Money Talks: The efficient frontier

As our friends from the north slowly make their way back, many retired investors here in paradise remain concerned as to the direction of the financial markets. Indeed there should be a heightened level of concern as the stock market continues to hit all-time highs without any clear and decisive rationale for the advance. However, there seems to enough complacency with investors that now may be the time to take a more scientific and proven approach to asset allocation within the portfolio.

For many retired investors, there are a number of incarnations within the world of asset allocation. In other words, how to properly balance a portfolio based on the investors goals and objectives. The Wall Street spin machine has trained investors for decades to think in terms of simple math. There has been a standard within the industry which was easy to digest while at the same time offered investors “perceived” diversification.

We have been taught over the years that a simple formula would solve all of our worries as to the value of diversification. The formula was simple; subtract the investor’s age from the number 100 and this would instantly generate the proper allocation between stock and bonds. For instance, a 60 year old investor would allocate the portfolio with 60 percent invested in bonds with the remaining 40 percent invested in stocks. Unfortunately, this debunked strategy shares a headstone in the graveyard of dead Wall Street euphemisms, right along the side of “buy and hold” and “stay the course.” The question here is simple; how valuable was this strategy during stock market crashes? Yes, the answer is worthless.

This is where investors must embrace the proven research of what is known as “The Efficient Frontier.” In fact, even the Wall Street spin machine has embraced the concept as it pertains to the risk reward ratio. According to Investopedia.com, “The Efficient Frontier is a portfolio balance that offers the highest expected return for a defined level of risk, or the lowest risk for an expected level of return.” The concept was “ … introduced by Nobel Laureate Harry Markowitz in 1952 and is a cornerstone of Modern Portfolio Theory.”

Investors of all types certainly can embrace the concept of maximum returns with maximum risk avoidance.  The previous age equation was loosely based upon efficient frontier. The concept makes a clear case for diversification in that ownership of multiple assets allowed for better performance while spreading the risk out with the expectation that a particular asset class would perform when another was suffering. This strategy stands today, except that in the majority of cases a critical asset class has been overlooked. The business model of Wall Street profiting from buying and selling the same old stocks over and over and over again has created a hidden bias that often puts the advisor and the investor on opposite sides of the table. A defined conflict of interest exists within this bias as it pertains to the entire concept of the “efficient frontier.”

As Wall Street and investors alike slowly began to comprehend this concept of reduced risk with increased performance, the formula took a left turn and became more of a stock and bond only formula, again similar to the age equation mentioned previously. However, the underlying concept of “balancing securities with the greatest potential returns with an acceptable degree of risk” certainly has an appeal to most retired investors.

Somewhere along the way, the very basis of this accepted, proven and Nobel Prize winning research was manipulated and lost a critical catalyst with which to push the risk reward ratio further for even greater returns and even lower risk. This critical asset is managed futures. Regardless of the familiarity investors may have with efficient frontier or Modern Portfolio Theory or even managed futures, the proven reality is that the epitome of efficient frontier requires the addition of managed futures.

Because the numbers never lie, maximizing efficient frontier requires ownership of a truly diversified portfolio including managed futures with nearly zero correlation to stocks while historically outperforming stocks with significantly less risk.

Certainly this allows investors to enjoy the life of a SWAN, Sleep Well At Night.

William F. Hague is a managing partner of Hague Wealth Management; 239-389-1999 or WFHague@earthlink.net. The opinions and observations stated above are those of the columnist.