Ever wondered to yourself, that for the investment Risk you are taking, are you being compensated fairly with Return?
Or could the return you are currently getting have been achieved with much less risk?
Well a gentleman by the name of Harry Markowitz went a step further in 1952 when he published a formal portfolio selection model in The Journal of Finance. His work on the efficient frontier and other contributions to modern portfolio theory eventually won him the 1990 Nobel Prize in Economics.
Different combinations of securities produce different levels of return. The efficient frontier represents the best of these securities combinations — those that produce the maximum expected return for a given level of risk.
According to Markowitz, for every point on the efficient frontier, there is at least one portfolio that can be constructed from all available investments that has the expected risk and return corresponding to that point.
An example appears below. note how the efficient frontier allows investors to understand how a portfolio’s expected returns vary with the amount of risk taken.
The relationship securities have with each other is an important part of the efficient frontier. Some securities’ prices move in the same direction under similar circumstances, while others move in opposite directions. We call these terms correlation and uncorrelation, respectively. The more out of sync the securities in the portfolio are, the smaller the risk (volatility) of the portfolio that combines them.
Presented below is a hypothetical portfolio that is optimally compensated with Return for the Risk the investors are accepting.
On the other hand, the example presents a case on an Inferior portfolio (in yellow) because for the same amounts of risk or return, there are 2 other existing portfolios which are more efficient.
Now comes the question, how do I make my portfolio more efficient?
A key method is to involve a combination of uncorrelated securities in your portfolio that move in opposite directions but give a similar weighted-average return.
The popular notion is that the higher the risk, the higher the return. In theory, if you invest 100% in bonds, you should have the lowest risk, and 100% in stocks should conversely give you the highest risk. But economists later found out that if you replace the 100% bond portfolio with some stocks (75% bonds, 25% stocks), you not only reduce risk, but also increase returns.
The good news is that our investment team has created model portfolios to suit different risk profiles that have been optimized through algorithms that search for the best combination of Funds according to risk numbers and yield. We optimize extensively so that no more optimal composition of a Fund portfolio is possible.
Would you like to find out if your portfolio is performing optimally for you? Feel free to enquire for an assessment of your investment portfolio or about any of my value-added services.
DISCLAIMER: The views expressed here are solely those of the author in his private capacity and not necessarily to the author’s employer, organization, committee or other group or individual.