Corrosion is the slow decay of metallic materials that, over a long period of time, can lead to catastrophic failure of a structure. Investment fees act in a similar nature, slowly and constantly eating away at your returns and severely damaging your potential to buy that house, put your kids through college or retire when you want. The good news is that, like an engineer dealing with corrosion, you can avoid the damage if you make smart decisions to protect yourself.
In 1952 a guy named Harry Markowitz introduced something known as Modern Portfolio Theory (MPT). Harry won a Nobel prize for his work which mathematically showed how and why risk and return for an individual asset should not be viewed on its own, but on how that asset impacts the overall risk and return of a portfolio of assets. My prior blog post on asset allocation explains the basic mechanics of how different asset classes can impact the risk and return of a portfolio. In this post we will dive a little deeper to show how the efficient frontier is constructed.
Stocks are risky but they generate high returns. Bonds are safer but they offer proportionally less returns. Investors may think that combining these asset classes in a portfolio linearly scales risk versus return. For the most part this is true; but due to a lack of correlation between these assets, combining them in a portfolio can actually increase returns without increasing risk.
With investing, we all know that if you want to play it safe you buy bonds and that if you want more return and can stomach the risk you buy stocks. But what if I told you that there is a way to have your cake and eat it to, to have less risk AND more return. Normally if you hear this kind of claim from someone I would advise you to run from them and run fast. But in this case I think you should hear me out because engineering a portfolio comprised of the right mix of different asset classes can help you travel on the efficient frontier all the way to the bank.