Lesson Overview

Efficient Portfolio Frontier

Very few people understand the concept behind the S&P 500. They know that it is the benchmark index; the one that everyone looks at and judges portfolios performance on. It all comes down to a very basic understanding of risk and reward and how to build a portfolio. It's the combination of different securities inside the portfolio as to which possible securities offer the best return with the least amount of risk. Today we'll completely break down the concept of building the most efficient portfolio of stocks possible and also explain why the investment community as a whole uses the S&P 500 as it's benchmark index.

Show Video Transcript +

In this video, we’re going to be talking about the efficient portfolio frontier. This is probably one of the more difficult topics to get across, and I’m going to try to get it across in one video.

It might be a little bit longer than usual but stick with me through this. I promise that I'll try to make it as easy and painless as possible, at least a little bit more painless than it was for me when I was in school.

The efficient portfolio: Simply a combination of assets, i.e. a portfolio that has the best possible expected level of return for its level of risk. That’s all it is. It's the most efficient portfolio that you can create.

You can create a portfolio of two stocks or three stocks. This is a combination of as many different stocks with as many different risk features that create the optimum level of risk versus return.

Here, every possible combination of risky assets without including any holdings in risk-free which are treasuries can be plotted onto a risk-expected return space to find the optimum market portfolio, and we’re going to go over that.

What it’s doing is that it's taking every combination of assets. You could take stock A and B, and B and C and A and C and all these different combinations and you can plot their risk versus return onto a graph, and you want to choose the one that has the best possible or most optimal risk versus return.

This efficient frontier in and of itself is the sloped portion that gives the highest expected return for a given level of risk, not just the lowest risk and that’s really important here. We’re not talking about the highest return for the lowest risk.

We’re talking about the optimal point at which each level of risk is equated to a higher level of expected return. Visually on this chart, this is what this efficient frontier looks like. It looks like this right here, this green line that I’ve drawn.

Just as a basis, we’re going to look at this line down here as being levels of risk. Down here at the left, it’s going to be low levels of risk, and up here it’s going to be high levels of risk. As we go out on this chart, we are increasing our risk. On the vertical, we’re going to be looking at the return.

Down here is low levels of return, returns of zero, right here is the risk-free security and this is going to be the Treasury market where you can buy treasuries that are virtually risk-free from the government, guaranteed return, and then anything above this is going to return that we get outside of the risk-free market.

What we’re going to do here is we’re going to the plot just different lines. For example, We could have stocks that are trading here, so stock A could be right here.

And it could give us a risk level of here of this risk level on this chart versus this return to the left, and you can see that that's a pretty good risk reward to start with. What if you could go out here?

You could take on more risk, and your return would be just slightly higher, and you’d have to think to yourself, “Is that worth my time and energy? I’m taking all a lot more risk for just only a slightly higher return.”

We move further out, we take on more risk, but this time, we take on, even more, return, expected returns. For the unit of risk that we’re taking, you can see that we’re returning much more money.

And then finally, you can have something that's even more efficient, that we’re taking on less risk overall, but we have a much higher expected return. This jump from this third blue dot to the fourth is much more of an efficient jump. We’re taking less risk overall for each unit of expected return.

What the problem is with this is that with all these combinations of different portfolios or individual portfolios, notice that here at this first blue level that for the same amount of risk, we can get an even higher return and you'd notice that because at this blue level.

You can see that the blue is at the same risk level as this market portfolio here and the same risk level, we could be expecting much higher returns. You can see there our blue portfolio, or our blue stock is not efficient.

In fact, it's really under efficient, and it's wasting precious time and energy here because it's taking on too much risk and not returning enough money.

This line here, this efficient frontier is a combination of all the possible securities that create the most efficient portfolios and, it’s a line, but it’s made up of a bunch of different portfolios and different weights.

This point here which is the most efficient portfolio, it has the best return versus risk, it has the highest sloping line if you will, and it’s giving you the highest return per unit of risk. That is the market portfolio, and in our case, for the US markets, this happens to be the S&P 500 index.

Most people don't know that the S&P 500 index is technically the most efficient portfolio. It is the 500 correlated stocks that are most efficient and give you the best return versus risk which is why it’s used as a wide benchmark for the economy in the stock market.

It’s the most efficient portfolio. That’s where the efficient frontier comes in. It’s this frontier that gives you all of these different allocations and gives you the best look at your returns versus risk.

Whenever you see a model asset allocation portfolio, chances are that they’re constructed to be relatively efficient regarding maximizing risk and reward. But if we take this theory above to the extreme, one could conclude that for each level of risk or return, there is a single best portfolio mix.

We’ve already proved that. Just because you have stock A and stock B in a portfolio, it doesn't mean that stock A and C could potentially be less risky and better for your portfolio. This is where the efficient frontier comes into.

We have this optimal use of portfolio and its right along this green line here that we’ve drawn. These stocks that are inside this green line, all the blue ones here are relatively inefficient because, for the same level of risk, we could be making much higher returns.

You can look at it kind of like this as a “stocks versus bond” portfolio. If you have higher and lower risk on the bottom scale and potential return higher, and lower on the vertical scale, you can see that a conservative portfolio made up of mostly bonds is going to be lower risk, but also lower return.

A balanced portfolio that's about 60% stocks and 40% bonds is going to be about middle of the road, it’s going to take on average risk, and it’s going to take on an average potential return.

And then of course, a 100% equity portfolio or all stocks is going to be much riskier, but it’s also going to offer the potential for much higher returns, and this is where that mix comes into place, where we can mix and match different securities, not just stocks, and bonds, but hundreds of stocks in between here and hundreds of different bonds.

There are four things to consider, and I’m going to go over these very, very detailed. The efficient frontier is based completely on the past. Correlations will change and so should your portfolio.

Remember that figures from the last 50 years are going to be different than the next 50 years and this is very easy to understand. The last 50 years of trading, we didn't have as many tech and computer and internet companies.

Now that we’re transitioning to the next 50 years, we’re going to have much, much more of those. Those are going to be more efficient, better for risk reward possibly and the portfolio is going to adjust and change.

Actually, the S&P 500 does this automatically, and it will have times where it throws out stocks out of the S&P and has times where it adds stocks that are more at the portfolio as the market evolves.

Every year, there's new data, and the ideal portfolios change like we talked about. What was the ideal portfolio in 1984 isn’t now, so make sure you're adjusting for the better. Adjusting your portfolio is always a good thing. You want to throw out the bad and keep in the good.

There are limitations on asset classes, and investments do track such asset classes. For example, I was in the REIT industry which is Real Estate Investment Trust which I think is completely different asset class while others do not.

There are some things that are a little bit different, and you want to just understand what kind of investment classes you’re throwing in there.

Some people think that REITs, they have exposure just to real estate when in reality, they could have exposure to mortgages or to industrial complexes or multi-family, whatever the case is.

Remember that they’re real cost like management fees, taxes, brokerage fees that are not taken into account with the efficient frontier. It’s just purely the best mix of stocks.

Clearly, these areas have a huge impact on your bottom line return, but are widely variable to the equations, so make sure as always that even though you think you have the most optimal mix, that you look at what securities are being added to your portfolio and how much they cost you both on a fee basis and on tax basis.

As always, I hope you guys enjoyed this video. I hope it helped clear up what the efficient frontier is. As always, you can share this video right below with any of your friends, family or colleagues on your favorite social network.

Join 209,817 Options Traders

Membership is always FREE & you can upgrade anytime to unlock software tools.