Wealthfront and the Fintech Frontier

25 November 2014

One of the oldest industries out there, and one where tech can still make a huge incremental impact, is finance. There are gigantic opportunities here, but also immense challenges, ranging from increasingly complex government regulations to the fact that individuals are just not that great at understanding their personal finances.

One new company that's looking to tap into this opportunity is Wealthfront. This is an online personal investment manager where average individuals can put some money into an account, answer some questions about their risk tolerances, and then sit back as algorithms automagically manage their money in a diverse set of investments.

After using Wealthfront for around a year, I think it executed very well on its core purpose, but also illustrates a number of challenges any new tech product will have to overcome when dealing with the personal finance space.

First: The potential of FinTech

To lay the groundwork, it's interesting to think about this sector from a higher level. Fintech, as the intersection of technology and finance is often called, has a number of potentially revolutionary impacts on the finance world.

One potential impact is just democratizing information. A lot of finance information is already both standardized and available online, thanks to a lot of accounting regulations and high demand for this kind of structured information (mostly from within the finance industry). But, there's still a lot more information, or perhaps more accurately knowledge, that can be more widely spread. Personal finance is not an easy thing to master, in terms of either knowledge (e.g. doing X will be better for my taxes, I should choose retirement plan Y, or the best thing to do with my money is Z, etc.), or keeping track of personal data (e.g. where is all of my money, what rates of return are my different investments getting, etc.).

A second major impact would be helping people understand the choices that they can make. In general, it seems like individuals make financial choices reactively, namely only when they are prompted to do so, which is often when they have to do so. Thus, many people miss a lot of decisions they can make proactively that could be very beneficial to them. Even when individuals want to make a decision, they might not know the entire realm of choices they can make.

Third, fintech can help individuals actually execute their financial decisions. Execution of a decision to buy a stock, for example, is probably something a lot of people know how to do. But what if somebody wanted to, say, cash out part of their retirement plan and invest it in a well-diversified way? Wealth advisors are the traditional way through which some individuals executed their financial decisions - you tell the advisor what you want, and he can make it happen.

Finally, fintech can even help widen the set of financial opportunities that exist for individuals. This stretches the regulatory landscape, but something like crowdfunding a real estate investment project would've been much harder to do before the internet.

What Wealthfront does well

Wealthfront provides a really smooth investment management solution. The first thing is does well is that it boils people down to one number representing risk tolerance. When you first join, you answer a series of simple questions, and the Wealthfront algorithm assigns you a number on a 1 to 10 scale, which is shown to users on their main dashboard. This is great because risk tolerance is perhaps the biggest factor impacting the kinds of investments a person should make. The "fuel gauge" indicator is very understandable to users, and there's plenty of communication about how having a higher risk tolerance level means higher volatility in investment outcomes.

On a related note, Wealthfront makes the wise decision of letting users "decide" their risk tolerance levels (users can change it, on the same scale, if they aren't happy with the results of the initial questionnaire), and then nothing else. I've seen a number of different retirement investment companies offer employees a dizzying spectrum of funds to choose from, with lots of numbers and descriptions meant to better "inform" the investor and to let people choose the funds that best fit their risk profiles. That is a terrible way to do it. The level of sophisitication needed to use all the information provided is beyond what the average person in this situation has. Instead, Wealthfront does it right by showing people the one root factor, and then (ostensibly) algorithmically making all investment decisions for that user based on that one variable.

After the risk tolerance is set, Wealthfront follows the same philosophy as a lot of other investment tools: set it and forget it. Wealthfront users are not prompted with more decisions on an ongoing basis, and aside from periodic account statements, Wealthfront largely leaves users alone. There is no additional stress from additional decisions to make. The Wealthfront algorithm is taking care of things for you behind the scenes.

Of course, Wealthfront wouldn't be able to do well if it didn't follow sound investment theory. It diversifies a user's holdings across a number of different asset classes, in proportions dictated by her risk tolerance. This is a non-trivial thing to do, and although the formulas for determining allocations aren't shown to the user, the fact that this diversification exists at all is a great sign.

In addition, Wealthfront has an incredibly consistent message of helping users maximize their money. This is not just about creating and setting a diversified portfolio that just sits there forever - Wealthfront also emphasizes how it's constantly looking for ways to help increase your return. For example, just by using Wealthfront at a relatively light level, I would know that it's doing something called "tax harvesting" for me - I don't have to understand what that means to be convinced that Wealthfront is using it to save me money.

In short, Wealthfront addresses one of the above potential impacts of fintech very well, namely that of execution. And it actually does this by bypassing the need to educate the user about the different investment options available to her! Instead, it takes the user's deeper desire to "invest my money wisely", and does this in a pretty informed and algorithmic way.

Challenges Wealthfront illustrates

Despite the great experience that Wealthfront provides, it does illustrate some of the challenges that fintech products can face when dealing with personal finance and investment.

The first challenge is that the experience as a whole isn't "exciting" over a long period of time. Because it follows a "set it and forget it" approach, users only think about Wealthfront rarely. And this could be a problem, because whenever a user does log in to his account, he'll see on the main dashboard one headline figure, namely the percentage return of the portfolio. In most typical situations, this number is fairly unexciting - especially since Wealthfront doesn't show the market's change over the same period of time. These results don't necessarily inspire excitement or any other kind of hugely positive emotion - it rises to the level of "pleasant", but probably not much above that.

This in itself isn't a problem unless it reinforces some other reason why a user might want to leave Wealthfront. Unfortunately, such a reason exists: Wealthfront provides the user fairly low agency in terms of choices she can make. If a user suddenly hears a "great" trading idea, she might be tempted to think that she can do better trading on her own than by putting her money in Wealthfront. Combine the "unexciting" progress with any excuse to withdraw the money, and users might actually choose to branch off on their own with the money they previously had in Wealthfront.

Another challenge Wealthfront illustrates is that it's still fairly difficult to educate users. Wealthfront is able to boil down investing to such a simple process by not trying too hard to educate users about what they "ought" to be doing or what they could do. As a user, it's not even clear to me how Wealthfront used my risk tolerance score to choose my portfolio, or how my portfolio would change if my risk tolerance changed. This represents an intersting tension that fintech will probably have to resolve - how much do you educate the user to make better decisions, and how much do you just ignore the user and do what theory says is best for them?

In addition, Wealthfront is great for helping people invest their money intelligently, but is it helping the people who most need it? If you have enough money to put some into Wealthfront, chances are that you are a) at least a bit savvy about personal finances, and b) are not that strapped for money. Naturally, those with capital to invest represent a big market for fintech to address. But, perhaps there is a bigger societal impact that can be had by helping those with more limited means to invest that money more safely and wisely. This is, of course, a completely different problem from the one Wealthfront is trying to solve. But, it's sometimes easy to forget that many of the "big impacts" that fintech could have extend down to the less well-off.

Wealthfront is a great entrant in the fintech space, one which simplifies and improves individuals' abilities to invest their money in a diversified way. Although the product itself is great, it still hits upon some of the major challenges facing products in the fintech space. Given the creative new products in the age-old finance industry, I'm optimistic that a lot will change over the next couple of decades.

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