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Why the Efficient Frontier Matters

When I was a kid (I’ve been at this a long time), the practicality of the “efficient frontier” used to baffle me. The theory is essentially this: that there are different investments that offer different levels of risk (measured by standard deviation from the average), but some investments that offer similar risks also differ widely in their historical returns.

In other words, if you want a certain level of return, you can pay with reasonable risk or a lot of risk.

Therefore, your goal is to capture the most return you can at whatever level of risk you’ve deemed appropriate for your situation. That “frontier” of the best potential return for any given level of risk is called the “efficient frontier.”

The reason this used to confuse me was that, in my young mind, I thought to myself: wouldn’t everyone simply want the best return, regardless of risk? Why would anyone settle for less than the highest return potential? Just give me your best pick for the hot stock!

But it took me time to put two and two together. The fact is, with anything involving risk, we are always dealing with uncertainties. It doesn’t matter whether you think this or that investment is going to outperform the average; the truth is, you may be right and you may be dreadfully wrong.

In his book “The Only Three Questions That Count,” renowned investor Ken Fisher explains the importance of asking oneself the first of these three questions: What do I believe that is actually wrong?

This is, of course, a very difficult question to answer without input from others and some extremely honest research and self-reflection. But the big idea to capture at this moment is that, regardless of how much experience you do or don’t have in the investment industry, there is inevitably something you believe that is probably wrong, even if that’s simply a belief about something still future.

That’s where the importance of asset allocation comes in.

Balancing the Odds

When there is uncertainty in any realm of life, the best thing we can do as humans with limited knowledge is to balance the odds, to the best of our ability, in our favor.

What this means is that we will be wrong some of the time, and sometimes even badly wrong. But the beauty of odds over a long period of time is that, even with the knowledge that we will lose sometimes, there are things we can do that will give us a higher likelihood of winning more often than we lose. We can also decrease the likelihood of how much we lose in any given period of time, even if we can’t eliminate the risk altogether.

Because these are odds, then the greater the sample size (the time horizon), the more trust we can afford to place in the odds playing out in our favor.

There are a variety of asset classes which can be considered for an investment portfolio. Perhaps the three most common are equities (stocks), bonds and cash. But there are also other assets such as commodities (think precious metals, fossil fuels, crops), currencies, annuities, non-traded REITs (real estate investment trusts), and derivatives. Each of these face unique risks, some of which are very great risks depending on the strategy, the combination or concentration of the various categories.

To simplify for the purposes of this discussion, let us consider only the three most common: equities, bonds and cash.

Risk: Are You Both Willing and Able?

There are two main things that can work powerfully for or against an investor who takes on risk.

The first is an investor’s willingness to take on the risk. The fact is, not everyone wants to risk seeing their investment drop 30%+ in a bear market. Even if they have more than they could ever hope to spend in their lifetime, for their own peace of mind, they may simply not want to watch that sort of a roller coaster ride with their money.

Sometimes the theory of risk/reward over long periods of time simply matters less to one person than another. Some prefer the comfort they feel in the present of experiencing a smoother ride with their asset values.

This is extremely important for an investor to honestly determine early on, because often the biggest enemy of compounding returns is an investor’s desire for upside without the same willingness to ride through the inevitable downside. This leads to constant second-guessing, causing them to materially shift their asset allocation on a fairly regular basis, and even take large cash positions whenever markets become volatile or bad news strikes (an almost constant occurrence).

But what most of these types of investors fail to realize is that, even if one or a few occurrences of this are successful, the odds are against someone who tries to time the market in such a manner. It’s easy to get out; it’s far more difficult to decide when to get back into markets. By the time things are “back to normal” (does normal even exist?) markets have foreseen it a long time ago when they recovered, passing the investor by while they sat idly on the sidelines.

Timing markets is a losing long-term game. Only in extremely rare cases might there be a way to predict with a high degree of confidence an imminent bear market, but the rareness of these inefficiencies in markets is reason to either leave such decisions to a professional or simply choose to ride through all types of market conditions with the level of risk that you have determined you are willing to shoulder.

Ability is the second part of risk tolerance. Some people may be willing to take on the risk, but may not have the ability.

Let’s illustrate with an example.

Take Jeremy who has recently sold his house and plans to rent for a couple of years while looking for his next house to purchase. He is feeling confident about the future and believes that we are in a bull market which is likely to run for several years. He decides to invest the proceeds from the sale of his house in an all-equity strategy, hoping this will grow in value for when he withdraws in two years from now to make his next house purchase.

While Jeremy’s plan might work, it also has an uncomfortably high chance of failing because two years is a very short period of time when it comes to stock markets. If Jeremy is wrong, and equity markets take a steep drop in year two, then he has significantly less money to buy his new home than if he’d simply left it in cash or a cash equivalent. The potential reward would be nice to have if things go his way, but the risk it entails is unbearable if things should go the other way.

As a consequence, Jeremy would have to a decision to make: does he now wait longer to buy his house (while real estate values potentially continue to rise) or does he settle for a less valuable property than originally intended?

On the other hand, if Jeremy receives an inheritance that he plans not to touch for 20 years until his retirement, this may be a much better situation in which to invest in the all-equity strategy. The odds are much more in his favor because he has a larger sample size (of years) with which to work. Even if a bear market occurs, which is extremely likely to happen multiple times over a 20-year period, he has plenty of time to recover because he doesn’t need the money for at least two decades.

Even when it comes time to retire in 20 years, he won’t need the whole amount at once, but rather in gradual increments over his retirement years. This is a situation where he might be wise to consider all or mostly equities, depending on his willingness to take on risk and ride out the waves.

For the house purchase in two years’ time, he’s better off to avoid the risk since the potential reward is not worth the risk to obtain it.

Conclusion

There is a lot to know about the risk factors of various asset classes, and this article has been a simplification of those factors and decisions that go into it. Even standard deviation, which is the common measurement of risk, is not the only way (or even totally sufficient way) to measure it. We have the unrepeatable past to look at; we can only guess at the future. That’s why investment disclosures often include the language that past returns are not an indication of future returns.

There is always risk, in some ways difficult to measure, and the past does not repeat itself exactly. But what we can do is take an educated guess at the future, weighing the foreseeable risks and diversifying among them, so that an investor has a high potential to be able to reach his or her goals in the future. Think about it like rolling weighted dice; you still stand to lose from time to time, but the more you roll, the greater your overall wins are likely to be.