The Markowitz Efficient Frontier

Harry Markowitz won the Nobel Prize for Economic Science in 1990 for his ground breaking work on investment portfolio construction. Simply put, Dr. Markowitz’ research showed that for any level of investment volatility there is an optimal level of investment return. Volatility is one measure of risk. Volatility is how much a given investment return varies over time. The measurement tool is called “Standard Deviation.” Standard deviation is how much a given investment will be above or below its average return in any given year. For example, an investment with an annual average return of 8% and a standard deviation of 11% will, two out of three years, produce a return between 19% (average return plus 11%) and -3% (average return minus 11%).

MAXIMIZING EXPECTED RETURNS FOR ANY LEVEL OF VOLATILITY

Past Performance is no guarantee of future returns!

The chart below is called “Markowitz’ Efficient Frontier”. It is a simple illustration of the relationship between volatility risk and investment returns. For each point on the horizontal axis (the 1 Standard Deviation Volatility Measure) there is a corresponding “optimal return”- the theoretical point at which all uncompensated risk  (the risk you do not get paid for) is eliminated from the portfolio.

Knowing where your investment portfolio plots on this graph tells you how much uncompensated risk you run. Uncompensated risk is risk that the market does not pay you for because the market does not require you to take these risks. The market pays you only for the risks it requires you to take; the biggest risk you get paid for is simply the risk of loss of  principal because by simply being invested in the market your money is at risk. The market does not pay you for risks like poor diversification, frequent investment turnover, or excessive investment costs. The money lost from these risks come directly and only out of your pocket because it is only you that create these risks.

In the above graph a simple S&P 500 index fund is plotted with a volatility index (1 Standard Deviation) of about 18.4%. The return for this hypothetical illustration is about 9.5%. Where the volatility  index and return intersects is where this sample S&P 500 fund plots on the Efficient Frontier.

According to  Efficient Frontier thinking, an investment with a volatility index of 18.4% should optimally be generating a return of about 13.5%. Go straight up from the S&P 500 plot point until you intersect the Effiicient Portfolio line that is the optimal return point for a fund with an 18.4% volatility index.

The difference between the S&P 500 plot point and the optimal return is the risk you do not get paid for. In this case, poor diversification is the main culprit for the uncompensated risk. Owning only one asset class, the US Large Growth class (which is the S&P 500), is a very poorly diversified portfolio. You do not get paid for poor diversification because it is your fault. The stock market does not pay you for poor diversification because it does not require you to be poorly diversified. Only you created the risk, only you pay for it.

You can have your current investment portfolio analyzed to determine where you are on the Markowitz Efficient Frontier. Once you know where you are you can reduce the uncompensated risks you are now taking through better diversification, lowering investment costs, and/or reducing your portfolio turnover.

A well engineered Retirement Money Machine will have you closer to the optimal mix of risk and return. The engineering starts with an analysis of where you are currently positioned on the Markowitz Efficient Frontier.

THIS IS A NOBEL PRIZE WINNING INVESTMENT TOOL YOU CAN USE TO IMPROVE YOUR FINANCIAL FUTURE.