Investment
This Is the Most Underrated Chart for Building Your Investment Portfolio – Arizona Daily Star
Most investors make an important mistake when they’re building their investment portfolio, and it can be a costly one. Luckily, we can all take valuable insights from an important chart that’s used by professional asset managers. This chart won’t create the perfect portfolio for you, but it provides essential guidelines for building an investment allocation.
The efficient frontier
The efficient frontier is a chart that plots portfolio returns against portfolio risk.
The chart is well-known among asset managers and financial advisors, but it’s rarely mentioned by individual investors. Professionals have to focus more on risk management — losses tend to shake a client’s confidence in an asset manager. Meanwhile, financial media overwhelmingly covers market indexes and the performance of individual stocks.
Returns are intuitive. If you invest a certain amount of capital, the value of that investment grows or falls by a certain percentage. Over the long term, those returns are based on the fundamental performance of the asset. Companies that grow and produce profits tend to have stocks that appreciate. The stocks of unsuccessful companies generally lose value. That’s all pretty straightforward.
Risk is a bit more complicated, and there are whole fields of study dedicated to understanding it to a high degree. Risk is defined in different ways, but portfolio risk usually refers to volatility. Volatility is generally calculated as the standard deviation of returns over a given period, and beta is a popular metric for measuring relative volatility. Portfolio returns tend to follow long-term trend lines, but they fluctuate over the short term around that trend. The bigger the swings in a portfolio’s value, the higher a risk it’s considered to be.
This chart suggests that there’s a trade-off between investment risk and return over the long term. In an efficient capital market, investors are forced to accept more risk in exchange for higher expected returns. Equities are more volatile than bonds, but they produce larger gains in the long term. Growth stocks have higher upside than value stocks, but they’re also prone to steeper losses due to high valuation ratios.
How the efficient frontier works
The efficient frontier is theoretical — the exact numbers aren’t really known or universally established. Instead, it represents the highest theoretical return that can be achieved at a given level of volatility. The curve is the collection of potential returns across the spectrum of risk, from low volatility to high.
From a portfolio composition perspective, any point along the frontier is just as valid as any other. It might seem odd to suggest that a strategy with a 6% average rate of return could be just as good as one with a 10% average return, but it’s true in the context of asset management. Not everyone is in the position to assume the risk that’s required to achieve higher rates of return, and the frontier illustrates a balance between the two. Investors with low risk tolerance can’t achieve the same long-term growth as those with high risk tolerance.
Any point below the frontier is inferior to any point that’s on the frontier. If a portfolio’s long-term combination of volatility and returns places it below the frontier on a graph, then that portfolio is not compensating investors enough for the risk that’s being taken. In that case, there are better allocations that could deliver more growth without adding any additional volatility.
Using the frontier
The key to portfolio management is to identify your optimal spot along the efficient frontier, then ensure that your investment strategy gets as close to the theoretical limit as possible. That’s how the best allocations are defined, rather than simply the biggest gains over a small window.
The first step is to quantify risk tolerance, which should reflect time horizon and personality. Risk tolerance questionnaires are popular tools to accomplish this, and they allow investors to set a volatility target for a portfolio.
Once that volatility cap has been determined, it’s important to maximize the potential growth within those boundaries. Obviously, that’s easier said than done, and there are tons of variables and unknowns that dictate gains and losses moving forward. Fill your allocation with high-conviction stocks that will deliver growth, but make sure that it’s governed by risk tolerance. That’s the best way to place yourself on the right part of the efficient frontier curve.
People who have long time horizons and can stomach volatility are able to take more risks in favor of growth. Those portfolios should contain more growth stocks, small caps, and emerging markets. On the other end of the spectrum, some investors need to sacrifice growth to limit volatility. Those portfolios tend to have more bonds, dividend stocks, and stable value stocks.
A 30-year-old should generally focus on growth in their 401(k) or IRA. Investors nearing retirement have to pull back on the reins to ensure that they aren’t forced to sell stocks at the bottom of a market cycle.
We’re seeing this in action with the current stock market correction. Any retiree whose well-being is seriously jeopardized by this pullback has mismanaged their volatility exposure and ignored the efficient frontier.
10 stocks we like better than Walmart
When our award-winning analyst team has an investing tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*
They just revealed what they believe are the ten best stocks for investors to buy right now… and Walmart wasn’t one of them! That’s right — they think these 10 stocks are even better buys.
Stock Advisor returns as of 2/14/21
The Motley Fool has a disclosure policy.
Continue Reading
Economy
S&P/TSX composite down more than 200 points, U.S. stock markets also fall
TORONTO – Canada’s main stock index was down more than 200 points in late-morning trading, weighed down by losses in the technology, base metal and energy sectors, while U.S. stock markets also fell.
The S&P/TSX composite index was down 239.24 points at 22,749.04.
In New York, the Dow Jones industrial average was down 312.36 points at 40,443.39. The S&P 500 index was down 80.94 points at 5,422.47, while the Nasdaq composite was down 380.17 points at 16,747.49.
The Canadian dollar traded for 73.80 cents US compared with 74.00 cents US on Thursday.
The October crude oil contract was down US$1.07 at US$68.08 per barrel and the October natural gas contract was up less than a penny at US$2.26 per mmBTU.
The December gold contract was down US$2.10 at US$2,541.00 an ounce and the December copper contract was down four cents at US$4.10 a pound.
This report by The Canadian Press was first published Sept. 6, 2024.
Companies in this story: (TSX:GSPTSE, TSX:CADUSD)
The Canadian Press. All rights reserved.
Economy
S&P/TSX composite up more than 150 points, U.S. stock markets also higher
TORONTO – Canada’s main stock index was up more than 150 points in late-morning trading, helped by strength in technology, financial and energy stocks, while U.S. stock markets also pushed higher.
The S&P/TSX composite index was up 171.41 points at 23,298.39.
In New York, the Dow Jones industrial average was up 278.37 points at 41,369.79. The S&P 500 index was up 38.17 points at 5,630.35, while the Nasdaq composite was up 177.15 points at 17,733.18.
The Canadian dollar traded for 74.19 cents US compared with 74.23 cents US on Wednesday.
The October crude oil contract was up US$1.75 at US$76.27 per barrel and the October natural gas contract was up less than a penny at US$2.10 per mmBTU.
The December gold contract was up US$18.70 at US$2,556.50 an ounce and the December copper contract was down less than a penny at US$4.22 a pound.
This report by The Canadian Press was first published Aug. 29, 2024.
Companies in this story: (TSX:GSPTSE, TSX:CADUSD)
The Canadian Press. All rights reserved.
Investment
Crypto Market Bloodbath Amid Broader Economic Concerns
-
Sports21 hours ago
Lawyer says Chinese doping case handled ‘reasonably’ but calls WADA’s lack of action “curious”
-
Sports6 hours ago
Dolphins will bring in another quarterback, while Tagovailoa deals with concussion
-
News21 hours ago
RCMP say 3 dead, suspects at large in targeted attack at home in Lloydminster, Sask.
-
News20 hours ago
B.C. to scrap consumer carbon tax if federal government drops legal requirement: Eby
-
News21 hours ago
Ceiling high for Vancouver Whitecaps midfielder Ahmed: Canada coach
-
Sports7 hours ago
David Beckham among soccer dignitaries attending ex-England coach Sven-Goran Eriksson’s funeral
-
News20 hours ago
A linebacker at West Virginia State is fatally shot on the eve of a game against his old school
-
News21 hours ago
Ottawa loses bid to quash Israel advocates’ lawsuit calling for halt to UNRWA funding