What is an Efficient Frontier?

What is an Efficient Frontier?

The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal because they do not provide enough return for the level of risk.

Portfolios that cluster to the right of the efficient frontier are sub-optimal because they have a higher level of risk for the defined rate of return.

The efficient frontier comprises investment portfolios that offer the highest expected return for a specific level of risk.

The standard deviation of returns in a portfolio measures investment risk and consistency in investment earnings.

Lower covariance between portfolio securities results in lower portfolio standard deviation.

How Does an Efficient Frontier Work?

It is represented by plotting the expected returns of a portfolio and the standard deviation of returns. The y-axis is made up of the expected returns of the portfolio. The x-axis is labeled as the standard deviation of returns, which is a measure of risk.

A portfolio is then plotted onto the graph according to its expected returns and standard deviation of returns. The portfolio is compared to the efficient frontier. If a portfolio is plotted on the right side of the chart, it indicates that there is a higher level of risk for the given portfolio. If it is plotted low on the graph, the portfolio offers low returns.

Assumptions of the Efficient Frontier Model

  • Investors are rational and know all the facts about the markets. This assumption implies that all the investors are vigilant enough to understand the stock movements, predict returns, and invest accordingly. That also means that this model assumes all investors are on the same page regarding knowledge of the markets.
  • All investors have a common goal: avoid the risk because they are risk-averse and maximize the return as far as possible and practicable.
  • There are not many investors who would affect the market price.
  • Investors have unlimited borrowing power.
  • Investors lend and borrow money at a risk-free interest rate.
  • The markets are efficient.
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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.

Significance of an Efficient Frontier

The efficient frontier is the foundation for modern portfolio theory, which is the idea of how investors aim to create a portfolio that maximizes expected returns based on a specific level of risk. It helps investors understand the potential risks and returns in their portfolios and analyze how they compare to the optimal set of portfolios that are considered to be efficient.

 Doing so helps investors to accordingly change their investing strategies by understanding the level of risk that pertains to each portfolio.

It should be noted that there is no single efficient frontier for everyone. Each one is different for every investor because it depends on multiple factors – such as the number of assets in the portfolio, the industry of the assets, and the degree of the investor’s risk tolerance.

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