Valuation-Informed Indexing vs. Passive Investing – Which is Better?

This article was selected as one of the top articles in the June 6th, 2011 Best of Money Carnival at Free From Broke.

Well folks, it’s been on my research topics list since January of this year, but during the past several days, I’ve finally been able to perform the detailed comparative analysis the topic deserves.

What topic is this, you’re probably asking? The topic is Valuation-Informed Indexing (or Valuation-Informed Index Fund Investing – however you want to call it). This topic/investing strategy was first introduced to me by Rob Bennett when he guest posted on the subject over at Free From Broke and has been the topic of numerous online and offline discussions in the personal finance world.

Reading Rob’s post really got me interested in this form of investing, because it is sort of an attempt to put a more actively managed role on my current investing strategy of passive investing, but without all of the emotion that normally causes the performance of active investors to suffer. More specifically, I wanted to find out two things after first hearing about Valuation-Informed Indexing. These are described below:

  • Determine the exact method it uses to find out how unbiased and repeatable it is.
  • Perform a long term (approximately 20 years) performance comparison between Valuation-Informed Indexing and passive investing to determine which makes you more money.
    • In this analysis, I would also want to compare risk levels (standard deviations) and attempt to optimize the Valuation-Informed Indexing method. 

So, armed with nothing but a Toshiba laptop, a “why-not” attitude, and a smile, I set off in trying to find some answers to the aforementioned goals.

Note from Jacob: I really get a lot of enjoyment out of these types of post that require putting together a spreadsheet, inputing some interest rate formulas, and analyzing large amounts of historical data. Maybe it is the scientist in me that enjoys this!

What is Valuation-Informed Indexing (VII) and How is it Different from Passive Investing?

Truthfully, it was fairly difficult to figure out the exact method that defines Valuation-Informed Index Investing and makes it different from passive investing. This is most likely due to the fact that it doesn’t yet have a wide following, as opposed to passive investing where there are shelves full of books written on the subject!

However, through study of 1) Rob Bennett’s website about Valuation-Informed Indexing (in particular, his “How To” guide) and 2) Professor Wade Pfau’s preliminary research, I was able to piece together enough information to define the VII method and construct a study.

In a general sense, Valuation-Informed Indexing involves changing your asset allocation targets in response to fluctuations in market prices. What does this mean exactly? It means that you should have a higher equity asset allocation when the market is lower and a lower equity asset allocation when the market is high.

Now, this all sounds well and good. But, the real question is “How do we actually go about doing this in a way that doesn’t introduce investor sentiment and ineffective market timing tactics?” VII has an answer to this too!

A summary of the Valuation-Informed Indexing methodology is summarized below:

  • First, decide on your base asset allocation. For example, in my study, I used 60% equity / 40% fixed income securities.
  • Second, use PE10 data (Current price of S&P500 divided by average inflation-adjusted earnings over the past 10 years) published by Professor Robert Shiller at Yale to change your asset allocation targets based on market fluctuations.
    • When the PE10 goes above 20, switch to 30% equity / 70% fixed income.
    • When the PE10 goes below 12, switch to 90% equity / 10% fixed income.
    • When PE10 is between 12 and 20, use your base asset allocation (60% equity / 40% fixed income, for example).

Application of this strategy is supposed to deliver superior returns at much less risk (standard deviation of returns) than a fixed asset allocation with regular rebalancing (in other words, passive investing).

Existing Findings

The only other numerical studies comparing passive investing to Valuation-Informed Indexing were conducted by Professor Wade Pfau. His preliminary findings can be found here, and the definitive, complete report, can be found at this link.

Wade’s findings reveal that VII provides more wealth for 102 of the 110 rolling 30-year periods from 1870 to 1980. However, in recent years, it appears that the out performance of VII over passive investing is becoming less and less.

As someone in my mid-20’s, the time period I was most curious about was the most recent twenty year period. Additionally, I wanted to test this period because in order for me to be convinced to give up passive investing in favor of Valuation-Informed Investing, I would need to see demonstration of its superiority in a time frame that is more relevant to me.

