Finding balance with the Efficient FrontierSubmitted by Agrawal Associates on April 3rd, 2017
April 4, 2017
Risk versus return. It's one of the primary challenges of wealth management: finding the balance between a client's risk tolerance and desire for a certain rate of return.
This is where the "Efficient Frontier" comes in.
The Efficient Frontier is an investment management portfolio theory which guides us to select portfolios which offer the highest rate of return for a defined level of risk. This same theory can help us minimize risk for a given level of expected return.
This theory was developed by Harry Markowitz in 1952, who was later awarded a Nobel Prize in economics. Visually illustrated below, Girish Agrawal often uses this graph to explain the concept.
The Efficient Frontier balances risk and reward
The blue line in the simplified graph above represents the Efficient Frontier.
- The investments that lie close to the blue line — depicted with blue diamonds — represent the ideal: investments that offer the best rate of return for the investor's risk tolerance.
- The purple squares above the line are the 'unicorns' — investments with greater proposed reward than is reasonable for the given risk.
- The investment represented by the red square represents an area for possible change. A more efficient investment could give the same rate of return for lower risk (yellow diamond) or if the client was comfortable with that level of risk, a more efficient investment could produce a higher rate of return (orange diamond).
"When looking at the Efficient Frontier, you can see that risk to the client is infinite, but the potential return is not," explains Agrawal.
Portfolios below the Efficient Frontier do not provide enough potential return for the investor's risk tolerance. An advisor following this prudent principle would discuss the client's risk tolerance, and move their assets to a portfolio that had the same risk, but with returns that would fall closer to the Efficient Frontier.
Guided by prudent principles
At Agrawal Associates, we use the Efficient Frontier as one of our prudent principles of wealth management, specific to investments. These prudent principles help consultants and clients focus on long-term financial health following well-researched, successful theories and strategies. The principles form investment tactics for financial stability and growth.
Following Girish Agrawal's lead, our team uses these principles to ensure that clients get the best possible rate of return for their risk tolerance. Along with prudent principles for wealth management, Girish has also developed principles for all ten areas of your financial life to guide the team.
Learn more about the types of wealth management services Agrawal Associates offers.
- Agrawal Associates