Concept Five: Design Portfolios That Are Efficient
How do you decide which investments to use and in what combinations? Since 1972, major institutions have been using a money management concept known as Modern Portfolio Theory. It was developed at the University of Chicago by Harry Markowitz and Merton Miller and later expanded by Stanford professor William Sharpe. Markowitz, Miller and Sharpe subsequently won the Nobel Prize for Economics for their contribution to investment methodology.
The process of developing a strategic portfolio using Modern Portfolio Theory is mathematical in nature and can appear daunting. It's important to remember that math is nothing more than an expression of logic, so as you examine the process, you can readily see the common sense approach that it takes—which is counter-intuitive to conventional and overcommercialized investment thinking.
Markowitz has stated that, for every level of risk, there is some optimum combination of investments that will give you the highest rate of return. The combinations of investments exhibiting this optimal risk/reward trade-off form the efficient frontier line. The efficient frontier is determined by calculating the expected rate of return, standard deviation and correlation coefficient for each institutional asset class fund and using this information to identify the portfolio at the highest expected return for each incremental level of risk.
By plotting each investment combination, or portfolio, representing a given level of risk and expected return, we are able to describe mathematically a series of points or "efficient portfolios." This line forms the efficient frontier. It's important to note that, while a portfolio may be efficient, it is not necessarily prudent.
Most investor portfolios fall significantly below the efficient frontier. Portfolios such as the S&P 500, which is often used as a proxy for the market, fall below the line when several asset classes are compared. Investors can have the same rates of return with an asset class portfolio with much less risk, or higher rates of return for the same level of risk.
Exhibit 6 illustrates the efficient frontier relative to the "market." Rational and prudent investors will restrict their choice of portfolios to those that appear on the efficient frontier and to the specific portfolios that represent their own risk tolerance level. You want to ensure that, for whatever risk level you choose, you have the highest possible return on the efficient frontier so that you can maximize the probability of achieving your financial goals.
