The Efficient Frontier: The Guiding Principle of Modern Portfolio Theory

This article was originally published on Quadrant Group’s website. Quadrant Group was acquired by Progeny in March 2017.

This month marks the 25th Anniversary of Professor Harry Markowitz being awarded the Nobel Prize for his pioneering work in financial economics. Markowitz developed a model for understanding portfolio allocation under uncertainty, which has endured as Modern Portfolio Theory. By urging investors not to focus solely on returns of individual stocks but to also consider the concept of risk exposure, he changed the way people invest. Today, trillions of pounds are invested (including our AstutePortfolios) according to his principles of risk and return.

A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies. – Harry Markowitz

Anyone familiar with investment theory will know that diversification is paramount to portfolio success over the long term. It mitigates exposure in the market and manages risk. Most investors will naturally want to avoid risk. Some will want returns without any risks, but avoiding all risk is the same as avoiding potential returns. Markowitz introduced the now widely accepted notion that when putting together a portfolio it is not sufficient to focus on returns alone; risk must be considered as well. A diversified portfolio that captures the right blend of market indexes avoids the type of risk associated with individual stocks and bonds. It leaves you only with the risk of the market itself, a risk that must be taken if you want market returns.

An optimal portfolio is based on your capacity and willingness to take risk. This investment principle should certainly be very familiar to anyone that has met with a Quadrant Group adviser. That is why we ask investors to take the FinaMetrica questionnaire. Based on your results, we suggest an AstutePortfolio that will best meet your needs and expectations in the long term, matching the risk exposure of the portfolio to your personal risk capacity. This process allows us to identify expected returns and the journey you can expect over the lifetime of your investment.

Specifically, we use highly sophisticated computing systems that allow us to make some assumptions about expected returns, variances, and correlations of different securities (or asset classes). We are able to structure a portfolio that maximises return for a given level of risk or minimises risk for a given level of required return. When combining a mix of assets, whether at the individual security or asset class level, we can mathematically understand three key metrics: the mean (expected return), the standard deviation (risk) and the covariance or correlation (statistical relationship between the two variables). Knowing these variables for each combination of assets allows us to run an optimiser to see what combination of each asset yields the highest return for a given level of risk. This investment principle, developed by Markowitz, is known as “the efficient frontier.”

Taking an academic approach to investing means that we rely on objective and peer-reviewed research that has stood the test of time and withstood the high level of scrutiny by qualified professionals. We aim to give our clients the highest possible probability of a successful investment experience. While anyone can make an unsubstantiated claim (e.g. “Tesco share price will bounce back by the end of the year”), we have structured our AstutePortfolios on methodologies that have withstood the test of time.

Perhaps the most important job of a financial advisor is to get their clients in the right place on the efficient frontier in their portfolios. But their No. 2 job, a very close second, is to create portfolios that their clients are comfortable with. Advisors can create the best portfolios in the world, but they won’t really matter if the clients don’t stay in them. – Harry Markowitz

This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and the value of investments can fall as well as rise. No representation is made that the stated results will be replicated.

Dominic Lobo

Dominic Lobo

Associate Director, Wealth

Dominic became a founder and Director of the Quadrant Group in 1994.

Learn more about Dominic Lobo