What Is an Inefficient Portfolio?

An inefficient portfolio is one that delivers an expected return that is too low for the amount of risk taken on. Conversely, an inefficient portfolio also refers to one that requires too much risk for a given expected return. In general, an inefficient portfolio has a poor risk-to-reward ratio.

Key Takeaways

  • An inefficient portfolio is one that delivers an expected return that is too low for the amount of risk taken on.
  • In general, an inefficient portfolio has a poor risk-to-reward ratio; it exposes an investor to a higher degree of risk than necessary to achieve a target return.
  • In an efficient portfolio, investable assets are combined in a way that produces the best possible expected level of return for their level of risk—or the lowest risk for a target return.

Understanding an Inefficient Portfolio

An inefficient portfolio exposes an investor to a higher degree of risk than necessary to achieve a target return. For example, a portfolio of high-yield bonds expected to provide only the risk-free rate of return would be said to be inefficient. An investor could achieve the same return by purchasing Treasury bills, which are considered among the safest investments in the world (rather than high-yield bonds, which are, by definition, rated as risky investments).

Efficient Portfolios vs. Inefficient Portfolios

In an efficient portfolio, investable assets are combined in a way that produces the best possible expected level of return for their level of risk—or the lowest risk for a target return. The line that connects all these efficient portfolios is known as the efficient frontier. The efficient frontier represents those portfolios that have the maximum rate of return for every given level of risk. The last thing investors want is a portfolio with a low expected return and a high level of risk.

No point on the efficient frontier is any better than any other point. Investors must examine their own risk-return preferences to determine where they should invest in the efficient frontier. This concept was first formulated by Harry Markowitz in 1952. In his paper "Portfolio Selection," which was published in the Journal of Finance in 1952. Markowitz pioneered the concept of the modern portfolio theory (MPT). According to MPT, an investment's risk and return characteristics should not be viewed alone. Instead, they should be evaluated by how the investment affects the overall portfolio's risk and return.

MPT assumes that investors are risk-averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns; an investor who wants higher expected returns must accept more risk. The assumption is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-expected return profile.

Practically, MPT can be used to construct a portfolio that minimizes risk for a given level of expected return; it is very useful for investors trying to construct efficient portfolios using exchange-traded funds (ETFs). Efficient portfolios utilize modern portfolio theory. According to the theory, you can limit the volatility of your portfolio by spreading your risk among different types of investments. Using this idea, a portfolio of risky stocks could, on the whole, have less risk than a portfolio that holds only one concentrated position, even if it is a relatively safe holding.