Lastly, over any 20 year period, it would reason to believe that random, short term fluctuations in the market should be hidden by the correct, overall, long term behavior.

 

Study Methodology

So, now that I’ve explained a little bit about what Valuation-Informed Indexing is in general and what existing research has been done on the subject, we can now get in to the specific investigation that I conducted.

The details of how I set up my analysis are summarized below:

·      Investment Total – For simplicity, we will assume that our investment only consists of a one-time initial purchase of $10,000. Transaction fees, fund expense ratios, and taxes will not be considered in the scope of this analysis.

·        Time Period – January, 1990 to May, 2011.

·        Portfolios – There will be two competing types of portfolios – 1) a Valuation-Informed Indexing portfolio, and 2) a passive investing portfolio. Various parameters within each of the models will be changed in order to analyze performance.

o   The equity portion of the portfolio will consist of shares of an S&P500 index mutual fund. Historical performance data for the S&P500 was taken from Yahoo Finance at the following link – S&P 500 Historical Prices – January, 1990 – Present at monthly intervals.

o   The fixed-income portion of the portfolio will consist of low-risk 1 year Treasury Bills. Historical yield data for 1 year Treasury Bills was taken from FederalReserve.gov Government Fixed Income Investments historical prices.

o   Both of these resources have a handy “export in Excel format” feature to facilitate quick analysis in spreadsheet format.

·        Rebalancing – Rebalancing for the passive investing and VII portfolios will be done monthly (the same as what I do currently). This is different than Pfau’s analysis, which assumed annual rebalancing.

·        Asset allocation changes – The passive investing portfolio will remain at the same asset allocation targets for the duration of the study. However, the asset allocation targets for the Valuation-Informed Indexing portfolio will be adjusted based on the PE10 trigger levels discussed previously.

 

Study Results

The complete results/details of my comparison between VII and passive investing can be found at the following Google Docs Spreadsheet – Valuation-Informed Investing vs. Passive Investing. Rows 1696 and 1697 contain the total return and standard deviation (risk level) for each portfolio.

The table below shows a summary of the portfolio returns and standard deviations of the analysis. Three passive investing portfolios were compared to three different Valuation-Informed Indexing portfolios/strategies. It’s interesting to note that from 1990-2011, the PE10 never fell to the lower trigger point level of 12.

valuation informed indexing time value of money passive investing mutual funds investing individual stocks vs mutual funds index funds carnival of passive investing

As can be seen in the table, passive investing with monthly rebalancing resulted in total returns over the ~20 year time period of 239%, 267%, and 220%, for 60/40, 75/25, and 50/50, asset allocation splits, respectively.

For comparison, three different Valuation-Informed Indexing strategies/portfolios were employed, as described below:

Valuation-Informed Indexing Portfolio 1

  • When the PE10 goes above 20, switch to 30% equity / 70% fixed income.
  • When the PE10 goes below 12, switch to 90% equity / 10% fixed income.
  • When PE10 is between 12 and 20, use your base asset allocation (60% equity / 40% fixed income, for example).

 

Using this strategy, a total return over the time period analyzed was 185% (much less than the 60/40 asset allocation passive investing portfolio).

 

Valuation-Informed Indexing Portfolio 2

Because the total return obtained from Portfolio 1 failed to outperform the passive investing portfolios, I decided to attempt to refine the strategy (because I really do feel that there is potential for this form of investing! We just have to find it!).

Next, I proceeded to take the average PE10 from 1990-May 2011, and saw that the average PE10 was a whopping 25.68. Since this PE10 seems to be higher than we’ve seen historically, I figured that maybe by increasing the upper trigger to 25, a higher return would be seen.

Making this change, the strategy for Portfolio 2 becomes as follows:

  • When the PE10 goes above 25, switch to 30% equity / 70% fixed income.
  • When the PE10 goes below 12, switch to 90% equity / 10% fixed income.
  • When PE10 is between 12 and 20, use your base asset allocation (60% equity / 40% fixed income, for example).

