Understanding the Efficient Frontier of Investing.

What is 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.
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Understanding Efficient Frontier

The efficient frontier rates portfolios (investments) on a scale of return (y-axis) versus risk (x-axis). 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 theory was introduced by Nobel Laureate Harry Markowitz in 1952 and is a cornerstone of modern portfolio theory (MPT).

 

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. The standard deviation of a security is synonymous with risk. Ideally, an investor seeks to populate the portfolio with securities offering exceptional returns but whose combined standard deviation is lower than the standard deviations of the individual securities. The less synchronized the securities (lower covariance) then 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. The relationship is not linear. In other words, adding more risk to a portfolio does not gain an equal amount of return. Optimal portfolios that comprise the efficient frontier tend to have a higher degree of diversification than the sub-optimal ones, which are typically less diversified.