As an investor, wouldn’t it be nice to know that your portfolio both limits your risk and maximizes return? Ideally, it will do just that. The efficient frontier is a set of investment portfolios that maximizes returns while minimizing risk. Learn how the efficient frontier works, why it matters, and how it can benefit your investment strategy.
Efficient Frontier: The Basics
Introduced by Harry Markowitz in 1952, the efficient frontier is a financial tool that helps an investor compose an investment portfolio with the best returns given the amount of risk. Think of it as a watermark of sorts. Portfolios that lie below or to the right of the efficient frontier are considered sub-optimal. That’s because the rate of return isn’t high enough to justify the risk. Profiles that lie above the frontier are optimal, and returns balance out the risk.
The efficient frontier is an idea crucial to modern portfolio theory. That theory represents a framework for creating an investment portfolio with the highest returns given a limited amount of risk.
How It Works
Whether a portfolio measures up to the efficient frontier can be calculated using a graph. An investment’s returns represent the y-axis, while its level of risk lies on the x-axis. The investment itself is plotted on the graph according to these two factors. It is then compared to the curved line of the efficient frontier, which determines if it calls above or below the efficient frontier—in short, whether that investment is “efficient.”
Keep in mind that one investor’s efficient frontier can be very different than another’s. That’s because it considers an investor’s risk tolerance when determining what securities might earn the highest returns within those risk limitations. It also considers the individual investments that make up a specific portfolio and how they fall within these two axes.
But if your portfolio doesn’t fall within the efficient frontier, don’t panic. Adjusting your portfolio’s asset allocation, which spreads out the portfolio among different asset classes, can help move a portfolio into the efficient category.
Of course, every investor wants a portfolio that minimizes risk while maximizing rewards or returns. It’s nearly impossible to build a portfolio entirely devoid of risk, due in part to the stock market’s inherent risk. However, potential returns can balance a portfolio or an investment’s risk. That’s why the efficient frontier is important.
This tool helps investors get the most for their investment by analyzing the risk and returns associated with an investment portfolio and helping the investor adjust their asset allocation or individual investments accordingly.
It can also be helpful in determining if an investor should pull their funds from an investment with a certain amount of risk and return for a similar investment with less risk and the same return.
The Optimal Portfolio
According to Markowitz’s theory, an optimal portfolio would offer a perfect balance between risk and return. It wouldn’t contain too many high-risk investments that can yield high returns. Nor would it be as conservative as a low-risk portfolio with low returns.
The optimal portfolio contains securities with the greatest potential returns with an acceptable degree of risk. It also features securities with the lowest degree of risk for a certain level of return. Optimal returns tend to lie along the efficient frontier.
Thus, a risk-ready investor could choose securities right end of the efficient frontier. Those would likely have a high degree of risk coupled with high potential returns. Meanwhile, securities on the left end of the efficient frontier would be suitable for more cautious investors.
Efficient Frontier Limitations
The efficient frontier relies on assumptions that aren’t always realistic. It assumes that asset returns follow a normal distribution. In reality, returns can also vary within three degrees of standard deviation. A so-called heavy tail can prove challenging for investors.
Additionally, Markowitz assumes investors are rational and typically avoid risk. He also believes the number of investors can’t influence market prices. Also, he seems to think that investors all have the same access to borrowing and can get money at a risk-free interest rate. In truth, the market features the opposite of every scenario listed above.
The Bottom Line
The efficient frontier is comprised of investment portfolios that maximize returns while minimizing risk. Think of it as a curved line on a graph. The y-axis representing returns, while the x-axis represents risk.
An investor can plot his or her portfolio on this graph, analyzing how this dot compares to the efficient frontier threshold. In other words, a portfolio that offers the highest possible returns with the lowest possible risk. The efficient frontier can be a useful tool for investors to determine if their portfolio is performing adequately.
- If you’re not sure how to diversify your portfolio, a financial advisor may be able to help. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Do you know how much investment risk you’re willing to take? How much will taxes and inflation eat into your investment? Can your investments grow quickly enough to reach your goals? SmartAsset’s investing guide can help you answer those questions and set a firm foundation for future investments.
Photo credit: ©iStock.com/veerasakpiyawatanakul, ©iStock.com/utah778, ©iStock.com/benedek