Loading the player...

What is the 'Efficient Frontier'

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.

BREAKING DOWN 'Efficient Frontier'

Since the efficient frontier is curved, rather than linear, a key finding of the concept was the benefit of diversification. 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. The efficient frontier concept was introduced by Nobel Laureate Harry Markowitz in 1952 and is a cornerstone of modern portfolio theory.

Optimal Portfolio

One assumption in investing is that a higher degree of risk means a higher potential return. Conversely, investors who take on a low degree of risk have a low potential return. 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. The points on the plot of risk versus expected returns where optimal portfolios lie is known as the efficient frontier.

Selecting Investments

Assume a risk-seeking investor uses the efficient frontier to select investments. The investor would select securities that lie on the right end of the efficient frontier. The right end of the efficient frontier 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.

Limitations

The efficient frontier and modern portfolio theory have many assumptions that may not properly represent reality. For example, one of the assumptions is that asset returns follow a normal distribution. In reality, securities may experience returns that are more than three standard deviations away from the mean more than 0.03% of the observed values. Consequently, asset returns are said to follow a leptokurtic distribution, or heavy tailed distribution.

Additionally, Markowitz's theory assumes investors are rational and avoid risk when possible, there are not large enough investors to influence market prices, and investors have unlimited access to borrowing and lending money at the risk-free interest rate. However, the market includes irrational and risk-seeking investors, large market participants who could influence market prices, and investors do not have unlimited access to borrowing and lending money.

RELATED TERMS
  1. Homogeneous Expectations

    An assumption in Markowitz Portfolio Theory that all investors ...
  2. Modern Portfolio Theory - MPT

    A theory on how risk-averse investors can construct portfolios ...
  3. Markowitz Efficient Set

    A set of portfolios with returns that are maximized for a given ...
  4. Capital Market Line - CML

    A line used in the capital asset pricing model to illustrate ...
  5. Frontier Markets

    Less advanced capital markets from the developing world. Frontier ...
  6. Mean Return

    1. In securities analysis, it is the expected value, or mean, ...
Related Articles
  1. Investing

    The 3 Largest Frontier Markets ETFs (FM, FRN)

    Discover what frontier markets are and why you may want to invest in them, and learn about the three largest frontier market ETFs available in early 2016.
  2. Investing

    Explaining The Efficient Frontier

    Most investment choices involve a tradeoff between risk and reward. The "Efficient Frontier" is a modern portfolio theory tool that shows investors the best possible return they can expect from ...
  3. Investing

    3 Frontier Market Funds You Should Consider Investing!

    Discover what frontier markets are and and learn about three funds that are worth your while, even though they have high expense ratios.
  4. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    See why investors today still follow this old set of principles that reduce risk and increase returns through diversification.
  5. Investing

    3 Reasons to Invest in Frontier Markets in 2016

    Learn why investing in frontier markets will be a great long-term investment as these markets grow in ways that will propel them to success in the future.
  6. Insights

    Forging Frontier Markets

    Pioneering is never easy, but it has its exciting - and worthwhile - moments for investors.
  7. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in Modern portfolio theory to quantify investment risk.
  8. Investing

    Frontier Communications Trades Ex-Dividend Monday (FTR)

    Frontier will send its dividend payment on June 30 to shareholders of record as of June 15.
  9. Investing

    Find The Highest Returns With The Sharpe Ratio

    Learn how to follow the efficient frontier to increase your chances of successful investing.
  10. Investing

    3 Expensive Frontier Markets Equity ETFs Worth Your While (FM, FRN)

    Explore the contrarian opportunities in frontier markets equity ETFs, including high dividends and participation in oil and commodity price appreciation.
RELATED FAQS
  1. What are the advantages of portfolio planning with the efficient frontier?

    Learn about modern portfolio theory and the efficient frontier. Understand the advantages of portfolio planning with the ... Read Answer >>
  2. How have portfolios from within the efficient frontier performed historically?

    Explore how the efficient frontier is used in selecting investment portfolios. Find out how risks and returns are used to ... Read Answer >>
  3. Why is risk return tradeoff important in designing a portfolio?

    Learn how the risk return tradeoff is used in the construction of portfolios, and how modern portfolio theory seeks to diversify ... Read Answer >>
  4. Which of the following is the most true regarding the type of assets found along ...

    The correct answer is b. The efficient frontier is comprised mainly of portfolios that contain several imperfectly correlated ... Read Answer >>
  5. How do I calculate the production possibility frontier in Excel?

    Learn how to create production possibility frontier curves in Microsoft Excel and understand the importance of production ... Read Answer >>
  6. How is correlation used in modern portfolio theory?

    Discover how modern portfolio theory and the efficient frontier use correlation between investment assets to predict an optimal ... Read Answer >>
Hot Definitions
  1. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  2. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  3. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  4. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  5. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  6. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
Trading Center