Please draw me the best risk/return portfolio !
As introduction I' like to start with a linguistic paraphrase inspired from the Petit Prince wrote by Antoine de St Exupery that he could ask to his portolio manager : "Please draw me the best risk/return portoflio" Which is the best way to introduce you to the concept of the risk/return efficiency for portfoflio management.
1) Origin of the risk/return efficiency curve :
In 1952, Harry Markowitz published a formal portfolio selection model in The Journal of Finance. He continued to develop and publish researches on the subject over the next twenty years, eventually winning the 1990 Nobel Prize in Economics for his work on the efficient frontier and other contributions to modern portfolio theory.
According to Markowitz, for every point on the efficient frontier, there is at least one portfolio that can be constructed from all available investments that has the expected risk and return corresponding to that point.
2) Definition :
"A set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are also sub-optimal, because they have a higher level of risk for the defined rate of return." (look at the chart below)
3) Question of the day : "what's the best balance between risk/return on a long time investment ?"
Knowing one of my teachers at SDA Bocconi he would probably answer : "It depends!" to this thorny question. Yes, because it depends on different factors and among others : personal risk aversion, investment horizon, investment experience, personal situation, Market knowledge etc.
Those various elements will be discussed with your portfolio manager. Starting from those topics you'll decide about an investment strategy. Thereafter the daily job of your portfolio manager will be to adapt your strategy to the following efficiency curve, representing the ideal diversified model portfolio (maximizing the couple risk/return) :
4) Concretely : This is the efficiency curve linked to model portfolio's
5) Observations:
To maximize your risk/return your portfolio must follow the Frontier line as faithfully as possible
Its highly recommended to diversify your asset classes (different bonds, shares etc)
For a very conservative investor its interesting to consider to invest a small part of the portfolio in ....stocks which is paradoxically sometimes less risky than a 100% bonds portfolio on a long time investment (see chart).
Sources:
http://www.investopedia.com/video/play/explaining-efficient-frontier/http://monevator.com/shares-deliver-the-best-long-term-returns-so-why-invest-in-bonds/http://www.investinganswers.com/financial-dictionary/investing/efficient-frontier-1010
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