An Efficient Frontier

Yesterday, I sold some shares in two different companies. One was a happy story, Piedmont Natural Gas a consistent dividend producer that recently produced some nice capital gains, is going to be purchased by Duke Energy. There is a chance the Government will not approve the deal, so I decided not to hang around to get the last couple of dollars. I also needed to harvest a loss to help lower my tax bill. I decided to sell my shares in GoldCorp. I bought this stock before the big run up in gold and then watched it run back down faster than the value of the underlying precious metal. Under normal circumstances, I would have held on to this dog because I believe gold will go back up in the future.

In the next week or two I need to decide what to do with that money. Since I don’t have any hot tip that I find particularly convincing, I need to drop back to Harry Markowitz’s presentation of Modern Portfolio Theory that demonstrates that selection of an optimum mix of asset class is more important that selecting particular members of that asset class.

A caveat: Benoit Mandelbrot has demonstrated that the market is a much more dangerous place than is predicted by Modern Portfolio Theory.

Part of Markowitz’s work is now termed, an efficient frontier. This is a line showing the risk reward ratio of any portfolio. If your holdings fall on the line you have optimized your return for a particular level of risk. A selected base interest rate, such as ten year Treasuries, will form the low point on the graph, currently a miserable 1.28%. While I am showing a generic graph without numbers, an actual graph will have a bit of a nose, showing that as you diversify a portfolio of 100% bonds with some equities, your expected rate of return will increase as you lower your risk. Soon, however, increasing your stock holdings will increase both your risk and your expected rate of return.

I am not posting a graph with numbers, because no one can predict the future by back testing the past. However, let’s discuss some numbers based on an efficient frontier graph produced as an advertisement by a nameless investment advisor and the most recent recommendations found in a news letter I generally trust written by Richard Young.

Nameless shows that a portfolio of 100% bonds producing a return of 9% with a risk of 9% and a portfolio of 75% bonds and 25% stocks producing a return of 10% while the risk drops to 8%. 40% bonds and 60% stocks raises your expected return to 11% and your risk to 11%.

Richard Young drops the current 100% bond point to a little over 4%, realistic if you have a few junk bonds in your mix. This comes with a risk of 6.75%. 40% bonds and 60% stocks increase your expected rate of return to 6.75% and the associated risk to 8.75%. By the time you jump to 30% bonds and 70% stocks, you can expect an 8% return on your money, but the risk to your portfolio has increased to 13%.

Is it worth it?

What does risk in this example actually mean? Generally the person proposing a particular efficient frontier is talking about one standard deviation, a statistical measure that shows how much your portfolio will vary from its expected average return in a given year. So, for an expected 6% return with 4% risk means that in a given year there is a 68% chance your actual results will fall between 2% and 10%. An 8% return on your money with a 13% risk would mean that it is likely your actual return would fall between 21% and -5% (ouch!).

I think I will put at least half the money in a boring hybrid fund, Vanguard Wellesley Income, containing 65% in investment grade bonds and 35% in dividend paying stocks. I don’t think this is a time to increase my exposure to equities, but I while I should never have 100% of my investments in stocks, I should always have some of my money in corporate shares.

Of course, if I knew what I was doing, I would be dictating this blog post to my secretary while waiting for the maid to bring me breakfast on a veranda overlooking the Pacific Ocean in my beachfront estate in Hawaii.

Please! Let’s be careful out there.