The Efficient Frontier
For any investor, it is important to develop a solid investment strategy to achieve their long-term goals. One way an investor can do this is by comparing their current portfolio to a portfolio with an ideal asset allocation. This introduction is meant to show you the benefits of using asset allocation in a portfolio.
An asset allocation strategy takes into account the historical performance of stocks, bonds, and cash and exploits their different return characteristics to improve the probability of achieving a desired long-term total return. Stocks, bonds, and cash do not always gain or lose value at the same time, so setbacks in one category can be offset by gains in another. Historically, volatility has been reduced over time by holding all three asset classes in a portfolio.
Asset allocation differs from simple diversification because it involves being diversified in more than one asset class—not only in mutual funds, such as large cap growth and value, but also, for example, in fixed income, whether it be a government, corporate, or a municipal issue. Diversification within an asset class is important, but it is equally important to spread risk among various asset classes. Asset allocation benefits an investor by reducing the volatility in their portfolio while also attempting to maximize their portfolio return within the limits of their accepted level of risk.
Investors must realize that investment returns vary from a short to a long time frame. They must also understand the risk in their investment choices and set realistic expectations for the growth of their assets. By applying the concept of asset allocation to a portfolio, an investor will reduce portfolio volatility by spreading risk over various asset classes. Asset allocation also structures an investor's assets to help them achieve their goals with a minimum level of risk. This should give investors confidence that their money will grow over time at an expected level and be there when they plan on needing it.
Utilizing inputs from the Client concerning investment time horizon, growth and cash flow needs, Hollencrest works on establishing your Ibbotson Risk Type classification. Based on this, we are able to construct an Efficient Frontier line representing Portfolios with the highest possible return for each level of risk (standard deviation), given the capital market assumptions and constraints being used.
