Concept #5 for Financial Success: Crafting an Efficient Portfolio

November 8, 2013
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The fifth and final concept in our blog series “Intelligent Investing: Five Key Concepts for Financial Success” focuses on efficient portfolios. We’ll look at how the concepts behind Modern Portfolio theory can help design portfolios that seek to achieve maximum return for minimum risk.

Concept Five: Design Efficient Portfolios

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 in Economic Sciences for their contribution to investment methodology.

KEY DEFINITIONS

Expected rate of return is typically calculated as the risk-free rate of return plus the risk premium associated with that equity investment.

Standard deviation is a description of how far from the mean (average) the historical performance of an investment has been. It is a measure of an investment’s volatility.

Correlation coefficients measure the dissimilar price movements among asset classes by quantifying the degree to which they move together in time, degree and direction.

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 commonsense approach that it takes—which is counter-intuitive to conventional and over-commercialized investment thinking.

Markowitz stated that for every level of risk, there is some optimum combination of investments that will give 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 asset class and using this information to identify the portfolio with the highest expected return at 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.

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.

exhibit5Exhibit 5 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. Our job is to make sure that for whatever risk level you maximize the probability of achieving your financial goals.

In our next post, we’ll wrap up the series by discussing how a wealth management approach can take care of more than just your investments—it can address your advanced planning needs.

 

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Examples are hypothetical in nature and are for illustrative purposes only. HFG Wealth Management, LLC (“HFG”) is an investment adviser registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. The views expressed by the author are the author’s alone and do not necessarily represent the views of HFG or its affiliates. The information contained in any third-party resource cited herein, including but not limited to other blogs, websites or articles, is not owned or controlled by HFG, and HFG does not guarantee the accuracy or reliability of any information that may be found in such resources. Links to any third-party resource are provided as a courtesy for reference only and are not intended to be, and do not act as, an endorsement by HFG of third party or any of its content or use of its content. The standard information provided in this article is for general educational purposes only and should not be construed as, or used as a substitute for, financial, investment, or other professional advice. If you have questions regarding your financial situation you should consult your financial planner, investment advisor, attorney or other professional. A copy of HFG’s current ADV Part 2A discussing HFG’s investment advisory and financial planning services and fees is available for review upon request or at www.adviserinfo.sec.gov.

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