No. 2. (Sep., 1991), pp. 7-18. Black F. and Litterman R., Global Portfolio Optimization, Financial Analysts Journal, Vol. 48, No. 5 (Sep. - Oct., 1992), pp. 28-43. 3 Litterman, B. (2004) Modern Investment Management: An Equilibrium Approach. 4 Note that the risk aversion parameter is essentially a free parameter. 5 Ilmnen, A., Expected Returns.