[MUSIC] Okay, so now let's see another mistake which I encounter sometimes. And it's the one which I call here, shifting the efficient frontier to the North West provides a free lunch. What's that? [LAUGH] What do you mean? It's quite funny. That reminds me, once I did this presentation talking about efficient frontier shifting to the north east, and I did my whole presentation with the frontier shifting in the north east and nobody said anything. There were about 50 investors in the room, and at the end of it one came to me and very slightly in my ear, he said, you know what, I think it's the north west you're pointing and not the north east. [LAUGH] Okay, what do we mean by that? You've seen this and you will see more of this efficient frontier, right? This is a standard way of showing the relationship, the link between return and risk and the idea is that you start building your portfolio, you see here this inefficient portfolio, right? It has a combination here of various assets. You can think of red as being bonds, green as being equities and so forth. And it's not efficient. Why is it not efficient? because you can see that if you move this portfolio to the left, you can get, for the same return, a lower risk. So you can lower the volatility. Or alternatively, you can go upwards. And, hence, for the same risk you can get more return. And once you've done this, once you've combined all these assets via diversification, as we just saw in the previous example, the previous mistake, you get to the efficient frontier. So in the process of moving towards this direction of the north west, you get a free lunch right? Basically for the same level of risk you get more return or for the same level of return you get less risk. [LAUGH] Okay, now the problem is once you are on the efficient frontier, there's is no free lunch anymore. If you want more return and that's the standard answer and we'll also get back on this one. If you want more return, you need to accept to have more risk. Okay, now let's see what happens if, say, you start with an efficient frontier, which is a combination of traditional assets. Long equities, cash. And you come with a new asset, hedge funds, alternative investments. And typically, as we just saw, with the example of ice cream and umbrellas, the idea of hedge funds, of injecting, of bringing some alternative investments or hedge funds into a portfolio, is that their correlation is less than one. Ideally, even, it should be negative. This is in an ideal world. What we will get is a shift of the efficient frontier. We get a new one to the north west, not the north east, the north west. So here, we're getting a free lunch, aren't we? Again, if you compare these two lines, the blue and the green, you see that for the same level of risk, you get more return, or if you put it horizontally, for the same level of return, you get less risk. Okay, so it's better, right? It's a free lunch. Now is it really a free lunch? Tony Barala if he was here next to me would say, no way. And he's right, because basically what we're doing here is that we're expanding the universe, right? Off investable assets. We start with traditional ones and now we get into a new one, which is alternative investments, fine. But it could be a real estate, right? As my colleague also told you about in the first course. The beauty of including real estate in a traditional portfolio is that their correlation, they are lacking the correlation with traditional assets. So real estate would have the same impact here, which it would produce a new efficient frontier to the north west, and hence, it would apparently provide a free lunch. But this is just because you're you're expanding the universe of investable assets, its not really a free lunch right? Suddenly you wake up and you say hey, I could bring some hedge funds into my portfolio and then you get a new efficient frontier. Okay, fine. But the minute you've done this, you get the new efficient frontier and you move along this frontier and you get no free lunch anymore. You just have to accept the idea, again and again, that if you want more return, you need to accept to bear more risk. Now, mistake number three. Strategic asset allocation, I often encounter this when I talk even to some institutional clients and some pension fund. Sometimes, there's a confusion between strategic and tactical asset location. People are not really aware that this Strategic Asset Allocation refers to, well, we'll see in a minute to what it refers. But, you see, the mistake number three is, Strategic Asset Allocation should be modified if: financial markets have different returns. Your views on financial markets change. And we say, well, we're talking about the same things, aren't we? And maybe the fact that the returns on a financial markets go all over the place make you change your views on these markets. Maybe you've had a fantastic run on the US equity market, then you become a bit more cautious and so you reduce your allocation to US equities, possibly. Well no actually, these are two different statements and one is correct and the other one is not, okay? So we will see in this module that strategic and tactical asterocation are two different animals. Strategic has to do with your profile as an investor, or that of your client, if you're managing his wealth, so we're not going into details now but we'll be focusing on, what questions need to answered to define this client profile? A tactical asset allocation on the other hand, is everything which deals with investment policy. Your views on the markets, right? This is tactical. This is not strategic. So, to come back to this mistake number three, financial markets may have different returns and this will change the strategic asset allocation per se. Just simply, right? If you decide to have 40% in equities and equities have a fantastic run and they increase by 20%, then your allocation will go if everything else stayed the same, from 40 to 48% in which case, and we will also be talking about that. You need to re-balance this strategic asset allocation. So yes, when asset classes have differing returns, different returns. Then you may need re-balancing, but you should not change your Strategic Asset Allocation if your views on the market change. If you're more bearish on the US equity or more positive on bonds in the euro zones or whatever. That's a different ballgame. This is tactical, it's not Strategic Asset Allocation. Okay, right. And you will hear in this module a lot about MPT. MPT, well what does MPT stand for? Does it stand, this is a quiz for you. Does it stand for Moving Myanmar Forward? Does it stand for Maryland Public Television, or does it stand for Modern Portfolio Theory? Obviously, you know the answer. It's quite an achievement that this theory which was first created by an economist, a finance professor called Harry Markowitz in 1952, is still modern today. So we will see with Tony Borata going all over the efficient frontier and how this modern portfolio theory works and the main implications of this theory is that you should diversify your assets. For that brings a free lunch, actually, and maybe the only, we'll see, free lunch that you get with MPT is diversification. So stay tuned with this module, and you will see a lot of things that will prevent you from making the mistakes I just highlighted. [MUSIC]