Using this strategy resulted in a total return over the time period of 195% – higher than Portfolio 1, but still much lower than the passive portfolios.

 

Valuation-Informed Indexing Portfolio 3  

In a final effort to increase my returns using VII, I next tried to increase my equity exposure during “high PE10” times to 50% equity/50% fixed income (instead of 30/70 in Portfolio 1 and 2).

Making this adaptation, the strategy for Portfolio 3 becomes as follows:

  • When the PE10 goes above 20, switch to 50% equity / 50% fixed income.
  • When the PE10 goes below 12, switch to 90% equity / 10% fixed income.
  • When PE10 is between 12 and 20, use your base asset allocation (60% equity / 40% fixed income, for example).

Using this strategy resulted in a total return over the time period of 221% – higher than Portfolio 1 and 2, but still much lower than the passive portfolios, with the exception of the 50/50 asset allocation one.

Conclusion – Passive investing outperforms Valuation-Informed Indexing in the past 20 years, but VII displays much less risk. This is consistent with the normal risk/return correlation.   

So, what can we conclude from all of these results and confusing numbers? In my opinion, we can take away several key things.

1)     While Valuation-Informed Index Investing may have outperformed passive investing in most previous historical periods, evidence of it not performing as well in recent years is enough to keep me as a passive investor, at least until VII is refined.

a.      It’s interesting to note that by using the VII methodology, an investor would have been 30% equity / 70% fixed income from January 1995 until September 2008. The investor would have taken on less risk (in the subsequent market crash of 2008-2009) by owning fewer equity shares during this “high price” time. However, he or she also almost totally missed out on the 163% total return during the ~13 year time period.

2)     Valuation-Informed Index Investing has great potential because it greatly reduces the risk to investor returns.

a.      Even though VII failed to outperform passive investing in my analysis, it also provided much less risk, as evidenced by the sharp decrease in standard deviation of the portfolio value over time.

b.     For example, VII Portfolio 1 provides a slightly lower return of 185% over the time period analyzed (compared to the passive investing portfolios). However, the portfolio also has 34%, 55%, and 21% less risk (standard deviation of portfolio value) compared to the 60/40, 75/25, and 50/50 passive portfolios, respectively.

This ability of VII to deliver sufficient (but slightly lower) returns at less risk is what I think is the real power of Valuation-Informed Indexing. I feel that with some refinements, VII can become an effective investing strategy. However, I’m not quite ready to switch over just yet…Thanks for reading!

How about you all? Have you ever tried or heard of Valuation-Informed Index Investing? What are your thoughts about its efficacy? What improvements do you think need to be made? 

Share your experiences by commenting below!

50,000 Total Visitors = Just Awesome!

————————————————————————————————————————
Welcome to My Personal Finance Journey! If you are new here, please read the “About” or “First-Time Visitor” pages to find out more about us. If you would like to receive free updates on articles like this by email, then sign up here or you can subscribe to the RSS feed. Also, check us out on Twitter or Facebook. Thanks for visiting! Keep on learning!
————————————————————————————————————————

yakezie writing contest yakezie challenge yakezie site milestones passive investing carnival of passive investing blogging goals

Click here to enter my free giveaway for 2 copies of H&R Block At Home Premium Edition

Happy Memorial Day to everyone! In the spirit of celebrating success and taking a break on this holiday, I wanted to share something very special that happened to My Personal Finance Journey this past Saturday, May 27th, 2011.

We passed the 50,000 total visitors threshold!

This is very exciting news for all of us here at My Personal Finance Journey, even to Cheapskate Jake, who, to my surprise, hasn’t scared too many people away! Go figure!

It’s been an incredibly fun journey (pardon reference to the site name) to get to where we are today. This site started on January 15th of 2010 (almost a year and a half ago) as a way for me to share what I’ve learned about personal finance and investing and learn from other like-minded folks. I definitely had no idea when I started this site that it would be such a large part of my life and identity.

