The efficient frontier is a financial framework that investors can use to build an optimized asset portfolio that gives 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’s visualized as a curved line on a graph according to an individual’s goals and risk tolerance.
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.
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.
The concept is a key facet of modern portfolio theory, 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’s more risky, then it isn’t as well balanced as it could be. It’s also possible for a portfolio to provide returns that are greater than the frontier. As long as a portfolio’s returns justify the risk, then the portfolio is well-allocated.
To use this framework, it’s important to not only know the definition of the efficient frontier, but to also understand its benefits and limitations for investors.
How Does the Efficient Frontier Work?
Each investor has a different risk tolerance and their own goals for portfolio growth, so every investor has a different frontier. By adjusting their graph, 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.
To use the efficient portfolio frontier, an investor would create a graph where 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.
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 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.
Investors can use the efficient frontier to analyze the current performance of a portfolio and figure out which assets to adjust 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. 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.
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. Now that you know how to use them, you can apply them to your investments.
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