Efficient Frontier

Efficient Frontier

The Efficient Frontier is a concept in modern portfolio theory that represents the set of optimal portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given level of expected return. Portfolios on the Efficient Frontier are considered to be “efficient” because they maximize Returns while minimizing risk.

Typically, the Efficient Frontier is visualized in a two-dimensional graph where the x-axis represents risk (standard deviation) and the y-axis represents expected return. Portfolios below the Efficient Frontier are sub-optimal, as they do not provide enough return for the level of risk taken.

Example

Consider two portfolios: Portfolio A has an expected return of 8% with a risk of 10%, and Portfolio B has an expected return of 6% with a risk of 5%. Portfolio A is on the Efficient Frontier, while Portfolio B is not, because it offers lower Returns for its level of risk.

Cases

1. Investment in Stocks and Bonds: A mixed portfolio of 70% Stocks and 30% Bonds may fall on the Efficient Frontier, providing better risk-adjusted Returns compared to a portfolio that is 100% Bonds.

2. Sector Diversification: An investor diversifying across technology, healthcare, and consumer goods may construct a portfolio that achieves a higher return for the same level of risk, placing it on the Efficient Frontier.