Understanding the Efficient Frontier: Maximize Returns, Minimize Risk

What Is the Efficient Frontier?

The efficient frontier is a concept that is integral to modern portfolio theory, as developed by American economist Harry Markowitz. This frontier is the group of optimally-diversified portfolios that maximizes expected return for a given level of risk, or presents the lowest risk for a given level of expected return. The efficient frontier is graphically represented as a curved line with risk on the x-axis and expected return on the y-axis. Whether or not a portfolio is optimal or sub-optimal depends on where it appears in relation to the line.

Explaining Efficient Frontier in Modern Portfolio Theory

The efficient frontier theory was introduced by Nobel Laureate Harry Markowitz in 1952 and is a cornerstone of modern portfolio theory (MPT). The efficient frontier rates portfolios (investments) on a scale of return (y-axis) versus risk (x-axis). The compound annual growth rate (CAGR) of an investment is commonly used as the return component while standard deviation (annualized) depicts the risk metric.

The efficient frontier graphically represents portfolios that maximize returns for the risk assumed. Returns are dependent on the investment combinations that make up the portfolio. A security's standard deviation is synonymous with risk. Ideally, an investor seeks to fill a portfolio with securities offering exceptional returns but with a combined standard deviation that is lower than the standard deviations of the individual securities.

The less synchronized the securities (lower covariance), the lower the standard deviation. If this mix of optimizing the return versus risk paradigm is successful, then that portfolio should line up along the efficient frontier line.

A key finding of the concept was the benefit of diversification resulting from the curvature of the efficient frontier. The curvature is integral in revealing how diversification improves the portfolio's risk/reward profile. It also reveals that there is a diminishing marginal return to risk.

Limitations and Critiques of Efficient Frontier Theory

The efficient frontier and modern portfolio theory involve assumptions that might not reflect reality. For instance, they assume asset returns follow a normal distribution.

In reality, securities can have returns, or tail risk, that are over three standard deviations away from the mean. Consequently, asset returns are said to follow a leptokurtic distribution or heavy-tailed distribution.

Also, Markowitz assumes that investors are rational, can't affect market prices, and have access to unlimited borrowing and lending at a risk-free rate of return.

But in reality, markets have irrational, risk-seeking investors, big players who might affect prices, and investors without unlimited borrowing and lending access.

Important Factors When Using the Efficient Frontier

In investing, higher risk is assumed to bring higher returns. Conversely, lower risk means lower returns. According to Markowitz's theory, there is an optimal portfolio that could be designed with a perfect balance between risk and return.

The optimal portfolio does not simply include securities with the highest potential returns or low-risk securities. The optimal portfolio aims to balance securities with the greatest potential returns with an acceptable degree of risk or securities with the lowest degree of risk for a given level of potential return. Optimal portfolios form the efficient frontier on a plot of points of risk versus expected returns.

A risk-seeking investor would choose securities on the right end of the efficient frontier. The right end includes securities that are expected to have a high degree of risk coupled with high potential returns, which is suitable for highly risk-tolerant investors. Conversely, securities that lie on the left end of the efficient frontier would be suitable for risk-averse investors.

The Bottom Line

The efficient frontier, a concept developed by economist Harry Markowitz, demonstrates the importance of appropriate portfolio diversification with its graphic representation of balanced risk and return in investment portfolios. That is, portfolios on the efficient frontier provide optimal returns for specific risk levels. Risk-seeking investors might target portfolios on the right side of the frontier for higher potential returns, while risk-averse investors might focus on the left side for lower risk. The efficient frontier isn't without critics, so it's important to understand its assumptions and limitations, including its potential for deviation from real market conditions.