To boldly go to the efficient frontier…

Making the weight

Earlier this year I enjoyed attending as many events as I could squeeze in at the Gold Coast Commonwealth Games, including a range of sports that I had no meaningful knowledge of.

Watching the weightlifting I was intrigued to learn how strategy & psychology play a key role in the discipline, with some competitors aiming to beat their own personal best, and others choosing their weights carefully with a view to out-lifting their closest rivals.

Choosing too high a weight risks wasting valuable strength & energy on an unsuccessful lift, so it’s a fine balancing act between the chance of failure and the possible benefits of aiming high.

And all that’s before the athletes have to deal with choking under pressure!

The efficient frontier

In life, we don’t want to avoid risk entirely.

If you’ve ever applied for a dream job above your grade, taken the plunge to try an extreme sport, nervously asked someone you fancy out on a date, or decided to go travelling for a year, you’ll intuitively understand healthy examples of risk-taking for a potential reward.

Unfortunately common sense can go out the window when folks assess risk & reward with regards to manage their money.

The efficient frontier describes portfolios offering the strongest returns for a given level of risk (or, alternatively, the lowest level of risk for a given rate of return).

Take on too little risk, and the returns may be too low for achieving your objectives; if you take on more risk, on the other hand, there should be compensating higher expected returns.

I long ago lost count of emails received asking whether something or other is a ‘good investment’ (e.g. a flat in London’s West End, or some random cryptocurrency I’ve never heard of).

The answer, of course: it depends on your circumstances, goals, time horizon for investing, and tolerance for risk!

3 portfolio thoughts

3 things, then, to consider with regards to an investment portfolio:

(i) Define goals – if you don’t know what your objectives are, how can you know how much risk to take? Consider what you want to achieve, why, with whom, and by when;

(ii) Strike a balance – an ideal portfolio strikes a healthy balance between risk & return that’s appropriate for the individual – a great financial planner can help; and

(iii) Don’t put all eggs in one basket – familiarity with what you’re investing in is a good thing, but a key element of the efficient frontier and its curvature is the benefit of diversification. In plainer English, spread your bets!

Taking on some risk is OK; in fact, the efficient frontier holds that taking on a level of risk is necessary to increase potential returns.

But be wary of biting off more than you can chew, for when push comes to shove many of us don’t deal with risk as well we think.

As boxing champ Mike Tyson said: ‘Everyone has a plan…’til they get punched in the mouth’.

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