Investing > Efficient Frontier Explained

Efficient Frontier Explained

Efficient portfolios offer an optimal ratio of risk and reward — and the efficient frontier is the easiest way to find them.

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Updated March 18, 2022

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Are you looking for an investing strategy that doesn’t lose money?

The question is a complete no-brainer—who wouldn’t be looking for such a strategy, right?

Luckily for us, not losing money also happens to be possible—thanks to Nobel-prize-winning economist Harry Markowitz and his work on modern portfolio theory and the efficient frontier. ✅

MPT and the efficient frontier can teach you how to diversify in a way that will reduce risks while still retaining optimal returns. However, you’re gonna have to roll up our sleeves a little here—this stuff gets pretty technical.

You always have to expose yourself to some risk, and most investors are blissfully unaware of just how volatile equity markets are. By taking the time to learn about these concepts, you’ll be able to take more control over the way your investments will perform—and by doing so, you can gain an advantage over the competition.

MPT and the concept of the efficient frontier are hugely influential—not only do they form the basis for the investment strategies of financial institutions worldwide, but they’ve also had a profound impact on economic theory overall. However, we’re not talking about silver bullets here—both of these concepts have their shortcomings and detractors.

And although they may not offer you a straightforward blueprint to success, MPT and the efficient frontier are a part of that equation. There’s no getting around it—this stuff is required reading and we’ll do our best to make it as interesting and easy to understand as possible.

What you’ll learn
  • What is the Efficient Frontier?
  • Logic Behind Efficient Frontier
  • Efficient Frontier Example
  • Pros and Cons of Efficient Frontier
  • What is the “Optimal Portfolio”?
  • Conclusion
  • Efficient Frontier: FAQs
  • Get Started with a Stock Broker

What is the Efficient Frontier? 🔎

The efficient frontier is a term that was introduced by Harry Markowitz, a renowned economist and professor at the University of California, in his 1952 paper published in the Journal of Finance, titled “Portfolio Selection”. 

Markowitz’s influential paper served as a cornerstone of modern portfolio theory, and in 1990, he was awarded the Nobel prize in economics for his contributions to the field. The efficient frontier is a key term within modern portfolio theory. To fully explain it, we have to take a step back and explain MPT.

Modern portfolio theory claims that an investor can come up with a portfolio that provides the greatest amount of returns for any given amount of risk. Such a portfolio is optimal because all others either have lower returns for the same amount of risk or come with a higher risk for the same amount of returns.

So, what is the efficient frontier? The efficient frontier is a line that represents a set of optimal portfolios. Because MPT is a mathematical model, you’ll find that line on a graph that consists of an x-axis and y-axis, with the x-axis representing risk or beta (in the form of annualized standard deviation) and the y-axis representing return (in the form of compound annual growth rate).

MPT is an investment strategy that uses the efficient frontier to determine whether or not an investor is taking on undue risk. If a portfolio lies on the efficient frontier, it is optimal—meaning that it is also properly diversified. 

Hopefully, all of this sounds simple so far—it’s about to get a bit more technical. However, as you can see, the basic premises of MPT and the efficient frontier are simple: If you’re diversified enough, your portfolio will always grow at a predictable average rate compared to the markets at large.

The Logic Behind Efficient Frontier 💭

Every portfolio is a mix of different assets divided across asset classes—stocks, bonds, ETFs, and potentially more. Each asset that you purchase comes with a certain level of risk, as well as a certain expected return.

So, you construct a couple of portfolios, compare them through the lens of risk and return, and that’s it, right? Nope, not quite.

This is where correlations come in. Based on historical data, we know that certain asset classes are either negatively or positively correlated—meaning that when one goes up, the other goes down, or alternatively, when one goes up, the other goes up as well. We’re looking for negative correlations—asset classes that move in opposite directions.

Modern Portfolio Theory
How asset allocation influences the expected risk and return of a portfolio.

By constructing a portfolio with correlations in mind, an investor can diversify in a way that reduces unsystematic risk—the risk that is specific to any single asset on its own. The result is a portfolio that is less risky than the sum of its parts—if a few of your assets suffer losses, the others that are correlated with them will pick up the pace, and you’ve successfully hedged your bets.

Correlations are a key ingredient of MPT and the efficient frontier—without making use of correlations, you can’t find the portfolio that offers the best ratio of return to risk. The efficient frontier allows us to construct portfolios that are much less risky but can still offer average stock market returns, or portfolios that shoot for even higher returns but don’t come with undue risks.

Efficient Frontier Example 👇

Let’s use a hypothetical example in order to bring this stuff a little closer to home and down to earth.

First of all, we need to construct a portfolio. The most logical place to start is with your goals or risk tolerance—either what returns you’re aiming for or how much risk you’re willing to take on. We proceed with good old investing axioms, such as the fact that stocks are risky and offer higher returns, while bonds are less risky and offer lower returns.

We construct a series of portfolios, keeping correlations in mind, and look at how risky and profitable each of them is. We pick the portfolio that offers us the best ratio of risk to return and put it on a graph, like the one below.

efficient frontier graph
Two portfolios — designated as ‘A’ and ‘B’ — on the efficient frontier.

Let’s call that particular portfolio “Portfolio A”. But that’s just a single dot on a graph—we don’t have an efficient frontier yet.

