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Topic: What Do You Understand by Efficient Frontier (With Diagram) ? Introduction

The efficient frontier is a set of optimal portfolios that maximize expected return for a given level of risk or minimize risk for a given level of expected return. Portfolios on the efficient frontier offer the highest possible returns for their level of risk. Harry Markowitz developed modern portfolio theory and the concept of the efficient frontier in 1952. The efficient frontier shows the relationship between risk and return and allows investors to select portfolios based on their risk tolerance. However, it relies on assumptions that are not always realistic in practice.

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deepti sharma
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232 views

Topic: What Do You Understand by Efficient Frontier (With Diagram) ? Introduction

The efficient frontier is a set of optimal portfolios that maximize expected return for a given level of risk or minimize risk for a given level of expected return. Portfolios on the efficient frontier offer the highest possible returns for their level of risk. Harry Markowitz developed modern portfolio theory and the concept of the efficient frontier in 1952. The efficient frontier shows the relationship between risk and return and allows investors to select portfolios based on their risk tolerance. However, it relies on assumptions that are not always realistic in practice.

Uploaded by

deepti sharma
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Topic: what do you understand by efficient frontier (with diagram)?

Introduction:-
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.

In 1952, Harry Markowitz published a formal portfolio selection model in The Journal of Finance. He
continued to develop and publish research on the subject over the next twenty years, eventually winning
the 1990 Nobel Prize in Economics for his work on the efficient frontier and other contributions to modern
portfolio theory.

According to Markowitz, for every point on the efficient frontier, there is at least one portfolio that can be
constructed from all available investments that has the expected risk and return corresponding to that
point.

The relationship securities have with each other is an important part of the efficient frontier. Some
securities' prices move in the same direction under similar circumstances, while others move in opposite
directions. The more out of sync the securities in the portfolio are (that is, the lower their covariance), the
smaller the risk (standard deviation) of the portfolio that combines them. The efficient frontier is curved
because there is a diminishing marginal return to risk. Each unit of risk added to a portfolio gains a smaller
and smaller amount of return.
Optimum Portfolio:-
According to Markowitz’s theory, an optimal portfolio would offer a perfect balance between risk and
return. It wouldn’t contain too many high-risk investments that can yield high returns. Nor would it be as
conservative as a low-risk portfolio with low returns.

The optimal portfolio contains securities with the greatest potential returns with an acceptable degree of
risk. It also features securities with the lowest degree of risk for a certain level of return. Optimal returns
tend to lie along the efficient frontier.

Thus, a risk-ready investor could choose securities right end of the efficient frontier. Those would likely
have a high degree of risk coupled with high potential returns. Meanwhile, securities on the left end of the
efficient frontier would be suitable for more cautious investors.

Benefits:-
Of course, every investor wants a portfolio that minimizes risk while maximizing rewards or returns. It’s
nearly impossible to build a portfolio entirely devoid of risk, due in part to the stock market’s inherent risk.
However, potential returns can balance a portfolio or an investment’s risk. That’s why the efficient frontier
is important.

This tool helps investors get the most for their investment by analysing the risk and returns associated with
an investment portfolio and helping the investor adjust their asset allocation or individual investments
accordingly.

It can also be helpful in determining if an investor should pull their funds from an investment with a certain
amount of risk and return for a similar investment with less risk and the same return.

Limitations:-
The efficient frontier relies on assumptions that aren’t always realistic. It assumes that asset returns follow
a normal distribution. In reality, returns can also vary within three degrees of standard deviation. A so-
called heavy tail can prove challenging for investors.

Additionally, Markowitz assumes investors are rational and typically avoid risk. He also believes the
number of investors can’t influence market prices. Also, he seems to think that investors all have the same
access to borrowing and can get money at a risk-free interest rate. In truth, the market features the
opposite of every scenario listed above.

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