If I had to venture a guess, I’d say that I’ve spent about 1500 total hours on this blog. Big hint here: if you’re looking for a get rich quick venture, blogging probably isn’t the best for you! During this 1500 total hours, there have been 378 posts written by both myself and various guest posters (we’re not quite to the 500 post mark yet!).

When I think back on this ~1.5 year journey, there have been several accomplishments/actions in particular (other than simply writing posts) that stick out in my mind as being most significant. I’ve listed these below:

  • Joining the Yakezie Personal Finance Network.
    • Joining Yakezie was probably the best thing I ever did as a blogger. Not only have I gotten to meet some amazing friends, but I’ve also been able to learn many things about how to effectively run a website and organize advertising campaigns.
  • Starting the Carnival of Passive Investing.
    • The purpose of the Carnival of Passive Investing is to 1) highlight the various high quality posts written about avoiding investing in individual stocks each month and 2) to create a “go-to” network/community of passive investing knowledge.
    • As an example of this second purpose, one of the most prolific participants in the monthly Carnival of Passive Investing is Mike from The Oblivious Investor. By increasing awareness about Mike’s posts, I want people to know that if they are interested in the passive investing methodology, following Mike’s blog would provide material appropriate to their liking.

To close, I just want to say “THANK YOU” to all my readers! This milestone (obviously) would not have been possible without you, and your continued interaction and commentary keeps me going as a blogger!

How about you all? What have been some of your favorite posts from this site in the past year? If you are a site owner, have you hit any important site milestones recently? 


Share your experiences by commenting below!

    ***Photo courtesy of http://www.flickr.com/photos/squeakymarmot/1019406320/sizes/z/in/photostream/

    Find Out Your Credit Score For Free With CreditKarma And An Analysis of My Results

    ————————————————————————————————————————
    Welcome to My Personal Finance Journey! If you are new here, please read the “About” or “First-Time Visitor” pages to find out more about us. If you would like to receive free updates on articles like this by email, then sign up here or you can subscribe to the RSS feed. Also, check us out on Twitter or Facebook. Thanks for visiting! Keep on learning!
    ————————————————————————————————————————

    Click here to enter my free giveaway for 2 copies of H&R Block At Home Premium Edition

    The title of the infographic below is “Financial Responsibility in the United States.” I have to admit that I literally “laughed out loud” when I saw this title (please pardon the reference to emoticon abbreviations – i.e. LOL). Why did this title make me laugh, you may ask?

    Simple. The concept of being financially responsible in the US seems to be becoming less and less important. Why own something when you can just buy the car or cell phone on credit, right? Therefore, maybe a better title to this graphic would have been “Financial Irresponsibility in the United States?!”

    Regardless of my personal feelings on the situation, the infographic gives some important insight in to the credit scores of the US public. I’ve tried to summarize these in bulleted form below:

    • The average US credit score is 692.
      • A person’s credit score can range anywhere from 300 (minimum) to 850 (maximum), with higher scores indicating a higher degree of credit worthiness and that you are more dependable in paying back debts.
      • A credit score of 720 is generally regarded as the minimum you want to have in order to qualify for the most favorable credit terms (think lower interest rates!)
      • I admit that the national average of 692 is slightly higher than I expected it to be, stemming from the magnitude of debt problems I hear about from friends and the financial media. 
    • There is a clear trend that credit scores get progressively worse, as you go further south in the United States.
      • Texas, New Mexico, Nevada, and Louisiana have, on average, the lowest credit scores and the higher occurrence of personal bankruptcy filings. 
      • This makes me wonder – what causes this? Is it that financial education (both in the home and in schools) is worse in the Southern states? Do people just have less money? Is cost of living more expensive?
        • If any one has any theories on this, definitely chime in/comment below!
    credit scores credit report credit limit credit history credit card promotion credit card debt credit card bonus

    How To Find Your Credit Score Absolutely Free (no credit card information required)


    If you have read my previous series on building credit history and improving your credit score, you’ll know that I am a big fan of using Annualcreditreport.com to obtain my credit report for free once per year.

