The objective of Modern Portfolio Theory is always to obtain efficient portfolios, the criteria for which is either of the following:
A portfolio that meets these criteria is said to lie on the Efficient Frontier. The Efficient Frontier is an arc representing all the portfolios where:
- For a given level of expected return, there is no portfolio with a lower risk.
- For a given level of risk, there is no portfolio with a higher expected return.
The concept of the Efficient Frontier is shown on this chart where the three types of correlations are depicted.
- At a given level of expected risk there is no other combination of assets that has a higher expected return.
- At a given level of expected returns there is no other combination of assets that has a lower expected risk.
Credit: Managing Investment Portfolios. Asset Allocation, Chapter 7. William Sharpe
| The notions that emerge from this chart:
The question is, how does one build a portfolio using the principles of Strategic Asset Allocation and Modern Portfolio Theory?
- Perfect positive correlation results in no risk reduction
- Perfect negative correlation has the potentially for totally eliminating risk
- The arc that connects points X and Y is the condition of less than perfect correlation (neither +1 or -1).It represents 0 correlation in this figure, but with a little less curvature it could represent the typical positive, but less than perfectly positive +1correlations for a portfolio.
An optimized investment portfolio that achieves maximum returns with minimum volatility is said to lie on the Efficient Frontier as shown in the chart here.
| There are two ways investors can optimize Portfolio A:
- Adjust the portfolio to receive the same return with lower volatility resulting in Portfolio B, or
- Adjust the portfolio to receive a higher return with the same amount of volatility resulting in Portfolio C.
Either way, Portfolio A would be adjusted to lie on the Efficient Frontier and receive the maximum return for a given level of risk.
Here we see a series of portfolios on the efficient frontier
Source: CIBC Wood Gundy Private Client Investing
| Efficient Frontier 1950-2003
The first efficient frontier line is critical for your conservative clients: A portfolio comprised of 80% bonds and 20% equity carries about the same risk as a pure bond portfolio, yet offers roughly 150 more basis points in annual returns.
The second efficient frontier line is for more aggressive investors: Adding 20% fixed-income securities to a 100% equity portfolio (far right) significantly reduces portfolio risk with only a slight loss of return potential.
As you can see, adding foreign content (on the higher curve) moves the efficient frontier upwards and to the left. In other words, it reduces risk even further, while increasing returns.
Looking at this chart, we can see that conservative investors are even better served by mixing their bonds with Canadian equities and foreign equities
This type of analysis is the cornerstone of asset allocation, and it requires considerable resources and computing power to carry out successfully. Access to intelligent strategic asset allocation can add tremendous value to both your client relationships and their portfolios.
In the SAA Solutions module of this course we will show how CI has put MPT into practice with the CI Analyzer software (for Sun Life Financial advisors only) and the simple but sophisticated CI Portfolio Series.