Efficient Frontier
Candlefocus EditorThe efficient frontier is based on an investment selection approach which seeks to maximize returns based on the amount of risk involved. An efficient frontier portfolio usually contains either a mix of higher risk assets such as stocks, bonds, and alternatives, or a mix of lower risk assets such as cash and money market securities. In either case, the objective is to generate the highest return per unit of risk (standard deviation).
The efficient frontier is used as a tool to examine different asset allocations in an attempt to maximize the expected return per unit of risk. This involves exploring various combinations of asset classes and their associated risks, in order to determine the ideal portfolio. The idea behind the efficient frontier is to identify combinations of assets that offer the highest returns at the lowest levels of risk.
The efficient frontier progressions illustrate the risk-return tradeoffs associated with selecting portfolios containing different assets and weightings. As an example, greater information can be derived from a proactive decision to allocate both to high risk securities and an element of diversification. This diversification can be achieved through the selection of lower risk securities such as high-grade bonds.
Diversification reduces portfolio risk only when the assets selected are not perfectly correlated. This means that the performance of asset classes that are partially positively correlated should not move in the same direction to the same degree. As a result, diversification reduces the portfolio risk associated with investments of varying asset classes. This is why portfolios identifiably linked to the efficient frontier are likely to exhibit higher-level diversification than portfolios not identified on the efficient frontier.
Overall, the efficient frontier provides investors with a powerful tool to optimize their portfolio performance that balances risk and return. It allows investors to examine different asset allocation strategies and to identify the best combination of returns and risk that suits their particular risk tolerance and investment objectives. As such, it plays a valuable role in helping investors to create a balanced, well-diversified portfolio that is tailored to their individual circumstances.