What is the Efficient Frontier and Why is it Important?

With high market valuations and an ever-lasting bull market, one might get scared to invest in equities (stocks) and stay on the sidelines. We are not and continue to hold an aggressive portfolio of low-fee index funds (see our actual holdings). Over the long-term, the market has historically greatly rewarded equity investors but there is a balance to be found. With the help of the efficient market theory, we try to build a diversified portfolio which will support us throughout our journey.


How to balance between stocks and bonds?

Gathering data from 1928 to 2017, Aswath Damodaran from the Leonard N. Stern School of Business tallied that the average return of the S&P 500, which closely represents the American stock market, summed up to 11.42% per year before inflation.

Over the same period, 10-year Treasury Bonds averaged 5.18%. The short-term 3-month Treasury Bills averaged a return of 3.46% before inflation.

With this said, wanting higher returns and holding a large portion of your portfolio in stocks like we do is risky. By risky, we mean volatile. You will never lose a dime if you do not sell, but it will be a bumpy ride. One way we use to get a smoother ride is by holding an efficiently diversified portfolio.


The modern portfolio theory to the rescue

The modern portfolio theory developed by Harry Markowitz in 1952 states that it is insufficient to take a single investment approach or single asset class approach, but rather take a mixed-asset approach.

Better returns and less risk can be achieved with a combination of investments or an “efficiently diversified portfolio”. Having different asset classes does not mean to hold shares of Coke and Pepsi but rather holding investments that are not perfectly correlated or are, ideally, negatively correlated.

You can diversify your portfolio by investing in U.S. stocks, international stocks, bonds, real estate investment trusts (REITs), or emerging markets for example. You can get a free portfolio analysis with a customized efficient frontier chart with Personal Capital.


Efficient Frontier Optimal Portfolio

Source: Morningstar


Worldwide diversification

Holding a balanced portfolio can potentially increase your returns while greatly diminishing risk. We do not hold many bonds in our portfolio but we are greatly diversified across continents and asset classes.

To get into numbers, using asset class return statistics from the S&P TSX Composite Index returns, the DEX Long-Term Bond Index returns, and the S&P 500 Index returns from 1970 to 2009 provided by Standard & Poor’s Index Services Group, we can see in the table below how diversification can increase the average yearly returns while greatly diminishing the risk, or volatility, of your portfolio.

Holding a globally diversified portfolio with 40% bonds, for example, historically reduced risk by 41.64% while increasing returns by 0.64% per year over a Canadian stock-only portfolio. Over the whole period (from 1970 to 2009) this slight edge adds up to a 28.25% higher end balance.


Asset Class

Average Yearly Return

Standard Deviation (Risk)

Risk Reduction

Canadian Stocks



Balanced Portfolio
60% Canadian stocks, 40% bonds




Globally Diversified Portfolio
20% Canadian stocks, 20% U.S. stocks, 20% International stocks, 40% bonds




Source: The Index House


We do not expect history to repeat itself but the basic concept still holds; investing in different asset classes around the world and benefiting from the non-correlation of the markets over the long-term.

Over the past decade, the correlation between markets has generally been on the rise. This makes proper diversification harder but still possible. In the chart below, absolute correlation is represented by 1.00.


Market correlation in portfolioSource: Charles Schwab


It makes sense when you look at today’s economy. Most American companies have now expanded across the globe and now operate everywhere from Texas to Rio de Janeiro.

Not only does most major company now depend on emerging markets for growth but another major factor is the ease of information the internet has brought us. Information now spreads quickly across markets and anyone can now have access to the same information only large institutional investors used to get.


Controlling your fees

Going forward, we cannot predict returns nor can we guess which asset class will perform best. The one thing we can know and control is the fees associated with our portfolio.

We keep our fees low by holding index funds from Vanguard and using Questrade to trade for free.

The following graph clearly shows the impact of fees on your portfolio over the long-term. Over an investment lifetime (here results are shown since 1974) management fees can diminish total returns over threefolds.


Effect of fees on your portfolio

Source: Germak


At the very bottom, the blue line represents the historical returns of $10,000 invested in the S&P 500 after a 2.5% management fee commonly charged by Canadian mutual funds.

With almost twice as much total returns, the gray line illustrates the returns after a 1% fee and further up. The yellow line shows the potential after a 0.42% annual fee such as the average fee of TD e-Series funds.

Lastly, the blue line shows the historical returns after a 0.15% management fee charged by most ETF providers such as Vanguard and the green line represents the S&P total returns over this period.

It is astonishing to see how the simple fee structure of exchange-traded funds has tripled the returns of investors when compared to highly-priced mutual funds. We suggest you try out Personal Capital’s Fee Analyser for free to see exactly how much your portfolio is costing you.


If all of this sounds too complicated, we suggest Wealthsimple.

Start your automatic investment account today!


We cannot get an edge in the market but we can certainly get an edge by reducing our fees to the minimum. Find your ideal portfolio and start growing your wealth. The best day to start investing is today, Xyz.



Should I Change My Ideal Asset Allocation?

Today I have been reading a bit on approaches Financial Planners are taking when advising their clients on the ideal asset allocation. I was surprised to learn that most planners are now advising to shift investment strategies towards U.S. equities and bonds have deeply fallen out of favor. In the chart below, you will notice how U.S. equities recently saw a large influx of cash after the elections.

ideal asset allocation

The ideal asset allocation after the elections?

With the recent turmoil in the American and Global markets, mainly due to the new presidency, people are reconsidering their asset allocation and changing their investment strategy. I was surprised to see that financial planners, the people that are supposed to steer their clients in proper asset allocations and talk them out of reacting to the short-term news, are in fact changing their asset allocations according to short-term news. Planners are now buying more into U.S. equities and ditching the bonds simply on speculation.


