The Efficient Frontier represents the optimal combination of assets an investor can own for their risk tolerance, given a set of assumptions for risk, return, and correlation. While mathematically correct, most practitioners use historical rates of return to project the future and to create their efficient frontier. Projecting future returns using historical averages is only accurate if present conditions are identical to those that existed at the beginning of the historical average, specifically with regard to valuations. As a result, historical averages may be a decent assumption over a century, but what if your time horizon is 10 years? The historical rate of return on the S&P from 1926-2015 was 10.034%*. The actual return over the past 10 years was 7.89%**. This difference can lead to uncompensated risk by thinking you are efficiently allocated and getting something different. If you build a portfolio expecting one thing and getting another is that good? It isn't, because maybe you may have done something differently. That something different is that you wouldn’t have bought the same mix of assets. The real efficient frontier is the optimal mix of assets over an investor's time frame, not over an academic time frame that might be 100 years.
The following three things are crucial to an investor's success:
- Your Risk Tolerance
- Your Personal Time Horizon
- Current Economic and Market Environment that influence return and risk over your horizon, not a 100 year academic horizon.
*Return from 1/1/1926 to 6/30/15
**Return from 10 year period thru 6/30/2015