The first adjective refers to their risk tolerance over a short period of time (i.e., less than five years) while the second refers to a longer period of time (i.e., greater than five years). The second column, “Projected Total Return,” is our estimate of the total return for each portfolio for the next 10 to 20 years, assuming that inflation is 3%. Since returns don’t come nice and even, the next column provides the range of returns we expect most of the time (our euphemism for one standard deviation.) Finally, the last column is an indication of how bad it might be if we have a really rotten year. We use quotes around the descriptor “worst case” (our user-friendly term for two standard deviations) because it only reflects 90% out of 100 years. There is a slim chance that it could be even worse than that.

I tell the clients that if they feel they are really “conservative,” we can design a portfolio with a 6% return where most of the time the portfolio would break even. In a really rotten year, perhaps the “worst case” would be minus 4%. On the other hand, if that return seems too low, we might design for a positive 8.6% total return for the year, but the “worst case” may be minus 20%. I make it clear that this is a one-year estimated loss, not the loss reflected on the day after a crash. Then to remind them that really bad times happen, I point out what happened to the portfolio during the grand recession. We then have a lively discussion about the relationship between risk and return, resulting in the client “selecting” a portfolio that best reflects his balance between risk and return.


When we actually design the portfolio, we are acutely aware that we must consider all three risks, tolerance, capacity and risk requirement. In fact, we often use a third graph to illustrate these risks and how the portfolio reflects the client’s unique needs and circumstances. In this case, I usually draw a simplified efficient frontier on a blank paper. I don’t call it “efficient frontier” because I did that once with a client and he asked, “Is that like the ‘final frontier’?” (Obviously a Star Trek fan from the ’60s.)

Harold Evensky is particularly facile at using the efficient frontier scenario. This approach is from his book Hello Harold (coming out later this year). He uses a simple graph to plot risk and return, one on each axis, and then demonstrates where cash, stock and bonds fall. We then use a graph to explain the efficient frontier. (We use different versions of the graph to illustrate our points, but only the one with the efficient frontier is shown in Figure 3.)
Using the graph, this is how we explain investing and the efficient frontier to clients.  

As you’d expect, cash would not be very risky, but it would not provide much in the way of return, whereas stock might provide a high return but at some risk. Bonds are somewhere in between. With just these three choices, we could still design thousands of portfolios; for example, 99% bonds and 1% stock or 99% stock and 1% bonds. If I put dots on my graph for the risk and return combinations of all of these combinations, I’d fill up the picture with dots. Then if I drew a line enclosing all of those dots, I would end up with a curved line that’s called the efficient frontier.