If all of this sounds too complicated, we suggest Wealthsimple.

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You should not change your allocation with news events but rather, according to life events. You should have a set allocation and stick to it until your personal situation changes such as after marriage, kids, or retirement, for example. The most popular reasoning behind the equities and bonds allocation is age but I also disagree with that rational as I previously talked about in a guest post I did over at GenYFinanceGuy.


Advisers sharply increased allocations of client assets to U.S. equities, but some planners are cautioning against piling into a market where they see valuations as being too high. – Andrew Welsch


Advisers say the shifts in asset allocations were motivated by post-election expectations of changes in the tax code that would benefit wealthy Americans, an increase in interest rates and the possibility of new stimulus under President-elect Trump’s proposed infrastructure program. – Andrew Welsch


Over the years, there has been elections cycles, riots, wars, policy changes, but in the end, the market always goes up. If one would change its investment strategy every time something happens in the world, he would be switching something every single day!

As shown in the chart below, that shows the running percentage gain in the Dow Jones Industrial Average by presidential term, there have been some ups and down to the market but little correlation with the election cycle. Going back to Calvin Coolidge, the 30th president of the United States from 1923 to 1929, this graph shows how most presidents saw growth in the markets and all of them saw swings during their terms. This makes sense since, historically, the market has been up 7 out of 10 years on average. They are also all seeing swings because there is no clear equation that equates; this president = markets go this way. Markets are alive and a creature by themselves, the political structure around them might help contain it but, by no means, controls it.


Every US president can increase your stock market returns

Source: Macrotrends.


How about global markets?

In addition to a drastic change in the equity/bond allocation, financial planners are also pulling away from the global markets. I would argue that you cannot predict the markets but having investments across the globe, in different asset classes, allows you to always be there when it does go up.


Planners also said they pulled back on global equities for fear of protectionist policies being put in place in the U.S. and other countries. Andrew Welsch


Historically, the global markets have not always been correlated with the American market and have done very well over the long-term. More than 90% of your total investment return depends on your asset allocation so why only focus on your home country when the economy is now global?

Throughout history, the markets have jumped up and down (mostly up) and consistently been good to long-term investors. The following shows the annualized real returns of equities and bonds across the globe. In addition, the cumulative columns represent the number of times your dollar would have multiplied since 1900. For example, a dollar invested in the American market would have multiplied 1,248 times or to put in perspective, $10,000 would have grown to $12,480,000 over the last century. 🙂


Annualized real return of Equities Cumulative since 1900 Annualized real return of Bonds Cumulative since 1900
Australia 7.4% 3,332 1.5% 5.7
Belgium 2.6% 19.3 0.2% 1.3
Canada 5.7% 583 2.1% 11.1
China -3.8% 0.4 1.6% 1.4
Denmark 5.2% 325 3.1% 32.1
France 3.2% 35 0.0% 1.0
Germany 3.2% 38 -1.6% 0.2
Japan 4.1% 98 -1.0% 0.3
Netherlands 4.9% 246 1.5% 5.5
Norway 4.3% 116 1.8% 7.4
Portugal 3.7% 60 0.6% 2.0
Russia 5.8% 2.9 6.1% 3.1
S. Africa 7.4% 3,372 1.8% 8.1
Spain 3.6% 57 1.4% 5.1
Sweden 5.8% 601 2.6% 17.7
Switzerland 4.4% 137 2.2% 12.3
U.K. 5.3% 372 1.4% 4.9
U.S.A. 6.5% 1,248 1.9% 8.2
World Averages 5.2% 314 1.8% 7.6

Source: Credit Suisse Global Investment Returns Yearbook 2014


I do not think you should change your asset allocation because of political news and you should rather build an investment strategy around your current life situation and future goals. Even though the present speculation guides towards lower global market returns, you should always stay diversified and plan for the long-term.

If you truly want to be diversified across the globe, you can opt for a single fund portfolio through the Vanguard Total World Stock ETF (VT) or add the Vanguard FTSE All-World ex-US ETF (VEU) to your American holdings.If you are stuck with a limited selection of funds you can still gain exposer with Developed World Market funds and Emerging Markets funds that are available through most companies.

Ideally, your portfolio should roughly represent the world economies by weighting but many different models suggest many different weightings. Of course, many factors will change this allocation such as home bias, currency risks, and market instabilities, which is why even our portfolio does not represent the world economies.


Relative sizes of world stock markets, How to build your asset allocation and invest in a diversified portfolio.

Source: Credit Suisse Global Investment Returns Yearbook 2014


But how about the market capitalizations?

In terms of market caps, which is the total valuation of companies based on their current share price and the total number of outstanding stocks, your allocation should rarely change at all. The ideal portfolio for index investors would be to have the exact allocation present in the total market. For example, your small-cap holdings should represent roughly 6% of your portfolio (6.69% as of date of posting) and so on. The easiest way to achieve this is to invest in a fund like the Vanguard Total Stock Market ETF (VTI) for the U.S. or the Vanguard Total World Stock ETF (VT) for a global exposure that includes all market caps.

Following this structure, your portfolio would not change according to age nor to life events. Your exposure to market capitalization should stay pretty constant and simply follow the current breakdown. Below, you can watch a short video from Vanguard explaining the rationale behind this allocation.


Source: Vanguard


In conclusion, I do not think you should follow the current market trends that are heavily weighing on American equities and changing their portfolio because of presidential outcomes.


If all of this sounds too complicated, we suggest Wealthsimple.

Start your automatic investment account today!


The current news should not affect your decisions and you should apply a long-term approach to your investments. In addition, you can easily invest in a proper allocation using low-fee funds with brokers like Ally or Vanguard.

How about you, what is your allocation? Live Happy, Xyz.