Efficient Frontier (Investment) - Explained
What is Efficient Frontier?
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Table of ContentsWhat is the Efficient Frontier?How Does the Efficient Frontier Work?Optimal PortfolioSelecting InvestmentsLimitations
What is the Efficient Frontier?
The efficient frontier is a combination of the most favorable portfolios that offer returns at a high rate and have the lowest risk. It is a set of optimal portfolios that maintain efficient positions in terms of expected return and level of risks. The efficient frontier offers the maximum expected return and the minimum level of risk attributable to the return. Portfolios that do not perform to the level of the efficient frontier or portfolios that provide higher risks than the return they provide are regarded as sub-optimal portfolios. Sub-optimal portfolios offer higher risks that the rate or return they offer.
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How Does the Efficient Frontier Work?
Harry Markowitz introduced the efficient frontier theory in 1952. Generally, efficient frontier refer to a set of portfolios that offer benefits that no other portfolios or investments in the market offer. Although, they have the same standard deviation attributable to other returns, they offer expected returns that are higher than the others. The returns offered by efficient frontier are based on the nature of investments that make up the optimal portfolio. In order to maximise the highest level of returns for a defined level of risks, investors select securities that offer exceptionally high returns and low risks to make up the portfolio in the efficient frontier. Using the efficient frontier theory, investments are highly diversified, that is there is a mix of investments that offer the highest returns and those that offer the lowest risks in the portfolio. hence, diversification is an attribute of optimal portfolios that use the efficient frontier principle. Here are some important things you should know about efficient frontier;
- Investment portfolios and securities that offer the maximum expected return for a clearly defined level of risk make up the efficient frontier.
- The nature of investments that make up the optima porfilio determine the returns and risks of the investment.
- An investment portfolio is placed at the efficient frontier line based on the return and the risk.
- The compound annual growth rate (CAGR) is the metric for measuring investment return while the standard deviation is the metric that measures the risk of the investment.
- Diversification is an attribute of optimal portfolios that make up the efficient frontier.
In the investment market, there is always a belief or an assumption that the higher the benefit of an investment, the higher the risk that it entails. Also, the lower the risk, the lower the return. However, Harry Markowitz developed a theory that creates a balance between risk and return and that is the efficient frontier theory. The efficient theory uses a set of optimal portfolios in creating a balance between the expected returns of investment and their defined level of risk. This set of optimal portfolio offer the highest rate of return for a defined level of risk, aloco, they offer the lowest level of risk for a maximum potential return.
It is important to know that the types of investments that an investor selected in a portfolio will determine whether the portfolio will be an efficient frontier. Basically, securities that have a high level of risk as well as high expected returns occupy the right end of the efficient frontier. Also, on the left side of the efficient frontier are securities or investment instruments that have low risks as well as low potential returns. Investors that have risk-tolerance those that are interested in using the efficient frontier theory, usually, select from the right side of the efficient frontier. For investors that want to avert investment risks, selecting from the left side of the efficient frontier is the best choice.
There are many setbacks or limitations on the efficient frontier theory. One of the limitations of this theory is that it is best as a theory and not in practice. The fact that investments making up the optimal portfolio in the efficient frontier are selected based on the assumption that returns on assets usually follow normal distribution is another limitation of this theory. In reality, returns on assets are said to follow a heavy-tailed distribution and not the normal distribution. Aside from the above limitations, some underlying assumptions in the efficient theory such as the rationality of investors and their tendency to avoid risk is debatable. This is because the market generally witness irrational investors and risk-daring investors who can influence certain decisions in the market.