The Elements of Portfolio Design

We’ve spent the past few months drilling down on the various elements of financial planning. For the next few blogs, I’d like to break down the elements of portfolio management in much the same way. As you may recall from my first few blogs, portfolio management is the design, implementation, and on-going management of a client’s financial assets.

Today, we’ll focus on design and discuss a strategy many wealth management firms use to achieve a client’s targeted rate-of-return while avoiding unnecessary risks, taxes, and expenses along the way. It is called “Modern Portfolio Theory (MPT)” and was developed in 1952 by three Americans who won the Nobel Prize for their work. Essentially, MPT enables firms to design customized portfolios that combine the best mix of different asset classes—like cash, bonds, gold, real estate, international and domestic stocks, large and small company stocks, etc.—that work together to form a prudent, diversified portfolio.

The key element of MPT is the design of an “efficient portfolio,” which seeks to achieve the most appropriate balance between rate-of-return and risk. The guiding principle behind the theory is that it is possible for one portfolio to achieve the same rate-of-return as another one, but with a markedly lower level of risk.

The first step is to decide asset allocation based of a client’s level of risk tolerance. We then calculate the expected return and expected risk of each asset class, and measure the correlations between different asset classes. Using data that is updated monthly, we calculate the single portfolio with the lowest risk level at each different rate-of-return. Plotting these points creates a curved line called the “efficient frontier.”

Imagine a chart illustrating rate-of-return vertically and risk level horizontally. The higher you go on the chart, the greater the return, and the further right you go, the greater the risk. The “efficient frontier” is the point at which you achieve a portfolio with the greatest return and the least amount of risk.

For example, imagine we’re plotting three different portfolios for a client and need to achieve at least an 8% rate-of-return to achieve his or her financial goals. Portfolio A achieves an 8% return and has a low level of risk, Portfolio B achieves an 8% return and has a high level of risk, and Portfolio C achieves a 10% return with that same high level of risk.

Clearly, Portfolio A is a superior investment strategy for the client. Alternately, if an investor could tolerate the higher level of risk that Portfolio B already has, then we would design and implement Portfolio C, which earns the client not 8% but 10%. This is another superior investment strategy for the client. With no additional risk at all, the client would enjoy a higher long-term rate-of-return, and in either case, the client avoids investing in a portfolio that presents too much risk for its targeted return.