Asset allocation and the efficient frontier

Here is the link.

I like the example in the article, the explanation is very good for me to understand how to build efficient portfolio and reduce volatility.

Many investors don't appreciate asset allocation or understand intuitively how a diversified portfolio can exceed the sum of its parts. After all, the capital asset pricing model (CAPM) suggests that return follows risk, and therefore you can't increase return and reduce risk at the same time. But CAPM is just a straight-line projection. And at the efficient frontier, the math produces nothing but curves.

The efficiency of an investment is measured by the greatest return for the lowest volatility. Blending a portfolio allocation can make it even more efficient by either boosting returns or lowering volatility.

To understand the math behind blended returns, let's start with a simple case of two investment choices and two years. Investment A goes up 30% the first year and 0% the second year. Investment B goes up 0% the first year and 30% the second year. If you invest in either A or B, you get a 30% return over two years. Your average volatility is 15%.

It seems no matter how you mix these two investments, you can't get more than a 30% return over two years. But you can. And you can lower your volatility as well.

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Imagine a blended portfolio of half invested in A and half invested in B. The first year you would experience a 15% return, and the second year a 15% return. Your volatility would be 0%. Lower volatility means a more efficient portfolio.

You would have both lower volatility and higher returns. Compounding returns would produce a total return over the two years of 32.5%. You experience a higher return because after half of your portfolio invested in A grows by 30% the first year, you rebalance your portfolio. So half of the growth from investment A is rebalanced and put into investment B. Half the growth would experience another 30% growth the second year when investment B did better. Thus your total return for the two years would be 32.5%.

Actionable Items

Diversification is free lunch to reduce volatility. The example is given in MIT course 16. Portfolio management. Here is the link. The talk is from 48:00.

Diversification and free lunch, do not forget to rebalance.
Given two assets, A, B, I took notes, see my blog. Here is the link.