The Efficient Frontier
In order to compare investment options, Markowitz developed a system to describe each investment or each asset class with math, using unsystematic risk statistics. Then he further applied that to the portfolios that contain the investment options. He looked at the expected rate-of-return and the expected volatility for each investment. He named his risk-reward equation The Efficient Frontier. The graph below is an example of what the Efficient Frontier equation looks like when plotted. The purpose of The Efficient Frontier is to maximize returns while minimizing volatility.
Definition of efficient frontier
A set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are also suboptimal, because they have a higher level of risk for the defined rate of return. Since the efficient frontier is curved, rather than linear, a key finding of the concept was the benefit of diversification. Optimal portfolios that comprise the efficient frontier tend to have a higher degree of diversification than the sub-optimal ones, which are typically less diversified. The efficient frontier concept was introduced by Harry Markowitz in 1952 and is a cornerstone of modern portfolio theory.
Portfolios along The Efficient Frontier should have higher returns than is typical, on average, for the level of risk the portfolio assumes. Notice that The Efficient Frontier line starts with lower expected risks and returns, and it moves upward to higher expected risks and returns.
So, people with different Investor Profiles (determined by investment time horizon, tolerance for risk and personal preferences) can find an appropriate portfolio anywhere along The Efficient Frontier line. The Efficient Frontier flattens as it goes higher because there is a limit to the returns investors can expect.
The Efficient Frontier - Modern Portfolio Theory
When it comes to investing, it's easy to get drawn into complex debates on current market conditions – what to buy, what to avoid, what to sell, and when. These discussions are often fuelled by reports from the media, which tend to overdramatize how short-term events affect investors. Not surprisingly, these reports devote little space to how and why we invest in the first place. That would be much less exciting. Plus, the story line wouldn't change.
Why do people invest?
Most people save their hard-earned money because they have a dream for the longer term – whether retirement, a child's post-secondary education, a cottage or world travel. The plan and prudent management of your portfolio should focus on this dream, not on short lived market fears or frenzy.
So how should you invest?
The best way to move steadily toward your dreams is to adopt a consistent strategy that you stick with through market cycles, ignoring market and media "noise." Modern Portfolio Theory using The Efficient Frontier is one such investment strategy. This approach is based on an investing theory of risk efficient portfolios associated with Nobel laureates Harry Markowitz and bill Sharpe. They demonstrated that portfolio returns could be maximized for a given risk level through optimal diversification by carefully choosing the proportions of various investments such as asset class, geographic allocation and style of investment management.
What is the Efficient Frontier?
The Efficient Frontier is a curve on a graph made up of a series of dots, each representing an "efficient portfolio." Each portfolio maximizes potential returns at each risk level. The more risk you can handle based on your comfort with volatility, time horizon and other factors the higher the potential returns you can expect. You can see from the graph that it is possible to increase potential returns of an inefficient portfolio. represented somewhere below the curve by moving it up to the curve at the same or even lower risk level (i.e., without moving right on the risk axis).
How does it work?
Using the Efficient Frontier is an elaborate exercise that considers three factors for each investment in the portfolio:
- Its estimated rate of return, based on historical data and analysis.
- The level of risk (or volatility) associated with the investment. Risk measures the likelihood that the investment will earn much higher or lower returns than expected.
- An asset's correlation to the other assets in the portfolio. You want to choose investments that are "negatively correlated," or that react differently in different market conditions to smooth out annual returns.
As a simple example, if your money was invested only in Canadian resource equities, you could expect a rough ride from year to year, but potentially high returns on average over the longer term. If it were invested in a guaranteed investment, you would earn a stable but low return. But if you combined these two investments into a portfolio, you could achieve better returns than the guaranteed investment, but with less volatility than the equities. Add in more and different types of investments, and the expected performance of your portfolio could improve even further. At some point, however, increased diversification stops increasing expected returns. The "efficient portfolio" is thus reached. The key is identifying that ideal mix.
Then what?
Once an efficient portfolio has been identified for your risk level, there is still work to do. Some investments grow faster than others, causing the portfolio to "drift" away from and below the Efficient Frontier. As a result, your exposure to risk could increase or your expected returns could decrease, with negative consequences to your investment goal. The answer here is rebalancing. By selling investments that have outperformed and are now over their ideal target weighting and reinvesting the proceeds in asset classes that are undervalued, you can keep your portfolio efficient. What's more, this strategy helps you "sell high" and "buy low." Statistics show that 96 percent of the population never rebalances their investments, missing out on this opportunity to enhance potential profits.
How we can help?
Keeping your portfolio on or near the Efficient Frontier is a sound strategy to adopt and adhere to regardless of what the markets are doing. Unfortunately, creating efficient portfolios is a sophisticated undertaking that is beyond the skills and interest of most investors. That's where our team can help.
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