Here’s how an investor can benefit from the “efficient frontier” theory

Once we’ve selected the funds we want to invest in, how many people think it’s okay to deploy an equal amount of money in each of those funds. For example, you’ve decided to allocate, say, 50% of your equity portfolio to large caps. Spread the amount to be invested evenly or with some thought into the design. So many different portfolios can be created just by adjusting the allocation we give to each fund and this is also the real test of efficiency, there is a scientific way to decide on the best asset allocation that can optimize your returns. .

CNBC-TV18 with Vishal Dhawan, Plan Ahead Wealth Advisors explores the theory called “Efficient Frontier”, which explains what optimization is and how an investor can benefit from it.

What exactly is the efficient frontier and how is it useful for investors?

There is a strong case to be made around applying a lot of science to how portfolios are actually constructed. Also, there was something called Modern Wallet Theory, which gained a lot of attention decades ago and is still relevant today and is used by a lot of people. In fact, Harry Markowitz, who actually introduced this theory in the early 1950s, won a Nobel Prize for it in 1990.

“Essentially what the efficient frontier does is that it tries to map for a certain level of risk that you take, what is the optimal portfolio that will eventually be created, so that the return and the risk are well mapped to each other. Because a lot of times we look at these two things, return and risk are two independent decisions. In fact, they are very closely related to each other and this applies the science of how you can put them together. So the efficient frontier has on the x- and on the y-axis it has the returns. And what it’s trying to do is draw a curve , which looks like a half-C, to find out where the wallets are on the curves to be most effective, ”Dhawan said.

So anything below that curve is generally less efficient, and as a result, you may be taking too much risk to get that level of return, or anything on the right side of it is. also too risky for the type of return that you are getting. Anything above the efficient frontier curve is actually a place where you get better returns for the level of risk you’ve taken, he added.

So the idea is to ideally try to build portfolios to be on the curve, where you are able to manage risk and return at the best possible level.

What are the disadvantages ?

So there are some assumptions used by an efficient frontier model. Instead, it assumes that all the points that make up market information are shared and perfect, and everyone who makes decisions makes them rationally based on data. However, this may not always be the case, as you often find that feelings and emotions play an important role in decision making in the stock market.

The second area is that it assumes that you are going to diversify a portfolio so that you don’t have a single asset. And sometimes even that is not true because you might be holding all of your money in one single asset or one type of asset.

The third important thing to keep in mind is that it assumes what is called a normal distribution, which means that things are generally stable, but there may be out-of-normal events that cause the distribution to occur. delivery of this wallet. Say, for example, a lower return for the risk you took or delivered an unusually high return for the risk you took. The post-pandemic event of March 2020 and the lockdown was a classic example where things came out of this normal distribution. This also happens in other situations, if we go back to history and maybe look at the global financial crisis, for example, or the decrease, these are also events where a normal distribution might not have. been completely respected. Therefore, at this point, the Efficient Frontier might not have given you the most optimal portfolio.

For the full discussion, watch the accompanying video

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