How do you determine the portfolio that offers the maximum expected return for my chosen level of expected risk?

We use Mean-Variance Optimization to choose the mix of asset classes that maximizes the expected return for a specific level of risk (as measured by variance), or equivalently minimizes the risk for a specific expected return. The primary factor that determines your best portfolio is your particular tolerance for risk.

To identify your risk tolerance, Wealthfront applies behavioral economics research to simplify our risk identification process to only a few questions. For example, we are able to project an individual’s income growth and saving rate based on her age and current income. We ask questions to evaluate both your objective capacity to take risk and subjective willingness to take risk. We believe software can do a better job of evaluating risk than the average traditional financial advisor.

We ask subjective risk questions to determine both the level of risk you are willing to take and the consistency among your answers. The less consistent the answers, the exponentially less risk tolerant you are likely to be. For example, if you are willing to take a lot of risk in one case and very little in another, then you are inconsistent and are therefore assigned a lower risk tolerance score than the simple weighted average of your answers.

We ask objective risk questions to estimate, with as few questions as possible, whether you are likely to have enough money saved at retirement to afford your likely spending needs. The greater the likely excess income at retirement, the more risk you are capable of taking. Conversely, if your expected retirement income is less than your likely retirement spending needs, then we determine that you cannot afford to take much risk with your investments.

Our overall risk metric combines subjective and objective risk tolerance with a heavier weighting to whichever component is more risk averse. We chose this approach because behavioral economics research shows individuals consistently overstate their true risk tolerance, especially male investors who are educated and overconfident (Barber & Odean, 2001). Relying on an investor’s biased answers may lead to a more volatile portfolio than appropriate, which could increase the likelihood the investor sells when the market declines. DALBAR published an often-quoted study that observed the average equity investor underperformed S&P 500 by 4.32% on an annualized basis during the 20-year period 1992-2011 due to consistently buying after the market has risen and selling when the market declines (DALBAR, 2012).

For more details on how we determine your ideal portfolio please read our Investment Methodology white paper.  For a description of the risks associated with our investment strategy, please click here.