The efficient frontier is a financial framework that investors can use to build an optimized asset portfolio that attempts to give them the greatest returns within their particular risk profile. In other words, it shows which investment portfolio will be “efficient” or provides a higher expected return for a lower amount of risk. It does not, however, eliminate risk for investors, which is important to keep in mind.
It’s visualized as a curved line on a graph according to an individual’s goals and risk tolerance. The framework is called the efficient frontier or the efficiency frontier because if one’s investments fall within the ideal range, they are working efficiently to achieve one’s goal.
How Does the Efficient Frontier Work?
The efficient frontier concept is a key facet of modern portfolio theory, which was created in 1952 by Harry Markowitz. Essentially, the efficient frontier is the optimal baseline for an investment portfolio. If an investor’s portfolio gives them lower returns because it contains riskier investments, then it may not be as well balanced as it could or should be. It’s also possible for a portfolio to provide returns that are greater than the frontier. As such, as long as a portfolio’s potential returns justify its associated risks, then the portfolio is well-allocated.
Every investor has a different risk tolerance, and their own corresponding goals for portfolio growth. Accordingly, every investor has a different frontier. By adjusting that frontier, the inventors can then see if their current portfolio measures up to the parameters set by the efficient frontier graph, and make changes to their asset allocation accordingly.
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How Is the Efficient Frontier Constructed?
Investors hoping to utilize the efficient frontier concept as a part of their strategy will create a corresponding graph, and apply it to their specific portfolio.
When constructing the graph, expected returns are on the y-axis and the standard deviation of returns, which are a measure of risk, are on the x-axis. Then, they would plot a curve that shows where the ideal or expected portfolio would land on the graph and the standard deviation of returns.
Once the graph is created, the investor can plot a portfolio or individual asset on the graph according to its expected returns and their standard deviation, and then compare it to the efficient frontier curve. The investor can also plot two or more portfolios on the graph to compare them.
A portfolio that falls on the right side of the graph has a higher level of risk, while a portfolio that is low on the graph has lower returns. If an investor finds that their portfolio doesn’t fall on the graph where they would like it to, they can then make decisions about how to reallocate investments to move closer to the goal.
The curved line reflects the diminishing marginal return to risk. Adding more risk to a portfolio doesn’t result in an equal amount of increased return. Portfolios that lie below the curve on the graph are suboptimal because they don’t provide high enough returns to justify their amount of risk. Portfolios to the right of the curve are also suboptimal because they have a high level of risk for their particular level of return.
Again, the portfolios that display the lowest levels of risk are not inherently risk-free, which investors will need to keep in mind.
Efficient Frontier Example
Efficient frontier can be a somewhat difficult concept to visualize, so consider this: Your portfolio contains two assets. Each asset has its own respective expected annual return, and standard deviation — so multiple variables for each asset.
Data sets for each can be put together showing correlated expected returns and standard deviations, and plotted on a graph, as discussed. That graph will reveal the efficient frontier, and help investors determine which portfolio they’d prefer accordingly.
Again, it’s somewhat difficult to visualize, but practically speaking, a visual chart with different portfolios can be helpful in making portfolio decisions.
Benefits of the Efficient Frontier
The primary benefit of the efficient frontier is that it helps investors visualize and understand whether their investment portfolio is performing the way they would like it to. Every investment and portfolio comes with some risk, and oftentimes with more risk there is more reward. But it’s important to make sure that your returns are worth the risk, and to remember that there is no such thing as a risk-free investment or portfolio.
Investors can use the efficient frontier to analyze the current performance of a portfolio and figure out which assets to adjust, potentially liquidate, or reallocate. Investors can also see if a particular asset is giving them the same reward with less risk than other assets. In this case, they might want to sell the higher risk asset and put more funds into the lower risk asset.
How Do Investors Use the Efficient Frontier Model?
Using an efficient frontier model is one method of building a portfolio made of different types of investments that have the optimal balance of risk and return. No portfolio is without risk, and investors do need to reallocate investments on occasion to continue optimizing toward their goal. But the optimal portfolio would have a balance of high-risk, high-reward investments and more stable investments that still get decent returns.
There is often an assumption that investments with greater risk provide greater returns — as noted. Although this is sometimes true, the optimal portfolio holds both high risk and low risk assets, according to the efficient frontier.
If an investor has a higher tolerance to risk, they could choose to own a higher percentage of investments on the right end of the efficient frontier graph with higher risk and higher return. If an investor is more conservative, they could choose to hold lower-risk assets.
Proponents of efficient frontier claim that more diversified portfolios tend to be closer to the efficient frontier line than less diversified portfolios, and therefore have lower levels of risk, though they’re not risk-free.
Limits and Downsides of the Efficient Frontier
The main downside of using the efficient frontier tool is that it creates a curve with a normal distribution, which doesn’t necessarily always match reality. Real investments may vary within three standard variations of the mean curve. This “tail risk” means there are limits to the conclusions you can draw from the efficient frontier graph.
Another issue is that investors don’t always make rational decisions and avoid risk. Market decisions involve many complex factors that the efficient frontier does not factor into its calculations. Instead, the efficient frontier assumes that people always avoid risk and make investing decisions rationally.
Finally, the efficient frontier assumes that the number of investors in a market has no impact on market prices, and that all investors have the same access to borrow money with risk-free interest rates.
Investors using the efficient frontier should understand its limitations and might consider using it in conjunction with other tools for analyzing an investment strategy.
The Takeaway
The efficient frontier is one of many useful methods of analyzing portfolios and creating a long-term investing plan. It involves utilizing a financial framework to build an optimized asset portfolio with aims to maximize their potential gains within their particular risk profile. It also involves visuals to help investors get a better sense of where their portfolio stands. Investors should remember that it is not a tool that will help them completely remove risk from their investment portfolio or allocation.
It’s also a relatively high-level investing concept and tool that many investors may not feel comfortable using. There are plenty of strategies and tools that can be utilized in its stead, of course, and it may be worthwhile to consult with a financial professional if investors feel they’re in over their heads.
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FAQ
What are common assumptions of the efficient frontier model?
Common assumptions of the efficient frontier model include that asset returns will follow a more or less common distribution, that investors will act rationally, and that riskier investments inherently lead to larger returns.
Can the efficient frontier be negative?
The efficient frontier model cannot be negative, as a negative figure would imply that an investor garnered losses from a given set of potential portfolios. That means that the investor was not actually investing.
What is the difference between efficient frontier and efficient portfolio?
The efficient frontier is a set of investment portfolios expected to provide the highest return for a specific risk level. Efficient portfolio, on the other hand, is a single portfolio that provides the highest return for a specific risk level.
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