    However, one thing that I have been making up stupid excuses about not doing is checking my actual credit score. One of the these less-than-robust excuses was that I didn’t want to pay the $15-$30 to check my credit score through one of the three credit agencies – Transunion, Experian, or Equifax.

    But, this all changed last week when I was reading a blog post from a blogger friend describing her use of CreditKarma.com to get her real time credit score absolutely for free at any time! Since it seemed to have worked for her and more importantly, be secure, I decided to give it a go!

    To find out your credit score for free from CreditKarma, simply follow the easy steps below:

    • Go to https://www.creditkarma.com/signup.
    • Create an account and password.
    • Enter your personal information (note: this does include entering your Social Security Number).
    • Confirm your identity by answering some simple multiple choice questions about your past (typical questions you have to answer when requesting a credit score/report).
    Once you have done this, you will then be able to view your credit score. Sounds easy right!? It is! 
    My Credit Score Results and Analysis

    As the Credit Karma screenshot below indicates, my credit score result was 754, with an overall credit rating of “Excellent.” This is the score reported by the TransUnion credit rating agency. The results also showed that I am in the 80 percentile of credit scores in the country, meaning that only 20% of individuals have a credit score higher than mine. 
    Overall, I was pretty satisfied with this result. Probably two of the biggest things that helped to obtain this score were 1) never missing a credit card payment and 2) taking out a small personal loan from a local bank several years ago, with the sole purpose being to accumulate credit history.
    credit scores credit report credit limit credit history credit card promotion credit card debt credit card bonus
    Along with simply displaying your credit score (which will be updated periodically, and you can keep logging in to view it for free as many times as you like!), Credit Karma has several additional features. 
    One of these pretty cool features is what’s called the Credit Score Report Card (see screenshot below for my Report Card). Essentially, this report shows you how you’re doing in the various components that determine your credit score. Let’s take a look at what information this report gives you along with how I’m doing in the various categories.
    • Overall Credit Grade
      • Overall, the report said that I was doing pretty well managing my credit, with an Overall Credit Grade of an A! Nice!
    • Open Credit Card Utilization
      • Since I’m not currently carrying any balances on my credit cards, I have 0% credit card utilization. I would have expected that this would be a good thing, as higher credit card utilization can present a warning sign of credit risk.
      • However, for some reason, I was given a C grade in this category.
      • Maybe this is because the credit companies like you to carry a little balance from month to month so they know you’re not just using them for the cash-back benefits, as I am.
    • % of On-Time Payments
      • As mentioned above, I have never missed a debt payment, and got an A grade in this category, with 100% on-time payments.
    • Average Age of Open Credit Lines
      • I scored a D grade in this category, since the average age of open credit accounts I have is 2 years. 
      • In my opinion, an average age of open credit lines of 2 years is perfectly acceptable. However, I am guessing that the creditors like to see the average age be longer than this. This is something that I believe will come naturally with time.
    • Total Accounts
      • I scored a D grade in this category. This is most likely because I have a large number of credit card accounts that I opened only to receive the free money sign up bonus offers.
      • In addition, I also only have credit card accounts. I don’t have the desired mix of mortgages, personal loans, car loans, and credit card accounts that would make this score go up. 
    • Hard Credit Inquiries
      • Hard credit inquiries are ones that go on your credit report whenever you apply for new credit.
      • I got a C grade in this category, with a total of 5 hard inquiries in the past 2 years. 
    • Derogatory Marks
      • All of my debt accounts/credit cards are in good standing, so I got an A grade in this category.

    credit scores credit report credit limit credit history credit card promotion credit card debt credit card bonus

    Summary of My Results


    So, overall, I was very satisfied with my credit score of 754. It is above average, especially for someone that is my age. I could definitely improve my score by 1) signing up for fewer free money sign up bonus offers from credit cards and 2) setting up small automatic payments on all of my credit cards each month in order to show that those accounts are active.

    Does This Sound Too Good To Be True?


    If you’re like me, you probably are thinking that this Credit Karma thing sounds too good to be true. However, it really is something that makes sense, if you think about how Credit Karma is making their money.

