An efficient portfolio is one that is well-diversified and adequately compensates you for risk. When it comes to putting together an efficient investment portfolio, reducing volatility is the name of the game. Experts advise diversifying your portfolio by including stocks from different industries.
Opinions vary as to how many stocks it takes to create a diversified portfolio. Whatever number you choose, your portfolio should hold a broad spectrum of stocks from different industries. Pairing a high-flying technology stock with a utility company stock is an example of diversification. The idea behind diversification is that when one stock is down, the other stocks in the portfolio pick up the slack. You'll have to do your homework when it comes to stock picking. This means researching the top three or four companies in each industry, reading financial and analyst reports to understand the financial outlook for each company, and picking the best company to add to your portfolio.
Beta is a measure of risk. Essentially, beta tracks a stock's performance relative to the stock market. A beta of 1 means that a stock is as risky as the market (i.e., holds an average risk). So if the expected market return is 12 percent, a stock with a beta of 1 should produce the same return. A stock with a beta of 2 is twice as risky as the market. If the market has an expected return of 10 percent, a stock with a beta of 2 has an expected return of 20 percent. On the downside, the stock could decline by 20 percent or more. In other words, a high-beta stock is very volatile. You don't want include a high-beta stock in your portfolio unless it also contains stocks with counterbalancing betas as an offset. You can find a stock's beta by visiting a financial website such as Yahoo! Finance or Morningstar.
Investors fret over returns; namely, whether stock investments will produce expected returns. An efficient portfolio is not only one that is adequately diversified, but also produces the expected returns within an acceptable variance. To calculate expected returns, you assign a weighted distribution of possible returns and add the results together. For example, if you assign a 50 percent probability of a stock producing a return of 15 percent, a 30 percent chance of returning 10 percent, and 20 percent chance of returning 5 percent, the expected return for the stock is 11.5 percent.
Compensating for Risk
You don't want to heavily weight your portfolio with stocks that are extremely volatile. In good years, your portfolio will produce returns way above the market but, in lean times, produce very poor results. There is nothing wrong with taking risk when investing, but you should be adequately compensated for it. Therefore, another characteristic of an efficient portfolio is that it compensates you for the level of risk you take when you add a stock. So when you add a high-beta stock in your portfolio, it is with the thought of boosting the portfolio's overall return while dampening the potential volatility inherent in the stock with other stocks in the portfolio.