ITA Wealth Management

How efficient is your portfolio?  For the ETFs, stocks, bonds, and mutual funds used in your portfolio, do you have the optimal asset allocation mix?  We know the importance of asset allocation from Ibbotson’s research, but how to implement this research is another problem, and that is where the efficient frontier analysis comes into play.  While most portfolios are inefficient, I would posit that 99% of investors holding these portfolios do not know this to be the case or they have no idea how to readjust the portfolio to make it more efficient.

Here is the problem we want to solve.  For an acceptable level of risk, how do we adjust the percentage for each asset so as to maximize the return?  Selecting a risk level is a personal decision each investor needs to make.  For some investors, the risk may be as low as some percentage a little above the inflation rate, while other investors are willing to run up the risk to 20% or higher.  Most investors will select a risk level somewhere between 8% and 18%.

Let’s walk through the process of developing an efficient portfolio.  The very first step is to start with the investments that currently make up the portfolio.  While these investments may not be the very best choices, they are a starting point.  Given a group of stocks, bonds or ETFs, we run an analysis to find the correlation between the different investments.  I use a program called Quantext Portfolio Planner (QPP) to come up with a correlation matrix.  The next step is a bit complicated as it requires one to generate a variance-covariance matrix using the correlation matrix data.  To move to the next step of creating an efficient frontier graph, I highly recommend investors Google this hand-out paper, “Creating Efficient Frontiers Using Excel.”  Walk through this paper step by step so you know how to create an efficient frontier graph.  Premium Content readers are saved this hard work.

To know how to move from the correlation matrix to the variance-covariance matrix, I use a spreadsheet created by Zvi Bodie.  I can make this spreadsheet available to interested readers.  Assume we are now at a point where we have an efficient frontier graph created for the investments in our portfolio.  The next choice is a major one and it requires the investor to come up with a risk percentage as mentioned above.  I generally try to stay somewhere between 10% and 15%, with a preference toward a lower risk.  The risk one is willing to take is highly dependent on age, savings rate, current size of portfolio, etc.

Armed with a spreadsheet that calculates the efficient frontier graph for a set of investments, one can then select the risk percentage which in turn will determine the percentage to invest in each asset so as to optimize the return from that combination of investments.

In a recent analysis, I created an optimal portfolio using seventeen ETFs and three individual stocks.  The ETFs cover the world market and the three individual stocks where selected from last week’s “Creme List.”  The “Creme List” is available to Premium readers.  I then ran an analysis to see if such a portfolio would be sufficient to last a 50 year old through her retirement years.  The variables and analysis will be made available to subscribers over the next week.

Photograph: Preparation for Thanksgiving

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