Efficient Frontier

What Is the Efficient Frontier?

The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-standard since they don't give sufficient return to the level of risk. Portfolios that cluster to the right of the efficient frontier are sub-par since they have a higher level of risk for the defined rate of return.

Grasping the Efficient Frontier

The efficient frontier theory was presented by Nobel Laureate Harry Markowitz in 1952 and is a foundation of modern portfolio theory (MPT). The efficient frontier rates portfolios (investments) on a scale of return (y-hub) versus risk (x-hub). The compound annual growth rate (CAGR) of an investment is generally utilized as the return part while standard deviation (annualized) portrays the risk metric.

The efficient frontier graphically addresses portfolios that expand returns for the risk assumed. Returns are dependent on the investment mixes that make up the portfolio. A security's standard deviation is inseparable from risk. Preferably, an investor tries to fill a portfolio with securities offering extraordinary returns yet with a combined standard deviation that is lower than the standard deviations of the individual securities.

The less synchronized the securities (lower covariance), the lower the standard deviation. In the event that this mix of advancing the return versus risk paradigm is fruitful, that portfolio ought to arrange along the efficient frontier line.

A key finding of the concept was the benefit of diversification coming about because of the shape of the efficient frontier. The shape is fundamental in uncovering how diversification works on the portfolio's risk/reward profile. It likewise uncovers that there is a diminishing marginal return to risk.

Adding more risk to a portfolio doesn't gain an equivalent amount of return — optimal portfolios that include the efficient frontier will generally have a higher degree of diversification than the less than ideal ones, which are ordinarily less diversified.

Reactions of the Efficient Frontier

The efficient frontier and modern portfolio theory have numerous assumptions that may not as expected address reality. For instance, one of the assumptions is that asset returns follow a normal distribution.

In reality, securities might experience returns (otherwise called tail risk) that are more than three standard deviations away from the mean. Subsequently, asset returns are said to follow a leptokurtic distribution or weighty tailed distribution.

Moreover, Markowitz places several assumptions in his theory, for example, that investors are rational and stay away from risk whenever the situation allows, that there are insufficient investors to influence market prices, and that investors have unlimited access to borrowing and lending money at the risk-free interest rate.

In any case, reality demonstrates that the market incorporates irrational and risk-seeking investors, there are large market participants who could influence market prices, and there are investors who don't have unlimited access to borrowing and lending money.

Special Considerations

One assumption in investing is that a higher degree of risk means a higher likely return. On the other hand, investors who take on a low degree of risk have a low likely return. As indicated by Markowitz's theory, there is an optimal portfolio that could be planned with a perfect balance among risk and return.

The optimal portfolio doesn't just incorporate securities with the highest expected returns or low-risk securities. The optimal portfolio plans to balance securities with the best possible returns with an acceptable degree of risk or securities with the lowest degree of risk for a given level of likely return. The points on the plot of risk versus expected returns where optimal portfolios lie are known as the efficient frontier.

Expect a risk-seeking investor utilizes the efficient frontier to choose investments. The investor would choose securities that lie on the right finish of the efficient frontier. The right finish of the efficient frontier incorporates securities that are expected to have a high degree of risk combined with high likely returns, which is suitable for highly risk-open minded investors. Alternately, securities that lie on the left finish of the efficient frontier would be suitable for risk-averse investors.

Highlights

• The standard deviation of returns in a portfolio measures investment risk and consistency in investment earnings.
• The efficient frontier includes investment portfolios that offer the highest expected return for a specific level of risk.
• Lower covariance between portfolio securities brings about lower portfolio standard deviation.
• Optimal portfolios that include the efficient frontier generally show a higher degree of diversification.
• Effective optimization of the return versus risk paradigm ought to place a portfolio along the efficient frontier line.

FAQ

Why Is the Efficient Frontier Important?

The efficient frontier graphically portrays the benefit of diversification and can. The curve of the efficient frontier demonstrates the way that diversification can further develop a portfolio's risk versus reward profile.

How Could an Investor Use the Efficient Frontier?

To utilize the efficient frontier, a risk-seeking investor chooses investments that fall on the right half of the frontier. Meanwhile, a more conservative investor would pick investments that lie on the left half of the frontier.

How Is the Efficient Frontier Constructed?

The efficient frontier rates portfolios on a direction plane. Plotted on the x-hub is the risk, while return is plotted on the y-hub — annualized standard deviation is regularly used to measure risk, while compound annual growth rate (CAGR) is utilized for return.

What Is the Optimal Portfolio?

An optimal portfolio is one planned with a perfect balance of risk and return. The optimal portfolio hopes to balance securities that offer the best potential returns with acceptable risk or the securities with the lowest risk given a certain return.