What investors are doing wrong: Wealthfront’s Malkiel has some answers

Are you invested the right way for 2016? Automated investing startup Wealthfront peered into its clients’ portfolios and discovered some surprising data.

 

In January Wealthfront launched tax-minimized brokerage account transfers, which aim to let users move their money from a brokerage account to Wealthfront and in the process reduce the tax cost. Over the course of the year, Wealthfront was able to analyze data on their investors’ portfolios before they were transferred.

 

On Thursday, Wealthfront announced some of the findings. Just 8% of the investment portfolios linked to the company so far in 2015 were built properly, says CEO Adam Nash. The rest were challenged by a combination of high fees, poor diversification and excessive risk.

 

Wealthfront saw that 35% of their investors were holding at least 10% of their portfolio in cash. Nash says investors are likely foregoing much in the way of returns by gravitating toward the safety of cash. “In the short term you may have cash needs and we even advocate that young people have an emergency fund for unexpected expenses or a change in employment,” he says. “Now over the long term — 10, 20, 30 years — having a significant portion of your portfolio in cash really lowers the returns that you can expect, especially if you’re planning for a long-term goal like retirement.”

 

Another alarming finding: One-third of Wealthfront’s investors were overly concentrated in U.S. equities, and hold just one or a handful of stocks.

 

Wealthfront CIO and renowned economist Burton Malkiel cautions that investors need to ensure they aren’t too fixated on return that they overlook risk. “Diversification is really one of the only free lunches there is in investing. That with a broadly diversified portfolio, you can get a reasonable return and lower your risk as much as possible. And broad diversification is well known as a technique that lowers risk,” he says.

 

In 1973, Malkiel took the investing world by storm with the release of the investing guide “A Random Walk Down Wall Street.” It’s now in its 11th edition and having sold nearly two million copies, it’s considered one of the most insightful books written about the market (and thought of as instrumental in the creation of index funds).

 

It might seem odd that Malkiel, a two-time chairman of Princeton’s economics department and director at mutual fund giant Vanguard for 28 years, is now a CIO at a trendy robo-advisor. But Malkiel says, “I have believed in what Wealthfront does all my life.” After all, Malkiel was one of the original people to espouse index funds as a superior method of investing in stocks — primarily because of their low costs and the fact that stock picking was not something ordinary investors were good at.

 

What exactly does Wealthfront do?

 

Wealthfront, founded in 2008 and based in Palo Alto, Calif.,is an automated investment service — one of a handful of so-called robo-advisors — that offers clients a low-cost and diversified portfolio of index funds and ETFs.

 

“We automate all the little things that experts have been telling people they should do with their money, but never have the time or inclination to do,” says Nash.

 

Wealthfront currently has $2.6 billion in assets under management. The company doesn’t charge an advisory fee on the first $10,000 invested; above $10,000 customers pay an annual fee of 0.25%. Advisory firms normally charge 1% of your account balance per year.

 

New technology rooted in old beliefs

 

Malkiel has been a longtime proponent of passive investing, and first purported the idea of an index fund in “A Random Walk Down Wall Street” three years before the launch of Vanguard’s First Index Investment Trust, the first-ever index fund in 1976.

 

“Low-cost index funds didn’t exist then. But what I did suggest was index funds, rebalancing, reinvesting your dividends, being tax aware and most active funds are very tax inefficient,” says Malkiel. “And for me it was like dying and going to heaven that I could work with a company like this that was able to do this, automate it, and be able to charge a small fraction of what people are paying for investment advice.”

 

He had first written “A Random Walk” against a dismal investment backdrop, as U.S. equities were experiencing the worst bear market since the Great Depression. And despite the less dramatic markets we’re seeing this year, Malkiel says his diversification philosophy remains constant and Wealthfront helps investors achieve long-term returns.

 

“What automation can do is the moment there’s an opportunity to gain a tax saving we can do it,” Malkiel says. “And it’s just so very exciting to be able to take all of the good lessons that we know about finance and do it in the most efficient manner possible.”

Malkiel is referring to Wealthfront’s tax-loss harvesting software, which is a technique that lowers your taxes while maintaining the expected risk and return of your portfolio. It harvests investment losses to offset taxes due on your other gains and income.

 

The future of investing

 

Wealthfront was the industry leader in online investment services (in terms of assets under management) until recently, when competitor Betterment crossed the $3 billion mark. And now banking behemoths like Bank of America (BAC) and Charles Schwab are planning to roll out — or have already launched — their own versions of an automated investment service. Nash says he sees it as a positive that the financial services industry is entering the digital realm.

 

“We really only have two advantages. One is focus and trying to build the next generation of technology from the ground up. And then we have our pace of innovation,” he says. “I’m excited that [Bank of America] will roll out what we had in 2012 in 2016. Our job is always to be years ahead and really proving what technology can do for people.”

Disclaimer: Yahoo CEO Marissa Mayer was an early investor in Wealthfront.

 

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