Hey everyone, this is Kirk, here again at optionalpha.com.
And in this video, we're going to be talking about the efficient portfolio frontier.
This is probably one of the more difficult topics to get across.
And so, I'm going to try to get it across in one video.
It might be a little bit longer than usual.
But stick with me through this.
I promise that I'll try to make it as easy and painless as possible.
At least, a little bit more painless than it was for me when I was in school.
So, the efficient portfolio: Simply a combination of assets, i.e. a portfolio that has the best
possible expected level of return for its level of risk.
That's all it really is.
It's the most efficient portfolio that you can create, right?
You can create a portfolio of two stocks or three stocks.
This is a combination of as many different stocks with as many different risk features
that creates the optimum level of risk versus return.
So here, every possible combination of risky assets, without including any holdings in
risk-free, which are treasuries, can be plotted onto a risk expected return space to find
the optimum market portfolio.
And we're going to go over that.
So, what it's basically doing is that it's taking every combination of assets.
So, you could take stock A and B, and B and C, and A and C, and all these different combinations,
and you can plot their risk versus return onto a graph.
And you want to choose the one that has the best possible or most optimal risk versus
return.
This efficient frontier in and of itself is the sloped portion that gives the highest
expected return for a given level of risk, not just the lowest risk.
And that's really important here.
We're not talking about the highest return for the lowest risk.
We're talking about the optimal point at which each level of risk is equated to a higher
level of expected return.
So, visually on this chart, this is what this efficient frontier looks like.
It looks like this right here, this green line that I've drawn.
So, just as a basis, we're going to look at this line down here as being levels of risk.
So, down here at the left, it's going to be low levels of risk, and up here, it's going
to be high levels of risk.
So, as we go out on this chart, we are increasing our risk.
Now, on the vertical, we're going to be looking at the return, right?
So, down here is low levels of return, returns of zero.
Right here is the risk-free security, and this is going to be the treasury market where
you can buy treasuries that are virtually risk-free from the government, guaranteed
return.
And then anything above this is going to be returns that we get outside of the risk-free
market.
So, what we're going to do here is we're going to the plot just different lines.
So, for example: We could have stocks that are trading here.
So, stock A could be right here.
And it could give us a risk level of here of this risk level on this chart versus this
return to the left.
And you can see that that's actually a pretty good risk reward to start with, right?
But what if you could actually go out here?
You could take on more risk, and your return would be just slightly higher.
And you'd have to think to yourself.
Is that really worth my time and energy?
I'm taking all a lot more risk for just only a slightly higher return.
Again, we move further out.
We take on more risk.
But this time, we take on even more return, expected returns.
So, for the unit of risk that we're taking, you can see that we're actually returning
much more money.
And then finally, you can have something that's even more efficient, that we're taking on
less risk overall, but we have a much higher expected return.
So, this jump from this third blue dot to the fourth is much more of an efficient jump.
We're taking less risk overall for each unit of expected return.
Now, what the problem is with this is that with all these combinations of different portfolios
or individual portfolios, notice that here at this first blue level that for the same
amount of risk, we can possibly get an even higher return.
And you'd notice that because at this blue level, you can see that the blue is at the
same risk level as this market portfolio here.
And at the same risk level, we could be expecting much higher returns.
So, you can see there our blue portfolio or our blue stock is not efficient.
In fact, it's really under efficient, and it's really wasting precious time and energy
here because it's taking on too much risk and not returning enough money.
So, this line here, this efficient frontier is a combination of all the possible securities
that create the most efficient portfolios.
And really, it's a line, but it's made up of a bunch of different portfolios and different
weights.
This point here which is the most efficient portfolio, it has the best return versus risk,
it has the highest sloping line if you will, and it's giving you the highest return per
unit of risk.
That is the market portfolio.
And in our case, for the US markets, this actually happens to be the S&P 500 index.
Most people don't know that the S&P 500 index is technically the most efficient portfolio.
It is the 500 correlated stocks that are most efficient and give you the best return versus
risk which is why it's used as a wide benchmark for the economy and the stock market.
It's the most efficient portfolio.
So, that's where the efficient frontier comes in.
It's this frontier that gives you all of these different allocations and gives you the best
look at your returns versus risk.
So, again, whenever you see a model asset allocation portfolio, chances are that they're
constructed to be relatively efficient in terms of maximizing risk and reward.
But if we take this theory above to the extreme, one could conclude that for each level of
risk or return, there is a single best portfolio mix, right?
We've already proved that.
Now, just because you have stock A and stock B in a portfolio, it doesn't mean that stock
A and C could potentially be less risky and better for your portfolio.
Again, this is where the efficient frontier comes into, right?
We have this optimal use of portfolio and its right along this green line here that
we've drawn.
These stocks that are inside this green line, all the blue ones here, are relatively inefficient
because for the same level of risk, we could be making much higher returns.
Again, you can look at it kind of like this, as a stocks versus bond portfolio, right?
If you have higher and lower risk on the bottom scale and potential return higher and lower
on the vertical scale, you can see that a conservative portfolio made up of mostly bonds
is going to be lower risk, but also lower return.
A balanced portfolio that's about 60% stocks and 40% bonds is going to be about middle
of the road.
It's going to take on average risk, and it's going to take on an average potential return.
And then of course, a 100% equity portfolio or all stocks is going to be much riskier,
but it's also going to offer the potential for much higher returns.
And this is where that mix comes into place, where we can mix and match different securities,
not just stocks and bonds, but millions or hundreds of stocks in between here and hundreds
of different bonds.
So, there's four things to consider, and I'm going to go over these very, very detailed.
The efficient frontier is based completely on the past.
Correlations will change, and so should your portfolio.
Remember that figures from the last 50 years are going to be different than the next 50
years, right?
And this is very easy to understand, right?
The last 50 years of trading, we didn't have as many tech and computer and internet companies.
Now that we're transitioning in the next 50 years, we're going to have much, much more
of those.
Those are going to be more efficient, better for risk reward, possibly, and the portfolio
is going to adjust and change.
Actually, the S&P 500 does this automatically.
It will have times where it throws out stocks out of the S&P, and have times where it add
stocks that are more at portfolio as the market evolves.
So, every year, there's new data, and the ideal portfolios change, like we talked about.
What was the ideal portfolio in 1984 isn't now.
So, make sure you're adjusting for the better Adjusting your portfolio is always a good
thing.
You want to throw out the bad and keep in the good.
Now, there are limitations on asset classes.
And investments do track such asset classes.
For example: I was in the REIT industry which is real estate investment trust which I think
is completely different asset class while others do not.
So, there are some things that are a little bit different, and you want to take advantage
or just understand what kind of investment classes you're throwing in there.
Some people think that REIT's, they have exposure just real estate, when in reality, they could
have exposure to mortgages or to industrial complexes or multi-family, whatever the case
is.
Remember that their real cost, like management fees, taxes, brokerage fees, that are not
taken into account with the efficient frontier, it's just purely the best mix of stocks.
So, clearly, these areas have a huge impact on your bottom line return, but are widely
variable to the equations.
So, make sure as always that even though you think you have the most optimal mix, that
you look at what securities are being added to your portfolio and how much they cost you
both on a fee basis and on tax basis.
So, as always, I hope you guys really enjoyed this video.
I hope it helped clear up what the efficient frontier is.
As always, you can share this video right below, with any of your friends, family, or
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