Wealthfront is a new company that manages your investments according to an allocation plan that you decide. Primarily they invest in low-fee ETFs. Generally I like the idea of what Wealthfront offers, but there are some significant risks.
Generally I think asset allocation is a good investment strategy. Pick sectors that don’t usually correlate (bonds, stocks, possibly real estate, gold, commodities), decide on percentages that make sense given your age and risk tolerance (your age in bonds, as a percentage, is a common rule of thumb), and rebalance every year or so. I provide details on exactly how to do that in my post How to Get Rich Slowly Without a High-Paying Job, including Google Sheet examples and projections.
I’m concerned about the following scenario:
- Millennials, many of whom are more financially savvy and conservative than they are given credit for, choose services like Wealthfront to automate an asset allocation investment approach.
- After answering the questions in the Wealthfront asset allocation questionnaire, they select an allocation plan that is something like 80% stocks. This is because they are all young and all think they have a high tolerance for risk (most of them will find out later that losing money isn’t as fun as they thought it would be).
- They invest their hard-earned savings nut, buying into the stock market when the Shiller PE Ratio is well-above 20 (months ago it was up to 26). The Shiller PE Ratio, which includes historical earnings in its calculation, isn’t meant to be used as a market timing indicator, but historically it has predicted long-term returns quite accurately.
Investing 80% of your life savings in the stock market when the Shiller PE Ratio is this high is not wise. So what’s an alternative approach?
Choose an Automated Plan, but Lean Conservative (and Adjust Later)
I like the Wealthfront service. If I were to create my own investment management company, it would operate pretty much in the same way. Though I’m not an early adopter, I might even use it myself down the road (though probably not — I enjoy managing my own investments). But I wouldn’t rule it out. For the ostrich investor, it’s an ideal service.
My only criticism is from what I can tell, it’s too easy to end up with a very high stock allocation, which, under these market conditions, is damn risky. If your initial nut is $1000 and you are investing $1000 a month, the initial allocation doesn’t matter as much. Over time, you’ll be buying low more often than not (the automated allocation algorithm will do that for you–if the stock market plummets then the algorithm will have to buy more stocks to maintain your allocation percentage).
But if you invest $20K and then add $500 a month, the initial allocation makes a big difference. If you are 80% stocks, and the stock market tanks hard over the next few years (look how much it has gone down just in the last few months) then you’ve just taken a big hit, especially if you consider how much that initial investment can compound over 30+ years.
My simple advice for new Wealthfront investors is this: don’t go over 50% allocation in stocks while the Shiller PE Ratio is over 20, no matter what your allocation questionnaire results say, if you are investing a significant initial amount. Start with a more conservative allocation, then take a look in a few years. If the Shiller PE is closer to 15, or even 18, then up your stock allocation percentage (risk tolerance) as high as you want.
Usually asset allocation percentage adjustments go the other way — reduce your stock market exposure as you get older. But for young investors I would recommend the opposite at this point.
Is this strategy the same as trying to “time the market”? The Wealthfront blog offers a good argument as to why you shouldn’t change your risk tolerance score all willy nilly every time the market moves. You’ll end up selling low.
I’m simply suggesting that you don’t buy high, with all your money. If you want to make money long-term in the stock market you need to get in somehow, but there’s no reason you can’t limp in. It’s just safer that way.
Of course I could be wrong. The biggest stock market rally of all time could be about to begin, defying all historical trends. What do I know? I’ve made every investment mistake in the book.