You can optimize your retirement income if you let the Efficient Frontier Curve guide your allocation strategy. Every investor needs to know the relationship between risk and reward. A great way to visualize this relationship is to examine the Efficient Frontier Curve. And don’t worry, you don’t have to be a math nerd to get the concept.
Investors are rewarded for taking risk. Holding cash won’t give you that juicy return you want. But you don’t hold cash to get a return. In fact, holding cash actually yields a negative return.
Many people don’t know that there’s an optimal portfolio that balances securities with:
- High returns and risk
- Lower returns and risk
You may be taking more risk than you need to be to get the exact same return. This means you could lose more money than you otherwise would without getting paid any extra for it.
I ran my portfolio through Personal Capital’s Investment Checkup tool and found that my return of 9.4% and risk of 18.1% is slightly suboptimal. The tool tells me my target allocation should be 9.2% return and 15.5% risk.
Notice the small greenish dot below the curve. This is your risk/return profile if you invest in 100% bonds. This shows just how suboptimal investing all of your assets into bonds can be. You can achieve the exact same return with much lower risk if you simply invested in stocks along with bonds.
So what does all of this mean and how do I fix it? Well, my first inclination is always to do nothing (and that doesn’t just apply to investing).
The goal for every investor is to be on the line. Not above, not below, but on the line. That is part of optimizing your retirement income. You wouldn’t want to get the same monthly income but take more risk than needed. You should only take the absolute least risk possible for the return which you desire to achieve.
Figuring out your desired return is no easy feat. You could use a formula like CAPM or Gordon’s Dividend Discount Model to figure out your expected rate of return. Finance people developed these formulas; they lack a personal touch.
And who wants to use some fancy equation that probably doesn’t meet their needs?
You know your desired return should be somewhere between 0 and a number higher than 0 – say 25%. The number actually will change depending on the risk-free rate and the rate of inflation. Those two numbers should help guide you in determining your desired rate of return.
Inflation is currently around 2% and the rate on a 2-year Treasury is now 1.5%. I think a conservative multiplier of around 5 times the risk-free rate is smart to use when deciding your desired rate of return. In this case: 1.5% x 5 = 7.5%
Why is this a good number?
- It’s measurable and attainable
- It beats inflation by more than 3 times
- It’s not a dream – there is no hope required
- You can plan how to achieve
I shoot for an 8% return. This number includes my core holdings (equities), risk-free investments, and alternative investments. It may seem low given my age. But remember, this is my total portfolio that includes cash. I would, of course, expect my core holdings to perform in the 10-12 % percent range on average over a rolling 10-year period.
You can now plug your desired rate of return into the Efficient Frontier Curve. My 8% desired return translates into 9.5% risk on the curve.
Risk on the Curve
What exactly does risk on the Efficient Frontier Curve actually mean? Risk is simply the standard deviation of a given portfolio. A different efficient portfolio will be pulled in based on a given set of efficient portfolios depending on your risk tolerance. The risk percentage or standard deviation along the x axis will change depending on the risk-free rate and the the data set used. Personal Capital has standardized the process for the Efficient Frontier Curve.
When most investors think about risk, they think about beta. Beta is visible because it’s listed everywhere: Google Finance, Yahoo Finance, Morningstar, Market Watch, etc. Beta can help you reduce portfolio risk, but you’ll still be stuck with systematic risk. Systematic risk is the risk of overall market declines, think 2008-2009. The only way to reduce systematic risk is to diversify across investing dimensions:
- Equities / Stocks
- Debt / Bonds / Treasuries
- Real Estate / REITs / RealtyShares
- Options (which is a derivative of whatever dimension you invest)
Not only do you have to be diversified across different equities, you also have to achieve diversification across investable dimensions if you want to reduce systematic risk.
The Human Element
A limitation of the Efficient Frontier Curve is that it assumes investors are rational (ha!) and seek to maximize their investing utility. This means that given a choice between investing at a risk-free rate of 4% and a stock portfolio that yields 3.5%, the investor will always choose the risk-free investment. This is a really clear cut example. Investing is complicated. Sometimes investors don’t choose the “utility-maximizing” portfolio.
The Efficient Frontier Curve uses assumptions which may not represent reality, the reality of market participants like you and me making not-so-rational decisions. Hey, we’re human.
While I like the math of the Efficient Frontier Curve (and all of Modern Portfolio Theory) and recommend following it as a guide, I also realize its limitations. The problem with the nice looking math is that humans don’t operate as robots; they’re not homo economicus as most traditional economists think. And that creates opportunities in the market. While I’d agree that most of the time markets appear to be efficient, there are times when the pendulum swings to hyper-irrational and inefficient.
Optimizing Your Portfolio Using the Efficient Frontier Curve
Here at Optimize Your Retirement, we’re all about making the most optimal decisions with your money. But given the complexity of investing and the quantity of choices, it’s not easy to say: this is the best way to invest. It’s a combination of personal choice, desired / needed return on investment, and then best practice like using the Efficient Frontier Curve.
If you run the numbers and see that you could be taking on less risk while getting a very similar return, you should think about making a change. If you’re close to the curve, then you may not need to do anything. I think that’s perfectly fine if you’re close to, but not on the curve.