Loading the player...

What is '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'

A key finding of the concept was the benefit of diversification resulting from the curvature of the efficient frontier. 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 are 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 in 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 posits several assumptions in his theory, such as investors are rational and avoid risk when possible; there are not enough investors to influence market prices; and investors have unlimited access to borrowing and lending money at the risk-free interest rate. However, reality proves that the market includes irrational and risk-seeking investors, there are large market participants who could influence market prices, and there are investors who do not have unlimited access to borrowing and lending money.

RELATED TERMS
  1. Frontier Markets

    Frontier markets are less advanced capital markets in the developing ...
  2. Homogeneous Expectations

    Homogenous expectations is an assumption in Portfolio Theory ...
  3. Markowitz Efficient Set

    The Markowitz efficient set is a portfolio with returns that ...
  4. Risk Curve

    The risk curve is a two-dimensional display creating a visualization ...
  5. Delivered At Frontier - DAF

    In international trade, a contract specification requiring the ...
  6. Mean Return

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

    What Are Frontier Markets?

    Frontier markets refer to equity markets in small nations that are at an earlier stage of economic and political development than larger and more mature emerging markets. These markets typically ...
  2. 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.
  3. Investing

    3 Reasons Frontier Communications Stock Could Rise (FTR, VZ)

    Activity in the telecom arena has been fast and furious in recent years, as companies jockey for position between the high-growth and traditional areas of the business. For rural telecom Frontier ...
  4. 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.
  5. Investing

    3 Key Numbers for Frontier Communications (FTR)

    Telecom has been a haven for investors lately, and rural telecom pioneer Frontier Communications (NASDAQ: FTR) has tried to turn the trash of other major telecoms into treasure. Yet even as ...
  6. 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 ...
  7. Investing

    Analyst: Frontier Dividends Not Sustainable (FTR)

    Frontier Communications may be forced to reduce its dividend payout in 2018, says a Citi Research analyst.
  8. 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.
  9. Investing

    Frontier Lays Off 250 After Verizon Deal (FTR, VZ)

    Frontier Communications is laying off 250 midlevel managers to realize synergies after buying Verizon's wireline assets this spring.
RELATED FAQS
  1. 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 >>
  2. How do investment advisors calculate how much diversification their portfolios need?

    Learn how modern portfolio theory (MPT) can help determine a diversified mix of assets for inclusion in a portfolio that ... Read Answer >>
  3. What are the differences between weak, strong and semi-strong versions of the Efficient ...

    Discover how the efficient market theory is broken down into three versions, the hallmarks of each and the anomalies that ... Read Answer >>
  4. What are the most effective hedging strategies to reduce market risk?

    Learn about different hedging strategies to reduce portfolio volatility and risk, including diversification, index options ... Read Answer >>
  5. How can I calculate the expected return of my portfolio?

    Understand the components of the equation used to calculate the expected return of an investor's portfolio. Learn why the ... Read Answer >>
Hot Definitions
  1. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  2. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  3. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  6. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
Trading Center