Inasmuch as we already have several threads that mention the "efficient frontier", I thought that it be useful to some members to have an explanation of what it is and why it's important.

The efficient frontier considers two important aspects of investment: return and risk. Return is generally well understood by most investors: the percentage increase in the value of an investment over some period of time. Risk is generally poorly understood by most investors; it is the amount of uncertainty in achieving particular returns in the future. There are many ways to measure risk, but the most common method used in finance is the standard deviation of returns; this is a measure of how much the periodic returns vary around the average return over some period of time.

First, some history:

The March, 1952 issue of the Journal of Finance included a revolutionary article entitled Portfolio Selection by economist Harry Markowitz. In this article, Markowitz described how the risk of a portfolio of assets

 

nice write up. it's coming back to me

 

Magician, I emailed you some questions. I hope you don't mind.

Tom

 

Not at all.

 

Magician, I also have a several questions in regards to asset allocation, etc. Would you mind offering some insight and advice if I PMed you? Thanks.

 

Ask away. I'll do my best.

 

Magician,

I forgot one in my email

FAIRX

 

Does diversifying risk through the efficient frontier need to be combined with asset allocation such as small, mid, and large cap, value, growth, domestic, international, sectors, etc. or will it work on it's own?

 

GREAT WRITE UP MAGICIAN!!!

 

That's an interesting question. About a month ago I was talking with an experienced financial planner. He asked me more than once how we classify mutual funds: small-cap growth, large-cap value, international, whatever. I told him that I don't classify funds, because I don't care what they're called; all that matters are:

1. Returns
2. Volatilities (risks)
3. Correlations of returns with the rest of the portfolio.

After about an hour of this he finally said, "So, your analysis is based only on performance?"

It took all the effort I could muster not to say, "Well, duh!!! What else is there?"

After the meeting, I was talking with my business associate; he wanted to know why someone with so much experience in the business was having such a difficult time understanding our analysis. "Simple," I told him. "Since he was so high standing at his mother's knee he's been told that he needs a diversified portfolio. The problem is that he was never told diversification of what. When he got into the investment business he was told that diversification means investments in many types of securities, in many sectors, in many geographical areas, and so on. The people who told him that were wrong. Diversification means only one thing: diversification of risk; however, because most people - including most investment professionals - don't know how to measure risk, much less how to diversify it, they use diversification of securities, sectors, geography, and so on as a proxy for risk diversification. But they don't realize that it's only a proxy: they view what they're doing as the end itself, rather than as a means to the proper end: diversification of risk."

That's a long-winded way of saying that you should consider all of the asset allocation options you've listed: stocks, bonds, commodities, foreign securities, domestic securities, growth, value, small, mid, large, and on and on. However, when you're combining them into your portfolio, those labels mean nothing. What matters are returns, volatilities, and correlations. It doesn't matter if bonds generally move opposite stocks, so that a combination of a stock fund and a bond fund will lower your risk for a given return; if the particular bond fund you're considering has a +45% correlation of returns with the stock funds you already hold, it probably won't improve your portfolio at all. (I analyzed a portfolio that had exactly this situation. Traditional asset-class-based allocation would have said adding this bond fund was a good, risk-reducing move; it wasn't.)

So, Does diversifying risk through the efficient frontier need to be combined with asset allocation such as small, mid, and large cap, value, growth, domestic, international, sectors, etc.? Yes, in a sense. You start with your menu of securities, then do a risk/return analysis to come up with an appropriate mix.