    This question can be answered by one word – advertising.


    Credit Karma has figured out that by offering credit scores for free, they drive an enormous amount of traffic to their site. Furthermore, because Credit Karma displays your credit score, it enables them display credit card and bank account offers to you that you are pre-qualified for. And, credit card and bank companies will pay big money for this type of “captive” audience. This is how Credit Karma makes their money! Pretty reasonable/logical if you ask me!


    How about you all? What resource do you use to check your credit score? Have you ever used Credit Karma? Are there any other resources out there to get your credit score for free? 


    Share your experiences by commenting below!

      ***Photo courtesy of http://farm4.static.flickr.com/3509/3928496281_f906248523.jpg

      Tips For Buying A Foreclosed Property

      ————————————————————————————————————————
      Welcome to My Personal Finance Journey! If you are new here, please read the “About” or “First-Time Visitor” pages to find out more about us. If you would like to receive free updates on articles like this by email, then sign up here or you can subscribe to the RSS feed. Also, check us out on Twitter or Facebook. Thanks for visiting! Keep on learning!
      ————————————————————————————————————————

      real estate housing and apartments home repair home loans home insurance home buying buying foreclosures

      Click here to enter my free giveaway for 2 copies of H&R Block At Home Premium Edition


      The following is a guest post by editors at SmallBusinessLoansDirect.com. Enjoy!

      Tips For Buying A Foreclosed Property


      It’s no surprise that the U.S. housing market is in shambles.  The eruption of the Sub-Prime Mortgage Crisis and the popping of the real estate bubble in 2008 has led to millions of foreclosures in the United States.  RealtyTrac estimates that a record 3.8 million homes were foreclosed in 2010.

      These record high foreclosure rates in 2010 were due to a deadly combination of high unemployment, wage cuts, price inflation in many goods and services, and many people getting overextended using easy unsecured working capital loans.  As gas prices continue to rise in 2011, and unemployment continues to remain above 9%, the housing market will most likely continue to remain under pressure.  These horrible market conditions have created a dream come true for one segment of the market, however—the homebuyer.  We are currently in a buyers’ market like no other in history!

      Debunking A Myth


      If you are in the market to purchase a new home, you may want to consider a foreclosed property.  Navigating through the process can be tedious, and it can be best to hire a qualified real estate agent who specializes in distressed property acquisition.

      One of the stereotypes of foreclosed properties is that they are all completely trashed.  The traditional line of thinking is that if a person was irresponsible enough to lose their home in foreclosure, then they probably did not maintain it very well.  This myth has been completely debunked in the current crisis, however.  In today’s market, the worst recession since the Great Depression has forced millions of well-meaning Americans into foreclosure, and now there are homes in excellent condition selling at a fraction of their market-high prices.

      How To Find Foreclosures


      Foreclosures will generally be listed as public announcements, so the county courthouse is a great way to keep abreast of foreclosed properties that are up for auction.  Another way is to search the internet for reputable sites that post foreclosed property details.  These sites will generally require a monthly membership fee, so make sure you do your due diligence and choose one with solid user reviews.

      An experienced real estate agent can be your closest ally if you are attempting to find a good foreclosure.  An agent will also generally track down any good leads and make sure the property meets a few your general criterion before you have to spend time checking it out, and this can save you lots of time over the course of a house search.

      Finances


      Financing a foreclosure can be a much trickier process than a traditional home purchase.  Again, this is where a qualified professional can help tremendously.

      There have never been as many homes for sale and in foreclosure in the history of the United States property market.  Now, more than ever before, is a great time to find a good deal.

      How about you all? Have you ever bought a foreclosed property? If so, would you recommend it to others? What were the positives and negatives?


      Share your experiences by commenting below!

      Jacob’s Thoughts – Listed below are my random thoughts as I was reading this article.

