Efficiently lining up reward and risk
Joel Dresang: Steve, in talking about building a balanced investment portfolio – balance between risk and reward – one of the tools that you use is called the Efficient Frontier. What is that?
Steve Giles: Efficient Frontier is basically a model for risk assessment in a client’s portfolio, Joel. The Efficient Frontier gives us a sense of how much extra return we’re generating for the amount of risk that we’re taking in a client’s portfolio.
Joel: So, I think of stock as being a riskier investment and usually a higher reward. If I go 100% stock, isn’t that the highest reward?
Steve: You know, most people think that when they first come into our offices, Joel. They think that they have to have all their money in stocks to achieve their long-term goals. All they’re doing is putting themselves into perhaps the riskiest, from a volatility standpoint, portfolio that they can possibly do.
Just introducing a sliver of bonds into a 100% stock portfolio is going to dramatically reduce their overall risk and in doing so, reduce the volatility that they’re going to experience on a monthly, quarterly, or annual basis. And in reducing that risk, they’re not giving up much, if any, in way of return. We focus on downside protection first and foremost. We focus on protecting clients from loss.
By introducing a bond component, we’re actually able to reduce their overall volatility without giving up much in the way of return. I tell clients often that it’s darn near impossible to do above average in the markets unless you take above-average risk. You can actually achieve average returns but take below-average risk to get there.
Joel: So what about on the other end of the spectrum? If I have 100% of my investments in bonds, which are generally considered safer than stocks, isn’t that the safest investment?
Steve: A lot of people think, Joel, that 100% of their money in fixed income is going to be the least risky portfolio that they can have. It’s actually not. Just introducing a sliver of stocks to a 100% bond portfolio, we’re able to not only reduce your risk but also give you a commensurate amount of return.
Joel: So, the Efficient Frontier is set up so that you can see at what point the next increment of risk is not worth the return?
Steve: Absolutely. And that increment gets up around 55%-60% where if you go much higher in stock exposure, you’re just not getting compensated for the additional amount of risk that you’re taking. You get above 55%-60% in stocks, all you’re doing is increasing your volatility when ultimately longer term, you want to focus on increasing your return in the most efficient manner possible.
Steve Giles is vice president and investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May
(initially posted April 24, 2014)
Learn more Watch Kyle Tetting in Talking Money: Modern Portfolio Theory Read about Efficient Frontier, with links to further resources
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