Is this the most underrated chart to build your investment portfolio?


This article originally appeared on Fool.com. All figures are in US dollars unless otherwise specified.

Most investors make one big mistake when building their investment portfolio, and it can be costly. Luckily, we can all glean valuable insights from an important chart used by professional asset managers. This chart won’t create the perfect portfolio for you, but it does provide essential guidelines for establishing an investment allocation.

The efficient frontier

The efficient frontier is a graph that plots portfolio returns against portfolio risk.

Source: RBC Wealth Management — “Why is asset allocation important?” »

The chart is well known to asset managers and financial advisors, but is rarely mentioned by individual investors. Professionals need to focus more on risk management – ​​losses tend to shake a client’s confidence in an asset manager. Meanwhile, the financial media heavily covers stock indices and the performance of individual stocks.

Feedback is intuitive. If you invest a certain amount of capital, the value of that investment increases or decreases by a certain percentage. Over the long term, these returns are based on the fundamental performance of the asset. Companies that grow and produce profits tend to have appreciating stocks. Shares of failing companies generally lose value. It’s quite simple.

Risk is a bit more complicated, and there are entire fields of study dedicated to understanding it to a high degree. Risk is defined in different ways, but portfolio risk generally refers to volatility. Volatility is usually calculated as the standard deviation of returns over a given time period, and beta is a popular metric for measuring relative volatility. Portfolio returns tend to follow long-term trend lines, but fluctuate around this trend in the short term. The greater the fluctuations in the value of a portfolio, the higher the risk it is considered.

This graph suggests that there is a trade-off between investment risk and long-term return. In an efficient capital market, investors are forced to accept more risk in exchange for higher expected returns. Stocks are more volatile than bonds, but they produce greater long-term gains. Growth stocks have higher upside potential than value stocks, but they are also prone to larger losses due to high valuation ratios.

How the efficient frontier works

The efficient frontier is theoretical – the exact numbers are not really known or universally established. Instead, it represents the highest theoretical return that can be achieved at a given level of volatility. The curve is the collection of potential returns across the entire risk spectrum, from low volatility to high volatility.

From a portfolio composition perspective, any point along the boundary is just as good as any other. It may seem strange to suggest that a strategy with an average return of 6% could be as good as a strategy with an average return of 10%, but it is true in the context of asset management. Not everyone can take on the risk necessary to earn higher rates of return, and the frontier illustrates a balance between the two. Investors with low risk tolerance cannot achieve the same long-term growth as those with high risk tolerance.

Any point below the boundary is less than any point on the boundary. If a portfolio’s long-term combination of volatility and return puts it below the boundary on a chart, then that portfolio is not rewarding investors enough for the risk taken. In this case, there are better allocations that could generate more growth without adding additional volatility.

Use border

The key to portfolio management is to identify your optimal position along the efficient frontier and then ensure that your investment strategy comes as close to the theoretical limit as possible. This is how the best allocations are defined, rather than just the biggest wins over a small window.

The first step is to quantify risk tolerance, which should reflect time horizon and personality. Risk tolerance questionnaires are popular tools for doing this, and they allow investors to set a volatility target for a portfolio.

Once this volatility ceiling has been determined, it is important to maximize potential growth within these limits. Obviously, that’s easier said than done, and there are tons of variables and unknowns that dictate the wins and losses going forward. Fill your allocation with high conviction stocks that will generate growth, but make sure it is governed by risk tolerance. This is the best way to position yourself on the right side of the efficient frontier curve.

People who have long-term horizons and can handle volatility are able to take on more risk in favor of growth. These portfolios should contain more growth, small cap and emerging market stocks. At the other end of the spectrum, some investors have to sacrifice growth to limit volatility. These portfolios tend to hold more bonds, dividend-paying stocks, and stable-value stocks.

A 30-year-old should generally focus on growing their 401(k) or IRA. Investors approaching retirement need to pull the reins to ensure they are not forced to sell stocks at the bottom of a market cycle.

We see it in action with the current stock market correction. Any retiree whose well-being is seriously compromised by this setback has mismanaged their exposure to volatility and ignored the efficient frontier.

This article originally appeared on Fool.com. All figures are in US dollars unless otherwise specified.

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