Modern Portfolio Theory (MPT) explains that knowledgeable investors want the least amount of risk (typically meaning volatility) for a given level of potential return, the most amount of potential return for a given level or risk, or if possible, a combination of the two.
Consider the chart below:
This Efficient Frontier was created by Mean Variance Optimization (MVO) using data believed to be reliable. Past performance is not a guarantee of future results.
After analysis, if it is learned that your portfolio resides in “The Inefficient Interior”, following MPT, your goal would be to reallocate your investments in a way that moves toward the red curve. The Efficient Frontier can shift over time and although not likely achievable, it serves as an ideal to work toward initially and adjust to over time.
This intuitively makes sense to most people, yet few have the knowledge, skill, and experience to invest their assets in the capital markets in a way that shifts their portfolio toward the Efficient Frontier, as explained by MPT.
We work with our clients to help them take advantage of adhering to a process designed to benefit from MPT’s principles. Over time, the impact can be significant.
RSI’s
Three Fundamental Practices of successful investing are designed to help achieve this:
- Asset Allocation – The process of strategically weighting investments among different asset classes. The goal is to improve the risk/return trade-off using the principles of MPT, while also considering your long-term goals, assets, discretionary income, and time horizon.
- Disciplined Diversification* and Mitigating Unsystematic Risk – Inclusion of multiple asset classes, styles, and sub-styles with differing characteristics and methods of management, including active and passive.
- Systematic Rebalancing – Adjusting asset classes back to established ranges and appropriate levels given portfolio objectives, at stipulated time intervals.
Typically, when we meet with new clients, we discover that these concepts have never been discussed or considered. We find that in the past, their focus has been on smaller, technical details, such as individual security selection. While the technical details are important, focusing on the larger and more important factors can have a more significant impact on the end result.
One of the most important large factors to consider is
time. With consideration for the amount of money to be allocated initially and what will likely be added, we strategize about how to accomplish your goals within your timeframe or “
Time Horizon”. It is not uncommon to find a mismatch between your investment allocation and your “Time Horizon”, impairing your ability to achieve investment success.
Are You Biased?
We have identified
14 Investor Biases, which can negatively impact your ability to be a successful investor. The influence of biases can be powerful and cause you to lose sight of what you are trying to accomplish. Many outside forces can foster biases, and they may even have been handed down through the generations. They can deter you from making wise long-term decisions or cause you to fall victim to bad advice. Biases are particularly important to understand and mitigate in investing, and this can be extremely difficult to accomplish on your own. With emotional involvement it can be almost impossible to recognize when your biases are overly influencing your decisions.
Additional Resources:
Beware of Investor Biases
Solving the Investor’s Plight
A Helpful Mindset for the Current Times
Managing Assets in a Changing World: How to give your portfolio the attention it needs
Common Mistakes in Investment Portfolios
Redefining the Terminology Around Money
Modern Portfolio Theory
Another Example of the Value of Having an Appropriate Time Horizon
* Diversification cannot assure a profit or guarantee against a loss.