Efficient frontier

The efficient frontier describes the relationship between the return that can be expected from a portfolio and the riskiness (volatility) of the portfolio. It can be drawn as a curve on a graph of risk against expected return of a portfolio. The efficient frontier gives the best return that can be expected for a given level of risk or the lowest level of risk needed to achieve a given expected rate of return.

The efficient frontier is a key concept of modern portfolio theory. Things get rather more interesting in post-modern portfolio theory which has an infinite number of efficient frontiers: the frontier for each investor depends on their risk appetite and preferences.

The efficient frontier is usually used to describe the curve that is drawn in the absence of a risk free asset. With a risk free asset available it becomes a straight line: the securities market line.

The market portfolio lies in the efficient frontier, at the point at which it touches the securities market line.

The efficient frontier is extremely important to the theory of portfolio construction and valuation.

The concept of an efficient frontier can be used to illustrate the benefits of diversification. An undiversified portfolio can be moved closer to the efficient frontier by diversifying it. Diversification can, therefore, increase returns without increasing risk, or reduce risk without reducing expected returns.

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