Strategic Investing – Modern Portfolio Theory & The Efficient Frontier
Posted on:
Raffi Pailagian
MBA, BSc, DipFP
Financial Planner / Managing Partner
An Approach To Help Guide Your Strategic Investing Decisions
High risk, high returns, or so the saying goes. But what if there was a way you could balance risk and return in a way that optimises returns while at the same time managing the level of risk? Modern Portfolio Theory [i], and specifically the Efficient Frontier [ii], are great tools to assist with strategic Investing.
They can assist you with developing an optimal portfolio that manages both risk and return, in a way that suits all investors. So, what is Modern Portfolio Theory and how does it work?
Modern Portfolio Theory
This theory on investing was first developed by Harry Markowitz in 1952 and is still very much in use today, to support strategic investing decisions. According to Markowitz there is an optimal portfolio of investments that perfectly balances risk and return for any investor risk tolerance. This portfolio can be designed using the Efficient Frontier.
What is the Efficient Frontier?
The Efficient Frontier is a graphical representation that rates portfolios based on which offer the highest expected return for a defined level of risk.
If we chart the Expected Return (using the Compound Annual Growth Rate [iii]) of an investment on the Y Axis, and the Expected Risk (using Standard Deviation [iv]) on the X Axis, we can graphically represent the risk vs return of any security or portfolio. This representation will form a curved line, the Efficient Frontier. Any portfolio that sits on or near the line is referred to as optimal, that is to say, it provides a higher than expected return for the defined risk and any that sit below the curve, are sub-optimal.
Using this curve, you can identify assets which might have the same expected return as others, but with a lower risk, which is clearly a more favourable choice.
What about my Risk Tolerance?
As we have talked about previously in our article on Wealth Management, every investor will have their own risk tolerance or profile. When using the Efficient Frontier to evaluate a portfolio and make strategic investing decisions, those investments that fall on the right hand side of the curve will be more suitable to higher risk investors, whilst those that sit on the left hand side are more appropriate to investors with a lower risk tolerance.
Regardless of where you sit on the curve in terms of risk, there will be an optimal portfolio structure for you.
How do I use this to structure my Portfolio?
So, we have covered the theory, but what does all this mean in practice? Whether you already have a portfolio of investments, or are just starting out, the steps are the same:
- Establish what securities might be included in a portfolio – either new or existing
- Establish the mix or balance of assets in the portfolio
- Do the maths! Using Return and Standard Deviation data, optimise the portfolio so that it sits on the Efficient Frontier. This may mean changing the balance of assets, adding others, or deleting some entirely
- Monitor the portfolio to see if it meets expectations, and adjust the balance accordingly
Balancing and Rebalancing
Once you have established a portfolio that sits on the Efficient Frontier, you want to keep it there. As you would be aware, markets are constantly moving, so it is important to keep an eye on your portfolio and rebalance when necessary. This might mean swapping out a particular asset for another if it has moved your portfolio into the sub-optimal range, but these decisions are made easier when the aim is to maintain the point you are happy with on the curve.
Rebalancing is particularly important in volatile markets and can sometimes have a significant impact on the overall performance of your portfolio.
A little Expertise
Most people don’t have the knowledge, patience or time to structure an investment portfolio that sits on the Efficient Frontier, much less monitor it to make sure it stays there. This is where an experienced financial planner can help. They can combine the Efficient Frontier equations, with a detailed knowledge of the market and its movements to come up with the ideal portfolio structure, no matter what your risk profile might be.
Optimal Portfolios
An optimal portfolio will appear on or very near the Efficient Frontier. Generally, portfolios with a high degree of diversification are more likely to sit on the Frontier. Diversification helps balance out the idiosyncratic risks inherent in individual assets, to create a portfolio where the return is exceptional, and the risk is lower than the Standard Deviation of the individual assets.
But it is not simply about diversification. You also need to look at the correlation coefficient[iii], or how closely the individual securities within a portfolio are correlated. The lower the correlation, the greater the benefit of blending them, because when one is going down, the other may be going up.
If you would like some advice on how your current investments sit in relation to the Essential Frontier, or you would like to develop an investment portfolio that balances risk and return in a way that is just right for you, please contact us on (02) 9976 3388 or click below and we’ll be in touch.
Interested in knowing more?
[i] Modern Portfolio Theory
[ii] Mathematical Explanation of the Efficient Frontier:
[iii] Compound Annual Growth Rate (CAGR) – The rate of return that would be required to grow from its beginning balance to its ending balance assuming reinvestment of profits.
[iv] Standard Deviation – Measures the dispersion of data relative to its mean
[v] Correlation Coefficient – the measure of the strength of the relationship between two variables
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