The efficient frontier represents 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 below the efficient frontier are sub-optimal as they provide insufficient return for the risk, whereas those to the right involve unnecessary risk for the defined rate of return.
Key Takeaways
- Highest Returns for Given Risk: The efficient frontier includes investment portfolios that offer the highest expected return for a specific level of risk.
- Risk Measurement: The standard deviation of returns in a portfolio gauges investment risk and consistency in earnings.
- Impact of Covariance: A lower covariance between portfolio securities lowers overall portfolio standard deviation.
- Optimization Goal: Success in return versus risk optimization should align a portfolio along the efficient frontier line.
- Diversification Benefits: Optimal portfolios on the efficient frontier generally showcase a higher degree of diversification compared to sub-optimal ones.
Understanding the Efficient Frontier
Introduced by Nobel Laureate Harry Markowitz in 1952, the efficient frontier is a core concept of modern portfolio theory (MPT). It rates portfolios on a return (y-axis) versus risk (x-axis) scale using the compound annual growth rate (CAGR) and annualized standard deviation, respectively.
The efficient frontier graphically presents portfolios that maximize returns relative to their risk. By combining securities that provide high returns with lower combined standard deviations, an investor can situate their portfolio along the efficient frontier. The benefit of diversification is emphasized through the curvature of the frontier, revealing how it enhances the portfolio’s risk/reward profile.
Adding more risk does not yield an equal increase in return—efficient frontier portfolios typically feature significant diversification, distinguishing them from less diversified, sub-optimal portfolios.
Criticisms of the Efficient Frontier
The efficient frontier and modern portfolio theory hold multiple assumptions that may diverge from reality, such as the assumption of asset returns following a normal distribution. In truth, returns can exhibit fat-tailed distributions, where they deviate substantially from the mean. Additionally, Markowitz assumes rational investors, uninfluenced market prices, and unconstrained borrowing/lending at risk-free rates—all aspects that might differ in real-world markets comprising irrational participants, influential entities, and lending limitations.
Special Considerations
Higher risk is often associated with higher potential returns, while lower risk correlates with lower returns. The optimal portfolio strives to maintain this balance, blending high-return securities with acceptably risky ones or selecting low-risk securities yielding satisfactory returns. Positions along the risk versus expected returns plot—representing ideal portfolios—trace the efficient frontier. For risk-seeking investors, portfolios on the right end of the frontier offer high risk and high returns; conversely, portfolios on the left side cater to risk-averse investors with lower risk and returns.
Why Is the Efficient Frontier Important?
The efficient frontier visually displays the advantage of diversification, elucidating how it enhances a portfolio’s risk/reward profile.
What Is the Optimal Portfolio?
An optimal portfolio achieves a quintessential balance of risk and return, combining securities that maximize returns within acceptable risk levels or minimize risks for given returns.
How Is the Efficient Frontier Constructed?
The efficient frontier rates portfolios using coordinates where risk is plotted on the x-axis and return on the y-axis. Typically, annualized standard deviation measures risk, whereas CAGR is used for return.
The Bottom Line
The efficient frontier constitutes investment portfolios delivering the highest expected return for a given risk level. Graphically representing these portfolios outlines the perks of diversification. Risk-tolerant investors select from the right side of the frontier, while conservative investors choose from the left.
Related Terms: portfolio diversification, investment risk, return on investment, modern portfolio theory, risk tolerance
References
- The Nobel Prize. “This Year’s Laureates Are Pioneers in the Theory of Financial Economics and Corporate Finance”.
- Investment Management Consultants Association. “The Efficient Frontier in Modern Portfolio Theory: Weaknesses and How to Overcome Them”, Page 1.
- Investment Management Consultants Association. “The Efficient Frontier in Modern Portfolio Theory: Weaknesses and How to Overcome Them”, Pages 1-2.
- Investment Management Consultants Association. “The Efficient Frontier in Modern Portfolio Theory: Weaknesses and How to Overcome Them”, Page 3.
