Risk, Return and Portfolio Efficiency
Investors generally seek to maximize their returns for a given amount of risk and minimize their risk for a given return. Since we know that risk and return tend to go hand-in-hand, the following supposition may seem a bit counterintuitive: By adding small amounts of a relatively risky asset class (such as common stock) to a portfolio of lower-risk asset classes (such as bonds and money market securities), research has shown that it has been possible to increase portfolio returns while actually reducing overall portfolio risk. How can this be?
Because the price movements of different asset classes tend not to be perfectly correlated with one another, the incremental risk each asset class might add to one’s overall portfolio is less than its risk on a stand-alone basis. And therein lies the opportunity. For example, when common stock prices are "zigging," bond prices may be "zagging" and commercial real estate prices may be doing something else altogether. While each of these asset classes has tended to provide positive returns to investors, their price movements have been somewhat independent of one another. By maintaining exposure to a number of asset classes within a given portfolio, overall volatility is likely to be less than the individual parts might otherwise suggest.
A related tenet of investing is that investors are only compensated for bearing risk they cannot diversify away. Bottom line: If your portfolio is dominated by a particular asset class, it may not be efficient from a risk/return standpoint. If this is the case, you’re likely to be bearing more risk than necessary, not getting fully compensated for the risk you are bearing, or both. When constructing a portfolio, strive for portfolio efficiency.
