Staying on the Efficient Frontier

You've done your homework and realized that by investing now you can significantly improve your chances for affording a comfortable retirement. You have even gone so far as to place your money in some sort of tax-deferred 401(k) plan. You feel good about yourself — you've done the smart thing for your future. Now you can sit back and watch your returns compound, all the while planning what you will do in your retirement. Or can you?

Before you get too comfortable with your investment strategy, you may want to consider techniques used by professional money managers, investment consultants, and financial planners. For example, you would be wise to know the expected return and risk profile of the mix of investment options you are considering. Professionals use a concept called Modern Portfolio Theory, which includes the idea of investing on the Efficient Frontier. It is regarded as the difference between comprehensive financial planning and guesswork. First, in selecting which portfolio you wish to invest in, you may want to take note of where on the Efficient Frontier it falls, if at all. Secondly, in order to ensure that your portfolio consistently remains on the Efficient Frontier, you will need to consider rebalancing your portfolio on a regular basis.

What Is the Efficient Frontier?
The Efficient Frontier consists of a curve made up of points representing a number of portfolios with differing levels of risk and return. (See diagram below.) It is a curve that represents an optimal return for each level of risk. Assets and asset classes near the bottom left have low risk, but also low returns. Assets near the upper right offer higher returns, but at a higher risk. The dots along the line are "efficient" portfolios, meaning their assets have been optimally allocated to provide the greatest expected return for a given level of risk. A portfolio positioned along the Efficient Frontier will yield greater returns than a portfolio of a similar degree of risk that does not fall along the Efficient Frontier. Some assets and asset classes may be able to outperform the Efficient Frontier in the short run. But in the long term, staying in a portfolio on the Efficient Frontier offers the most reliable way to get the best returns for a given level of risk.

In order to determine whether or not a portfolio falls on the Efficient Frontier, you must consider three factors for each asset in the portfolio. First, you must find its estimated rate of return — what your money will earn when it is invested. Secondly, you must determine the level of risk associated with the investment. Risk measures the likelihood that your investment will do better or worse than the expected rate. The greater the volatility of an asset, or the chance that it can earn much higher or lower returns than expected, the more risky the investment is considered. Lastly, you will need to gauge an asset's correlation to the other assets in the portfolio. In other words, you want to ensure that the assets are not too much alike in their composition so that your entire portfolio does not take a hit when a particular sector of the market dips.

Staying on the Efficient Frontier — A Rebalancing Act
Once you have found a portfolio along the Efficient Frontier that satisfactorily offers an expected rate of return for your assumed degree of risk, there remains the act of ensuring that your portfolio remains efficient throughout the swings in the economy. This task is known as rebalancing.

If, over time, your portfolio moves away from its original asset allocation, you may expose yourself to one of two scenarios: your exposure to risk could increase beyond your comfort level, or your future growth potential could decrease and negatively impact your investment goal. By rebalancing your portfolio on a regular basis, you ensure that it is moving with the market yet in a manner where the asset classes remain fixed in how they relate to one another. You can effectively rebalance your portfolio in any of three ways:

• Sell any holdings that are now over your target asset allocation percentages and reinvest the money in other assets. Increase the total dollar amount you have invested and buy more of the investments that are beneath your target asset allocation percentages.
  
• Direct dividends away from the investments over your asset allocation percentages and into the ones that have dropped below your target percentages.

Obviously, each method of rebalancing has its own set of ramifications. You will want to consult with a financial planner to evaluate how each could impact your investment goal and decide accordingly.

"How Can I Possibly Do All of This?"
By now, you're probably saying to yourself, "But I already have a full time job. How can I possibly take on the task of rebalancing a portfolio to maintain its efficiency?"

The answer is, in most cases, you are on your own in this area. And statistics show that 96 percent of the population never rebalances their portfolios. The very law — ERISA — that requires companies to handle your investments with due diligence also restricts them from automatically rebalancing your portfolio for you. Yet, due to its unique use of trusts, GuidedChoice is able to not only offer portfolios strategically placed along the Efficient Frontier, but it is also able to rebalance those portfolios for you, thus ensuring you a reliably efficient portfolio throughout the years.

For the GuidedChoice portfolios, an Investment Committee will monitor the asset allocation exposure by using returns-based style analysis, and will rebalance if any of the asset classes are outside of their target ranges. When rebalancing, asset classes will be brought back to their target weights. This method was chosen since there are no explicit transaction costs and no tax consequences for investors. Rebalancing will be invisible to the participants, since the number of shares of the portfolio they own will not change. To rebalance, each portfolio will have the number of shares it holds in each mutual fund adjusted. Using this systematically applied rebalancing approach has the benefit of compelling an investor to sell assets when prices are high and to buy assets when prices are low, a good practice that in the long run is a proven formula for investment success. Such rebalancing practices will ensure that your chosen portfolio will remain within your initial asset allocation model. Thus, rebalancing ensures that you will not inadvertently move into a new sector of the Efficient Frontier that may expose you to too much or too little risk. If, however, you find that your circumstances are changing, you are able to revisit the GuidedSavings solution and reevaluate which portfolio you wish to be invested in. You can then rest assured that any new portfolio you might opt for to meet your changing lifestyle will undergo the same rigorous examination that your previous investment enjoyed.

Disclaimer: The views represented above are those of the author, and the information provided here does not constitute any tax, investment or legal advice. The historical data presented are for illustrative purposes only. Past performance is no guarantee of future results.