What Is Efficient Frontier?
The efficient frontier represents the best investment portfolios with the highest expected market return for a set level of risk. Conversely, it can also be defined as the lowest risk for a specific level of return.
Harry Markowitz: Efficient Frontier Father
Introduced by Nobel Prize winner Harry Markowitz, the efficient frontier theory is considered to be the cornerstone of modern portfolio theory.
According to Markowitz, for every point on the efficient frontier, there is at least one portfolio that can be constructed from all available investments (with the expected risk and return corresponding to that point).
Efficient Frontier Example
Graphically, the efficient frontier compares investments on a scale of risk (x-axis) and return (y-axis). The graph below shows investors how a portfolio's expected returns vary with the amount of risk taken.
The relationship securities have with one other is an important part of the efficient frontier. For example, when some securities' prices move in the same direction under similar circumstances, others move in opposite directions.
The more out of sync the securities in the portfolio are (i.e., the lower their covariance), the smaller the risk (e.g. standard deviation) of that portfolio.
What Does the Efficient Frontier Curve Mean?
The efficient frontier is curved because there is a diminishing marginal return to risk. Each unit of risk added to a portfolio gains a smaller and smaller amount of return.
This curved line also reveals that adding more risk to an investment doesn’t necessarily result in an equal amount of return.
How Many Portfolios Are on an Efficient Frontier?
There isn’t a single efficient frontier because portfolio managers and investors can edit the number and characteristics of the securities in the investing universe to conform to their specific needs.
For example, a client may require that their portfolio has a minimum dividend yield. Another may rule out investments in ethically/politically undesirable industries so the remaining securities would be included in their efficient frontier calculations.
What’s The Importance of Efficient Frontier?
One of the largest contributions of efficient frontier was its clear demonstration of the power of diversification. Markowitz's theory relies on the claim that investors tend to choose – either on purpose or inadvertently – portfolios that generate the largest possible returns with the least amount of risk.
How to Take Advantage of the Efficient Frontier
Whether you’re a beginner to the investing world or an experienced investing veteran, using the power of the efficient frontier to your advantage is a great way to invest.
For more conservative investment approaches, a portfolio that lies on the left side of our graph should provide investments with lower risk and lower returns. Risk seekers may want to choose a portfolio on the right end of the above graph (which should provide both securities with higher risk yet higher returns).