Now that we know how we should not invest, and how we should invest, and how we actually invest—where do we go from here? To start, let us introduce the Tangency Portfolio. The Tangency Portfolio is the Holy Grail of investing. It is the perfect investment—that ideal combination of everything (stocks, bonds, commodities, real estate, etc.) that gives you the highest return for the least amount of risk.
By analogy, you might say that once you have figured out that chocolate cake is the best desert in the world, you can have more chocolate cake or less chocolate cake, but nothing else will be better than chocolate cake. The same goes for the Tangency Portfolio. Once you have identified it, the only rational investment decision is how much of it you want to own. You can hold less by holding more cash alongside it, or you can hold more of it by borrowing money to lever up your stake. Either move will lower or raise your risk-adjusted returns better than any rearrangement of the holdings within the Tangency Portfolio itself. Any manipulations within the portfolio will only increase your risk more than they increase your returns.
It sounds pretty swell, doesn't it? So, wouldn't you like to know what the Tangency Portfolio is?
Well, we're not going to tell you. Ha-ha, just kidding. Okay, we'll tell you.
According to standard investment theory, the Tangency Portfolio is the portfolio of everything in the world. This ...