What is an efficient portfolio, and what role should such a portfolio play in investing?
When creating a portfolio for an investor we learned in chapter 1 that the first step is to identify them as an investor. What is their tolerance for risk? How much do they have to invest? What is their time horizon? The list goes on and on. This is called investor profiling. We take this information and come up with an investment plan or allocation. Our goal is to get the most return for the least amount of risk. We do this by using different asset classes, and different investments within those asset classes.
Our text gives us a lot of insight into what goes into a portfolio. By this point in the class we are very familiar with the concept of diversification. By combining multiple investments in a portfolio we are able to diversify out the business risk (the risk that one particular company will fail) of any individual investment. As we continue looking into efficient portfolios we see that there are many more things we can do to minimize risk while not sacrificing return, which is the definition of portfolio efficiency.
By looking at a concept called correlation we can eliminate even more risk from a portfolio. In order to diversify out risk we are looking for assets and asset classes that do not correlate, which is a fancy word for match. By including different assets such as foreign investment, different sectors of the economy, and even commodities and metals such as gold we can create a portfolio that is truly efficient.
Now this portfolio may not be the highest returning portfolio, but it should not be the lowest. It should match our investment profile while minimizing risk and achieving the maximum return for the amount of risk we bear. Let me know your thoughts on portfolio efficiency.