Now we need to construct a different portfolio—one that is aiming for higher returns. We go through the same process again, construct a couple of portfolios, compare them, and select the best one. As “Portfolio B” offers higher returns, it is riskier – meaning that it is slightly up and to the right on our graph.

If we repeat the process again, we’re eventually going to have a set of optimal portfolios—and once we connect them on the graph, we have an efficient frontier.

However, you won’t necessarily have to do a lot of manual calculations to make use of the benefits of MPT and the efficient frontier. A lot of the thought that went into these two concepts is applied effortlessly by using a reputable robo-advisor, for example, as their asset allocation algorithms are based on the same premises.

Benefits and Drawbacks of Efficient Frontier ⚖️

Pros

  • Easy to apply
  • Leads to proper diversification
  • A good framework for risk management
  • Doesn’t rely on timing the market

Cons

  • Assumes that correlations are fixed
  • Assumes market participants are rational
  • Ignores the possibility of market manipulation
  • Not all investors are risk-averse

The efficient frontier is an incredibly useful tool—it allows investors to get a simple, straightforward look at whether or not they’re properly diversified, and whether or not they’re taking on undue risk. It gives us an answer to a very simple yet important question: Am I investing in a way that maximizes returns for the level of risk that I am exposing myself to?

However, the efficient frontier isn’t a perfect tool—and much of that has to do with the shortcomings of the modern portfolio theory as a whole. MPT, useful as it is, is based on a couple of assumptions—and some of them are quite hard to defend, looking at recent years.

Like plenty of economic theories, MPT relies on the expectation that investors are completely rational at all times, and have access to the same information. On top of that, MPT also assumes that all investors are risk-averse, that the market is immune to manipulation by individual investors.

MPT also assumes that all market participants have equal access to money at risk-free interest rates—something that even the most recent news regarding interest rate changes proves false.

However, there is one area where MPT drops the ball slightly that has far less to do with how investors act. A cornerstone of MPT is that asset classes are correlated—some move in the same direction, and others move in opposite directions. 

However, research has shown that stock market crashes cause all asset classes to act as if they were positively correlated—they move in the same direction. This, in turn, means that when things go south, the benefits of properly diversifying are nowhere to be found, just when you need them the most. In response to these shortcomings, postmodern portfolio theory was developed – and you should definitely look into it as well.

What is the “Optimal Portfolio”? 🗂

As we’ve mentioned before, an optimal portfolio is one that is located on the efficient frontier—it offers the best possible returns for any given amount of risk. Put another way, a portfolio is optimal if there is no way to get better returns for the level of risk that you’re taking on.

The most important distinction that needs to be made is that there is no one single optimal portfolio—a portfolio being optimal simply means that it offers the best possible balance of risk and return. Every portfolio that is on the efficient frontier is optimal.

However, keep in mind that an optimal portfolio isn’t automatically the most profitable one. The primary goal of portfolio diversification isn’t to net you greater returns—it is to reduce risks. On top of that, the logic behind MPT is rooted in historical data—but the information that we can glean from reading a stock chart isn’t an indication of what will happen in the future.

In fact, plenty of experienced investors are critical of MPT, and many have had successful careers in investing without ever constructing an optimal portfolio. The best example of this is Warren Buffet, who has previously referred to diversification as protection against ignorance.

The term optimal portfolio doesn’t imply that there’s no way to construct a better portfolio—it simply means that the portfolio in question has the best possible proportion of risk and reward. Due diligence, fundamental analysis, and carefully picking your investments can provide the same, if not even better results, as using MPT and the efficient frontier.

Conclusion 🏁

If you’ve made it to the end of this guide, you have our thanks and our respect. The topic of the efficient frontier is a bit cerebral, technical, and abstract—and although it isn’t a page-turner, it is nevertheless an important bit of knowledge that will serve you well going forward.

While it requires a lot of other knowledge to utilize successfully, modern portfolio theory is an important part of economic thought—and for all its advantages and drawbacks, it’s an important piece of the puzzle.

You’ve just absorbed that important piece of that puzzle. The finer points of serious economic topics are hard to grasp, we know, but after a certain time, that knowledge will coalesce into a serious advantage over the competition. By taking an interest in MPT and the efficient frontier, you’ve made a great first step, but don’t stop there—and we’ll be here to help guide you along that journey going forward.

Efficient Frontier: FAQs

  • Is the Efficient Frontier Useful?

    Yes—the efficient frontier is useful in establishing whether or not your portfolio is properly diversified across asset classes, and whether or not you are exposing yourself to unnecessary risk. 

    The efficient frontier isn’t gospel, however—and it shouldn’t be the only lens through which you assess your portfolio and overall risk.

  • Why is the Efficient Frontier Curved?

    The efficient frontier is curved because of the diminishing marginal returns of risk. In other words, the more risk you add, the smaller your returns are.

  • Why is My Efficient Frontier a Straight Line?

    If your efficient frontier is a straight line, you’ve constructed a portfolio that is completely risk-free. This is highly unlikely, and even if it is true, the returns for such a portfolio would be miniscule- if your frontier is a straight line, you need to go back to the drawing board.

  • Can the Efficient Frontier Be Negative?

    No, the efficient frontier cannot be negative. If it were, you would accrue losses from each investment—meaning that you wouldn’t actually be investing at all.

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