The Efficient Frontier: How Much Risk Can You Stomach?

HRE PR Pic 2013

Harold Evensky CFP® , AIF® Chairman

Anchoring on the efficient frontier may sound like something out of Star Trek, but it’s not. It’s better.

Harold Evensky (HE): Mr. and Mrs. Curtis, good morning. I’m Harold Evensky and this is my partner, Matt McGrath. Welcome to Evensky & Katz. I always like to start by asking, “What brings y’all here?”

Mr. Curtis (Mr. C): Well, Harold, Vickie and I are thinking about retiring in just a few years. We’ve saved quite a bit and think we’ll be in good shape, but we had some friends who retired a few years ago, who thought they were in good shape only to discover that things didn’t work out quite as well as they expected and they’ve had to do some major cutting back in their lifestyle. We don’t want that to happen to us. The Hamptons said you helped them do some planning for their retirement so we thought we’d like to work with you to do the same.

HE: Wonderful. Let’s have some fun envisioning your future. And that’s the key—it’s your future. Our job is to empower you to plan that future. Suppose we start off with an introduction: “Modern Portfolio Theory and You.” Matt, may I have a blank sheet of paper from your pad? Thanks.

Here’s a simple picture of the investment world. On one axis, we’ll plot risk and on the other, return.

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As you’d expect, cash would not be very risky, but it would not provide much in the way of return, whereas stock might provide a high return but at some risk. Bonds are somewhere in between.

With just these three choices, we could still design thousands of portfolios. For example, 99 percent bonds and 1 percent stock or 99 percent stock and 1 percent bonds. If I put dots on my graph for the risk and return combinations of all of these combinations, I’d fill up the picture with dots. Then, if I drew a line enclosing all of those dots, I would end up with a curved line that’s called the efficient frontier.

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That means, at least theoretically, there is no best portfolio but rather an infinite number of best portfolios, depending on the risk one is willing to take. We know that everyone would like to have a portfolio with no risk and lots of return. Unfortunately, the real world of potential portfolios lies on or below the efficient frontier. So what does that mean for you?

Well, it means we have to do some planning, and then you’ll have a decision to make. First, as I said starting off, we need to make a best guess as to what return your portfolio would need to earn over time to provide you the money you need to accomplish all of your retirement goals. Then we need to make a best guess as to your risk tolerance. If we just focused on your return needs, we might conclude it was possible to achieve your financial goals with a portfolio allocated 90 percent to stock. But that might not work out very well if we faced a major bear market in a few years. After you saw your nest egg lose 40 percent, you’d call us and say, “Harold, we can’t stand it. Please sell our stock and put our money in cash!”

That’s why we define risk tolerance as the point of pain and misery you can survive—with us holding onto your belt and suspenders—just before you make that call to tell us to sell out.

With those two anchors, we can now revisit our graph. Suppose the results look like this.

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We have two portfolios for you. Portfolio A is one that provides the return you need to achieve your goals, and B is one in keeping with your risk tolerance. Which one is right? In fact, both are, but our recommendation is to plan on Portfolio A. Why? Even though we believe you can live with more risk and would end up with more money, determining risk tolerance well in advance of a terrible market is more art than science. The consequence if we’re wrong and you bail out of the market that would be catastrophic. So why take that extra risk if you don’t need it to achieve your goals?

How about if we found a different outcome? Suppose we concluded that you needed Portfolio A to provide your needed return but had a risk tolerance associated with Portfolio B in this picture.

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That’s not very good, because now you have to decide between eating less or sleeping less. In this case, our recommendation would be to readjust your goals to meet the return expectations of Portfolio B. Why? Again, when markets seem okay, it’s all too easy to say, “I’ll take a bit more risk.” But later, when it seems the world is coming to an end, you’re not likely to remember your willingness to hang in there.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.