There is a way for you to set up your portfolio for maximum gain and minimum risk. 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.
A portfolio is “efficient” if it has the best possible expected return for the minimum amount of acceptable risk. A portfolio is “inefficient” if it has a higher risk than is necessary for the expected return. It’s such a simple concept: don’t take on more risk than you have to in order to achieve the same result.
To illustrate this concept, think about taking a trip in your car. You have a destination in mind and you’d like to get there as soon as possible. Your goal to get there efficiently would mean you have to take the most direct route or possibly the faster route. Maybe there’s a highway that gets you there without side street traffic. You wouldn’t aimlessly drive around in circles before you reach your destination but that’s exactly what people do when they invest. Investors do things that add risk (driving around in circles) without increasing their expected return (changing their destination).
Most people don’t know if their portfolio lies on the efficient frontier curve. And it’s no fault of their own. Their advisors either don’t tell them because the advisor knows they aren’t on the curve or they don’t believe that it matters. Even if you aren’t on the curve, you should be informed to make a better decision. You can check to see if your portfolio is on the curve by clicking on Investment Checkup in the menu of PC and scrolling about halfway down. This is one of the fundamentals of investing that you must figure out before building your plan.
People who invest all their money in bonds, for example, would be way under the curve on the left side of the chart. This means that they’re taking on too much risk without getting an adequate return. It seems counterintuitive to say that investors in bond-only portfolios are taking on too much risk. Most people think that investors in stock only portfolios take on too much risk. But it’s true, you can take on too much risk for the expected return by investing in bonds only. By simply adding 10-20% equities, the investor’s portfolio gets much closer to the curve, which means that they’re taking minimal risk for the expected return.
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 a software 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.
The goal for every investor is to be on the line and not too far below it. 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.
To understand why using the efficient frontier curve is so powerful, let’s go over an example of a portfolio that holds two stocks versus one stock. You invest 50% of your money in each stock A and stock B. Stock A increases by 10% in the first year and 0% in the second year. Stock B increases by 0% the first year and 10% the second year. You rebalance your portfolio regularly so you can actually get more than a 20% total return over the two-year period. Why? Because of compounding: the second year’s return of 10% would be on a base that already had an increase of 10% in the first year.
Now take a look at a one stock portfolio that has a chance to return 20% in either year one or year two but not both. Putting 100% of your money into this stock would never generate a return of more than 20% over the two-year period. It either generates exactly 20% in year one or year two. This portfolio also has a higher risk because it has a higher standard deviation. This means this portfolio is riskier and produces a lower return than the two-stock portfolio.
This is a very simple illustration and not a real life example. But you can see now that it’s actually possible to generate a higher return with less risk. Now you can imagine a twenty-stock portfolio and how that affects risk and return. Again, seems counterintuitive but it’s just a mathematical fact. Understanding this simple fundamental finance concept should help guide your investment journey to make your portfolio more optimal.