In 1952, the investment community took a giant step forward with an idea put forth by Harry Markowitz in an article for an academic publication, the Journal of Finance. Mr. Markowitz was able to calculate a return for a portfolio and a measure of expected portfolio risk. He showed that the variance (or volatility) of the return was a good measure of portfolio risk.
Foremost in the development of risk and return assumptions is the idea of an efficient frontier. This idea considers that diversification is important and it proposes that we can learn how to effectively diversify a portfolio through an optimization process. Basically, the optimization process is like any mathematical problem where we are trying to find the optimum solution based on certain inputs and constraints. In essence, the efficient frontier is the optimum solution. It is the mix of the various asset classes to derive the highest level of return at a given level of risk. The efficient frontier is the best mix of asset classes to maximize return at a certain level of risk.
There are numerous software programs that are used to solve the mathematical programming problem to come up with the optimal solution. Basically these programs consider each asset class’s own return and risk profile. Higher return/risk assets (e.g., small cap stocks) are likely to come into an investor’s portfolio when the investor has a high risk tolerance. Similarly, low return/risk assets will make up a large part of an investor’s portfolio when the risk tolerance is low.
One important factor is missing here: correlation between the asset classes. Certainly, these asset classes do not always move up and down at the same time. If large cap stocks in the U.S. are down, foreign bonds may very well be up. Therefore, in solving the optimization analysis, the software considers the correlation between all the assets. Correlation is important because this is where diversification adds its benefit. This is why an asset on its own that may have a high return and high risk (e.g., small cap stocks) may be part of an investor’s portfolio with a decidedly lower risk profile. If the small cap stock asset class does not perform similarly to the rest of his portfolio, it may provide a higher return and increase the investor’s diversification without necessarily increasing the investor’s overall portfolio risk.
The result of this analysis is that one can develop optimal portfolios based on an individual’s tolerance for risk. Someone with a low tolerance for risk (say 5-10% annual standard deviation) could simply invest in U.S. bonds. However, by choosing an “efficient” mix of the various asset classes, they could achieve a higher return than the U.S. bonds with a similar amount of risk.
This can be used for individuals and institutions in developing an appropriate asset allocation. By maneuvering along the efficient frontier, independent financial advisors can derive the optimal, or “efficient mix” of asset classes to improve the client’s risk and return objectives.
Summit Brokerage Services has a number of industry-leading optimization software packages available to our advisors.