      • @ 3.8 million foreclosures in 2010 – This is astounding! How many homes can there be in the US after all, considering that there is about 300 million people living here? That’s like 1-2 people out of 100 affected! Do you know anyone that had to foreclose on their home?
      • @ Idea of the housing market still being under pressure in 2011 – I absolutely believe this. In my condo community, none of the units on my row have sold in the past year that I have lived here. Simply amazing! Let’s hope the market turns back around by the time I have to sell in around 2015 or so.
      • @ The stereotype that all foreclosed properties are trashed – I encountered this when I was searching for a house as well. What would happen is that I would find a property listed on the MLS system, and when I reviewed it with my real estate agent, she basically, immediately advised me to avoid the property. I wonder why this is? Maybe they have had some bad experiences with clients being unhappy with the results of buying a foreclosure and just want to “play it safe?” Any ideas?

      ***Photo courtesy of http://farm4.static.flickr.com/3235/2539334956_87cef7e457.jpg

      Simplify Your Asset Allocation and Remove The Impossible From Your Investing Strategy With Betterment.com

      ————————————————————————————————————————
      Welcome to My Personal Finance Journey! If you are new here, please read the “About” or “First-Time Visitor” pages to find out more about us. If you would like to receive free updates on articles like this by email, then sign up here or you can subscribe to the RSS feed. Also, check us out on Twitter or Facebook. Thanks for visiting! Keep on learning!
      ————————————————————————————————————————
      Click here to enter my free giveaway for 2 copies of H&R Block At Home Premium Edition

      If you’ve stopped by my site before, you probably know that I am a proud supporter and practitioner of passive investing strategies. In fact, in January of this year, I started The Carnival of Passive Investing just for the purpose of spreading the word about this very effective style of investing.

      Essentially, passive investing involves the use of different types of index ETFs and mutual funds to obtain a target asset allocation based upon your personal tolerance for risk. By applying this simple passive investing approach, we are able to actually outperform 70-80% of investing “professionals.”

      So, needless to say that I am a big supporter of any new products or services that makes it easier for individual investors to get off of the foolish active investing (individual stock investing) track and in to the proven world of passive investing.

      One of these services facilitating passive investing that I was recently exposed to is Betterment.com.

      What Does Betterment.com Offer?

      In a single sentence – Betterment makes investing the smart way as easy as it could possibly be.
      How does it do this you might be asking? Simple! Betterment only asks that you make one decision: deciding what percentage of your money you want in stocks and what percentage you want placed in bonds. After this decision (called your asset allocation) is nailed down, Betterment’s system takes care of the rest for you by investing your money in a mix of bond and stock ETFs.
      Got the gist?! Now that we’ve covered what Betterment offers at a high level, let’s delve in to everyone’s favorite – the details!

      Tools to Help You Decide Your Asset Allocation

      If you already have a feel for what you want your asset allocation to be, great! If not, Betterment has some nifty little tools to help you get started making this important decision.
      Below is a screenshot of the asset allocation decision making tool that Betterment offers. By inputing 1) how many years you have until you want to retire, 2) your current investment, and 3) your risk tolerance in 1 year and 44 years, Betterment is able to generate a suggested asset allocation.
      When I tried using this tool, the recommended asset allocation was 90% stocks/10% bonds. However, I am sort of a worry-prone person, and therefore go with a slightly more conservative asset allocation split of 75% stocks/25% bonds.
      vanguard portfolio rebalancing passive investing mutual funds individual stocks vs mutual funds individual stocks index funds fidelity etfs carnival of passive investing asset allocation

      What Does Your Money Get Invested in With Betterment?

      Once you’ve decided your asset allocation, your money will then be invested automatically by the folks at Betterment. Even though you don’t have to personally direct your money, I feel it is a very good to have a general idea as to what funds your money is being placed in to.
       
      The stock/equity portion of the Betterment portfolio is made up of the following index ETFs. Personally, I feel that simply investing in the VTI Vanguard Total Stock Market ETF would have been sufficient. However, the other ETFs are high quality and will still achieve the desired result.
       
