The Efficient Frontier
Occasionally, The Fry Group’s Chairman, Stephen Tucker, lends his thoughts on a particular area of financial planning. Below is his analysis of one such area:
Let me start with an apology. Not everyone reading this will find it as interesting as others but it is a fundamental principle of risk-adjusted financial planning so please bear with me.
The concept of the efficient frontier is a little complex and comes from modern portfolio theory. The following graph shows a curved line bending from the lower centre of the graph, left upwards and then further to the right.
The risk and return profile of portfolios depends on the mix of assets. It excludes risk-free assets such as cash. Low risk assets such as British Government stock still carry some degree of risk but obviously sit at the low end of both the risk and return profile (A). As you introduce other assets to a portfolio, such as equity, that blended portfolio actually starts to reduce in risk (B), shown by the curve moving to the left of the graph and at the same time increasing the rate of return showing the line rising as it moves to the left. As more risk assets are added to the portfolio the line turns again to the right (C to D) as the risk element increases but so does the expected return.
Achieving the optimum blend of investment return and a tolerable level of risk is more of an art than a science. We seek to explore with clients their capacity to live with investment risk over set time horizons and the level of investment return needed by those clients to achieve their financial objectives. Using that data we can then make recommendations of portfolios that blend various assets in proportions that provide the realistic prospect of the investment returns needed without exposing client’s overall capital to excessive risk.
Obviously over time things change and it is important to take account of changes in personal circumstances, taxation, asset allocation and fund managers. All of this can be achieved through regular review. Do please get in touch if we are not already assisting you with such matters.
The internet is a remarkable source for obtaining information on just about anything but of course you do need to know what you are actually looking for. For those of a technical disposition, a search under “the efficient frontier” will provide you with a great deal more detail than it is possible to include here.
Chairman and Managing Director