Touring Wealthfront's Efficient Frontier

Normally, we think of frontiers as boundaries that mark and often regulate our passage from one realm to another. In finance, though, the one frontier worth mentioning – the Efficient Frontier – isn’t a place through which we pass. It’s a destination, supposedly the only place we should want to be. Whatever traveling we do is back and forth along the frontier with the aim of picking a one spot at which we’ll settle down (and move to a new one later on if or when our preferences change).

NOTE: This post focuses on Wealthfront because its web site provides for the greatest level of insight as to how it works. Bear in mind, though, that the other large generalist robo advisers operate pretty much the same way, so most observations made here can be assumed applicable to the others as well.

The Great Wall of Finance

Imagine you’re atop a long narrow structure that looks a bit, like the Great Wall of China. You can move a long way in either direction along its length, but you can’t really go much along the width, since the wall is pretty narrow.

You do not want to go down off that wall.

Along one side is the mysterious and impenetrable Land of the Impossible, which is inhabited by creatures that don’t – can’t – really exist. If we think we see any, forget about it. They’d be mirages. One example: A risk-free six-month U.S. Treasury note yielding 42.4% in a zero inflation environment. Here’s another: a stock that goes up but can’t go down. If we assume the Great Wall runs east to west, then the land of the impossible is to the north. On a map, it would be “above” the frontier.

We could, if we wish, go down the other side, the south side, and enter the Land of Inefficiency. But we choose not to. It’s inhabited by undesirable “sub-optimal” creatures, such as high-risk startups with expected annual returns of 0.03%. We can grab as many of these creatures as we want. But no rational person would want to do that. All of these “portfolios” feature more expected risk than we need to assume for a given level of expected return, or they offer less expected return than we need to accept for a given level of risk.

The top of the wall, the frontier itself, is the only place worth being. In finance, this wall is known as the “Efficient Frontier.” It’s not built from bricks. It’s built instead from “portfolios.” But these aren’t just any portfolios Each is an “efficient” portfolio that offers the highest level of expected return anyone could rationally hope to achieve based on the spot along the wall/frontier (the level of risk) you have chosen.

Migration Along The Length of the Great Wall

Imagine you’re back atop the wall. If you take a step to the right, you’ll find yourself standing on a different efficient portfolio. It will be more risky than the one on which you previously stood. But as compensation for tolerating the extra uncertainty, you can rationally expect a higher return. The same sort of change occurs with each new portfolio you encounter as you move one step at a time to the right until you eventually reach the end, the highest level of risk to which you are subjected given the assets that are in the portfolio. That’s not for the feint of heart. But the intrepid souls willing to venture there get, as a payoff, the highest possible level of expected return.

Now, get back to the starting point but this time, move to the left. Now, your portfolio is a bit less risky than the one you started with. That feels comforting, but finance abhors a free lunch. You pay for that extra comfort by being willing to accept a lesser level of expected return. You can keep going to the left, and reducing both risk and return until you reach the end, a portfolio offering the lowest possible level of risk (and, of course, the lowest possible level of expected return).