Efficient frontier

By | 2019-08-29T09:41:35+00:00 13th September 2017|

The efficient frontier is the set of optimal portfolios that offers 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 also sub-optimal, because they have a higher level of risk for the defined rate of return.

Forming part of modern portfolio theory (MPT), an illustration of the efficient frontier is as follows: if very possible combination of assets that exists can be plotted on a graph, with the portfolio’s risk on the X-axis and the expected return on the Y-axis. This plot reveals the most desirable portfolios. For example, assume Portfolio A has an expected return of 6.5% and a standard deviation of 7%, and that Portfolio B has an expected return of 6.5% and a standard deviation of 9.0%. Portfolio A is more “efficient” because it has the same expected return but a lower risk. It is possible to draw an upward sloping hyperbola to connect all of the most efficient portfolios, and this is known as the efficient frontier. Investing in any portfolio not on this curve is seen as not desirable.