      • 20% VTI: Vanguard Total Stock Market
      • 20% IVE: iShares S&P 500 Value Index 
      • 20% IWD: iShares S&P 1000 Value Index
      • 15% IWN: iShares Russell 2000 Value Index 
      • 15% IWS: iShares Russell Midcap Value Index 
      • 10% DIA: DIAMONDS Trust Series 1 
      The bond/fixed income portion of the portfolio is invested in the following index ETFs. I think it’s really good that they thought to include the TIPS (inflation adjusted) bond ETF. Nice work!
       
      • 50% TIP: iShares Barclays TIPS Bond Fund
      • 50% SHY: iShares Barclays 1-3 Year Treasury Bond Fund 

      What Fees Will You Pay? + Other Account Details

      The fee structure at Betterment is in my mind, a very good deal. There are no minimum account balances (I started my account with $10), no transaction fees, and you can withdraw your money at any time. In addition, you can change your asset allocation a maximum of once per day and your portfolio is rebalanced once per quarter back to your asset allocation targets. Not bad right?!

      For all of this, you pay a fixed expense ratio/fee of 0.3-0.9%, based on what amount of money you have invested. Since most actively managed funds charge far more than 1% to under perform the market, this is quite good!

      Currently, Betterment is only offering individual, taxable investment accounts. I would like to see them add Traditional and Roth IRA options at some point, and the VP of Marketing for Betterment just informed me that they will be on the way shortly!

      Another really cool feature of Betterment is that they offer a simulator that will allow you to predict the value of your portfolio a set number of years in the future based on various asset allocation levels. I’ve pasted a screenshot of this tool below.

      vanguard portfolio rebalancing passive investing mutual funds individual stocks vs mutual funds individual stocks index funds fidelity etfs carnival of passive investing asset allocation

       

      How Does Betterment Stack Up Against the Competition?

      The niche in which Betterment operates is what I call the “single solution index investing asset allocation” space. They are targeting investors that do not want to devote the time to 1) investing in individual ETFs or index mutual funds on their own and 2) rebalance periodically throughout the year.
      So, even though you could easily obtain lower overall expenses/fees by employing an investing strategy with individual ETFs or mutual funds (as I do), this does not qualify as competition for Betterment.
      However, I did some brainstorming to think up products that would qualify as Betterment’s competition, and compared these to Betterment below:
      • Target Retirement Date Mutual Funds
        • These funds are similar to Betterment in that they place an investor’s money in a mix of equity and fixed income mutual funds.
        • An example of this category of funds are the Target Retirement Funds from Vanguard.
        • Vanguard’s expenses are much lower than Betterment’s (0.1-0.2% vs. 0.3-0.9%). However, they do require a $1000 minimum initial account balance, and you don’t have complete control over what asset allocation levels the funds uses (Vanguard decides for you).
        • One good thing though about these Target Date Retirement Funds is that you can invest them in an IRA with Vanguard.
        • So, in this case, Betterment has higher fees, but MUCH more flexibility.
      • Target Retirement Date ETFs
        • An interesting new type of ETF that has come out is the ETF version of the target retirement funds discussed above.
        • The only provider of these that I could find was iShares. You can view an example of one of these target date ETFs by clicking here.
        • These ETFs offer lower expenses than Betterment (around 0.3%) and slightly more flexibility in withdrawing your money. However, the asset allocation level is still dictated to you by the folks at iShares and you will most likely pay commissions on each trade you make.

      What’s the Bottom Line?

      “So, what’s the bottom line, Jacob? After reading this Betterment review, how do I decide if Betterment is right for me?”

      As you might have guessed, this comes down to your personal preference of how involved you want to be in your investing strategy of any money outside of your retirement accounts (because remember, Betterment doesn’t yet have IRAs).

      Betterment is not right for you if you enjoy selecting which ETFs or index mutual funds to invest in and rebalancing back to your asset allocation targets throughout the year.

      Betterment is right for you if you want a very simple, low-cost way to invest the correct way by making one asset allocation decision and then just watching your money grow.

      How about you all? Have you used Betterment? Are you a fan of these single solution asset allocation investments? 


      Share your experiences by commenting below!