Beware the “You Must Diversify” Mumbo Jumbo
Wealthfront is an online investment management company that says this about itself:
Wealthfront is re-imagining how people invest their money
By building an automated investment service from the ground up to put the client first, Wealthfront is paving the way for a new generation of investors to achieve their financial goals. We believe this is a once-in-a-generation opportunity to change an industry and build something new, something different, something better.
Wealthfront makes it easy for anyone to get access to world-class, long-term investment management without the high fees or steep account minimums
They invoke all the important sounding concepts in their marketing
- We use Modern Portfolio Theory (MPT) to identify the ideal portfolio for each client. The economists who developed MPT, Harry Markowitz and William Sharpe, received the Nobel Prize in Economics in 1990 for their groundbreaking research.
- We also evaluate each asset class on its potential for capital growth and income generation, volatility, correlation with the other asset classes (diversification), inflation protection, cost to implement via ETF and tax efficiency.
- Wealthfront determines the optimal mix of our chosen asset classes by solving the “Efficient Frontier” using Mean-Variance Optimization (MVO). MVO requires, as inputs, estimates for each asset class’s standard deviation, correlation and expected return.
- To estimate each asset class’s expected returns, we start with the Capital Asset Pricing Model (CAPM) (
) as the baseline estimate.
- “tax-loss harvesting”
- “Automatic rebalancing”
- “Efficient Frontier”
The whole white paper, “Wealthfront Investment Methodology White Paper” can be read HERE.
So, How Does The Portfolio Recommended by Wealthfront Do?
But it turns out, that with all their attention to modern portfolio theory, et. al. the Wealthfront’s portfolio failed to beat the simple S&P 500 over the ten year period, 1/31/2007 – 11/16/2017.
Proof of this outcome is presented in THIS spreadsheet.