Is My Portfolio On The Efficient Frontier?

My Portfolio And The Efficient Frontier

After publishing Gasem’s guest post, I wanted to take a closer look at my investment portfolio to see if it lies on the efficient frontier. As you recall, the efficient frontier is the set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.

A portfolio that lies on the efficient frontier is referred to as a tangent portfolio. It’s the point of maximum return for minimum risk. One of the hallmarks of such portfolios is having diversified investments with assets that are not correlated with each other.

Do I have a tangent portfolio that lies on the efficient frontier?

According to Betteridge’s law of headlines, the answer is “no”. Surprisingly, however, it’s not too far off.

Let’s take a closer look.

 

Investments In Multiple Accounts

Having multiple accounts complicates our investment portfolio.

In total, my wife and I have eleven accounts, including:

• Roth 401(k) plan
• Keogh retirement plan
• Old 403(b) from residency
• Vanguard Roth IRA
• Wealthfront roboadvisor taxable account
• Vanguard taxable account
• Vanguard joint taxable account
• Wealthfront roboadvisor taxable account (wife’s)
• Vanguard Roth IRA (wife’s)
• 457 plan (wife’s)
• 401(k) plan (wife’s)

Every year we are able to save $102,000 in our tax-advantaged retirement accounts. $55,000 (my Keogh and Roth 401k) + $11,000 (back door Roth for me and my wife) + $36,000 (my wife’s 401k and 457). That’s fantastic!

The problem is that a lot of these accounts have different investment fund options. For instance, the best investment options in my wife’s 457 and 401(k) plans seem to be the target date funds. Wealthfront seems to have their own idea of an optimal asset allocation. And most of our vanguard accounts consist mainly of VTSAX.

It can be hard to keep track of all of these investment accounts with different assets funds!

 

Investment Checkup With Personal Capital

The great thing about Personal Capital is that it can aggregate all of you accounts. And with a few clicks, you can see where your portfolio is in relation to the efficient frontier.

All you have to do is click on the “planning” tab then click on “investment checkup”.

You should see something that looks sort of like this…

As you can see, my current allocation is quite a bit different than the target allocation that Personal Capital recommends for me.

At least the projected growth rate of my portfolio looks appropriate.

 

Investment Profile

My investment profile is a very aggressive “high growth” strategy.

I chose this strategy for the following reasons:

• My profession earns a high income.
• Overall job security is relatively high.
• My Income is not correlated to the market. If the market tanks, I’ll still likely have a job and my salary would not decrease.
• I am relatively young (35 years old) and plan on working for 20+ more years. Thus my investment horizon is relatively long.

My investment profile will definitely change as I get older, but this is where I’m at right now.

 

Efficient Frontier

As you scroll down within your Investment Checkup, you can see where your portfolio is compared to the efficient frontier.

Looking at the graph below, my portfolio is below the efficient frontier.

Based on this comparison, my portfolio has 0.5% less return for 0.6% less risk.

Perhaps my returns are not as high as expected because I have so much money allocated to cash. Or maybe my risk is too high for my expected return because I am overweight in risky international stocks.

Whatever the case may be, my portfolio does not lie on the efficient frontier.

 

Recommendations for Rebalancing

To maximize the return-to-risk ratio and improve efficiency, Personal Capital makes some recommendations.

As you can see, I am overweight in cash. This is due to several reasons:

• I’m saving up cash to pay for quarterly estimated taxes due in mid September.
• Extra cash is currently being set aside to contribute to our back door Roth IRA accounts. Traditionally, we have always made contributions to these accounts in September or October.
• I considered deploying cash to alternative investments like real estate syndications or crowdfunding. However, I’ve been too chicken to pull the trigger. My lack of experience, unwillingness to do proper due diligence, and my skepticism that these investments will outperform the market make me hesitant.

Currently, most of our cash is in high-yield savings accounts earning 1.75% APY. So at least the money is not losing too much value to inflation.

 

Do International Stocks Provide Good Diversity?

Interestingly, if you read the last line in the recommendations, Personal Capital states that “Investing globally can be an effective way to maximize your potential return while minimizing risk.”

However, one of the key takeaways from Gasem’s guest post is that international stock funds have a lower expected return with a higher risk compared to the US total stock market fund. Plus there is a 0.86 correlation. Here are the numbers:

• VTSMX is 10.82% reward, 14.84% risk and a correlation of 1 with itself
• VGSTX is 6.65% reward, 17.16% risk with a correlation of .86 relative to VTSMX

Numbers don’t lie. It is clear that if I hold an international stock fund, I pay more risk for less return compared to a US total stock market fund.

Is Personal Capital wrong in suggesting that investing globally can maximize returns while minimizing risk? The numbers seem to suggest so. It certainly wouldn’t hurt if I lowered my allocation since I’m slightly overweight in international stocks anyway.

 

Plan Moving Forward

Taking all of this into consideration, one thing is clear.

We should buy more VTSAX when we make contributions to our back door Roth accounts. This would effectively rebalance our portfolio to be a little more weighted in US stocks and less in cash. This will bring us closer to our target allocation.

The beauty of being a frugal and minimalist couple that doesn’t buy much outside of necessities, food, and travel is that it is easy to save a lot of excess cash. And we have a lot of it.

Figuring out what to do with extra cash is a good problem to have.

Here are a few options I’m considering:

1. Pay additional principal in our mortgage loan to pay off our house faster. This would effectively be a guaranteed 3.625% return.
2. Buy more stock funds in our Vanguard taxable accounts or Weathfront. But what if the markets are overvalued and a downturn is looming?
3. Hoard more cash in our high-yield savings account at 1.75% APY then wait for a downturn to buy stocks or funds (VTSAX) while it’s on sale. This is effectively “timing the market” which very few people do well on a consistent basis.
4. Start investing in alternative investments like real estate syndications or crowdfunding. But what if the real estate markets crash? And this will require me to spend more time learning about due diligence.
5. Loosen the purse strings and spend more money on fancy things. Because YOLO.

I’m not sure what we are planning to do. But it will likely be a combination of options 1, 2, and 3. I think it’s a good plan to hedge against future uncertainty.

Option 4 sounds attractive too. I just need to learn little more and do some research before diving into alternative investments such as real estate syndications.

My wife and I would only consider option 5 if we believe such a purchase would bring us value and sustained happiness. You won’t see us living the YOLO lifestyle :).

Your Turn

What do you think I should do with my extra cash? Do you think I should stop investing more in the international stock market funds? Should I increase my allocation of alternative investments?