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Ask any investor what he is looking for from his investment portfolio, and the answer that you are most likely to hear is "best possible return with the least possible risk". A more demanding version of this could simply be "high return with no risk". The latter statement we know is not possible to achieve, but the former statement is what your clients will hold you responsible to deliver for them - best possible return with the least possible risk. Return and risk go hand in hand, which is why both statements don't just say "high returns" only : both statements acknowledge the element of risk when chasing high returns, and therefore place a responsibility on the advisor to find that optimum balance between return and risk. Helping you do this onerous job is a concept known as Modern Portfolio Theory (MPT).
What is MPT?
Modern portfolio theory (MPT) says that it is not enough to look at the expected risk and return of one particular stock. The risk in a portfolio of diverse individual stocks will be less than the risk inherent in one individual stock. Thus, the portfolio of various assets plays an important role in reducing risk. It explains how to find the best possible diversification. It places a large emphasis on the correlation between investments. For example, different assets such as bonds and stocks may not react in the same way to a particular market condition. Weak economic activity is usually good news for bonds as interest rates fall, while at the same time its not normally good news for stocks as earnings fall during periods of weak economic activity. Building a portfolio with uncorrelated assets or assets with weak correlations thus reduces overall portfolio volatility.
Now, we all know that diversification helps control volatility. But, how do you build a portfolio that has just the right level of diversification, which has the optimal mix of assets that delivers the required return at the lowest risk?
What is Efficient Frontier?
Modern Portfolio Theory suggests that for every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be plotted on a graph, and the resulting line formed is the Efficient Frontier. The purpose of the efficient frontier is to maximize returns while minimizing risk.
The theory assumes that given the choice of two portfolios with equal returns, investors will choose the one with the least risk. If investors take on additional risk, they will expect to be compensated with additional return. The efficient frontier line starts with lower expected risks and returns, and it moves upward to higher expected risks and returns. A rational investor will normally hold a portfolio that lies on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line.
MPT is designed to mitigate unsystematic risk, meaning the risk of having your portfolio concentrated in one asset class, like stocks. MPT does not claim to mitigate systematic risk, which is risk inherent in the entire market or in a segment of the market.
Thus for a given amount of risk, MPT explains how to select a portfolio with the highest possible expected return. Or, for a given expected return, it explains how to select a portfolio with the lowest possible risk.
We can calculate the expected return and risk of all possible portfolios that can be constructed using the available investable assets. If we begin to plot the return-risk for each portfolio, we see the following
We can see in this graph that there are some portfolios that appear better than others in terms of risk and return. For example, a risk averse investor would prefer A to B (more return and same risk) and would prefer C to D (same return and lower risk).
Lets take a practical example
Assume an investor has a return expectation of 13% that he seeks over the next say 10 years. You have 6 asset classes amongst which you can allocate his portfolio : domestic equities, international equities, gold, income funds, short term income funds and liquid funds.
When looking at expected returns, advisors would normally look at annual returns of each asset class over long periods of time - 10 to 20 years, and arrive at the average annual rate of return. You would also need to compute the level of risk of each asset class - as measured by the standard deviations of these returns.
As an advisor, you can construct several portfolios with different weightages to each of these 6 asset classes, which all give you an expected weighted average return of 13%.
In the table above, the expected return and risk are what you will compute for each asset class. Risk here will be the volatility with which this average return is generated over time.
In Option One, you allocate across all asset classes in a manner that gives you a weighted average return of 13.3% - which meets the benchmark return expectation. The asset mix and the risk within each asset class suggests that the overall risk will be around 20% - that's the kind of variability in annual returns that one should expect from this portfolio.
Option Two allocates only to 2 asset classes - while the return is similar to Option One, the risk is higher. This is because of the higher allocation to domestic equities, which is the most volatile of all 6 asset classes.
Several more permutations and combinations across these 6 asset classes can be created, with the objective of reaching the 13% target return. The option that achieves 13% expected return with the lowest aggregate risk, is the option that is likely to be most acceptable to most investors. That's the one that will feature on the Efficient Frontier curve, for a return expectation of 13%.
The other way of flipping this exercise is to define maximum volatility, or maximum expected risk. If the maximum risk is set at 10%, you would look at various combinations of asset classes and select the one that maximises return within the limit of 10% risk.
Conclusion
The goal of MPT is to identify your client's acceptable level of risk tolerance, and then to find a portfolio with the maximum expected return for that level of risk. An advisor would need to understand the investor's risk appetite and then make a portfolio which gives him maximum expected returns. As a result, diversification of assets in the portfolio plays a key role in Modern Portfolio Theory, and the Efficient Frontier can be a useful way to create optimal portfolios for your clients.
Share your thoughts and perspectives
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