Asset Allocation
Is There An Ideal Asset Allocation?
For every investment goal, and for every set of investment options, there
is an asset allocation that could reasonably be called ideal. This is the efficient
portfolio, the one that offers the correct balance between risk and potential
return.
The idea of an efficient portfolio was first introduced by Harry Markowitz in the
1950s. This model measures not just
how risky an asset is, but how much potential return you can get from a given level
of risk.
At the lowest level of risk on the graph, is the minimum variance portfolio. As we move away from that point, to the right on the "risk" axis, risk increases. But just because risk and return are related, you shouldn't assume that increasing your risk will automatically increase your return. In fact, many portfolios have high risk without a correspondingly high return potential. We can call these inefficient portfolios.
Fortunately, for every inefficient portfolio on the graph, there is a portfolio with the same level of risk and a greater potential return directly above it. If we find the portfolios that have the best possible return for the level of risk, and draw a line through those, we get the efficient frontier line.
Any portfolio whose level of risk and reward can be located on that line is an
efficient portfolio. For any given level of risk, it has the
highest potential rate of return. Conversely, for any desired rate of return, the
efficient portfolio will have the lowest risk level. It is efficient in the sense
that it doesn't take any unnecessary risk and doesn't sacrifice any potential reward.
Any other possible asset mix will be less efficient.
All the work that goes into planning investment packages for individuals focuses on
finding the right point on the efficient frontier. If there is a way to find an
ideal asset allocation, this is it.
