NEWSLETTER
Understanding
the efficient frontier
High expected reward
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For every level of risk, there is some
optimum combination of investments that
will give you the highest rate of return.
The combinations of investments exhibiting
this optimal risk/reward trade-off form the
efficient frontier line.
High risk
The efficient frontier is an integral part of investment portfolio theory and aims to
find the optimal portfolio structure for investors based on different risk tolerances.
This fact sheet outlines some of the key principles about the efficient frontier,
explaining what it means and how it is used in investment planning.
Your financial adviser can further explain how the efficient frontier relates to your
individual investment portfolio.
FUNDamentals
DISCOVERY INVEST
Harry Markowitz is an American economist born
24 August 1927. He is a recipient of the John von
Neumann Theory Prize and the Nobel Memorial Prize
in Economic Sciences. Markowitz is a professor of
finance at the Rady School of Management at the
University of California, San Diego. He is best known
for his pioneering work in Modern Portfolio Theory,
studying the effects of asset risk, return, correlation and
diversification on probable investment portfolio returns.
What the efficient frontier measures
The efficient frontier is a concept within modern portfolio
theory, conceived by Harry Markowitz, a US economist,
in 1952. The underlying notion of the efficient frontier
is that investment decisions are driven not only by
selecting the investment with the greatest return, but
the investment that achieves that level of return with the
least amount of risk or volatility.
Risk is an inherent part of higher reward. The efficient
frontier theory assumes that given the choice of two
portfolios with equal returns, investors will choose the
one with the least risk. If investors take on additional risk,
they will expect to be compensated with additional return.
Moreover, different assets experience different levels of
risk. To diversify one’s portfolio, investors will combine
different assets, such as equities, bonds, property, cash and
other, in different measures, to form a diversified portfolio
of assets that provide the maximum investment return
based on one’s risk tolerance.
There are endless possible permutations of investments
using the various asset classes that can be incorporated
into an investment portfolio allocation. The efficient
frontier represents the series of “optimal” portfolios
derived from the range of combinations available. It
ranges from the asset mix which is the least volatile, or
demonstrates the least risk, and subsequently provides the
lowest returns, to the asset mix which is the most volatile
or risky and has the potential for the highest returns.
There are many portfolio permutations, theoretically an
unlimited number of asset class combinations, which
are not an “optimal” portfolio mix based on the risk and
return criteria, and therefore not as desirable. These
portfolios will not lie along the efficient frontier. Instead
they will lie below the frontier on the graph.
Portfolios situated along the efficient frontier
Higher
expected
returns
Each dot
represents a
portfolio with a
mix of assets. The
dots or portfolios
closest to the
efficient frontier
are expected to
show the best
return based on
the relative risk.
The line represents the efficient
frontier - the optimal combination
of asset risk and return.
Expected return of asset mix
The efficient frontier uses two measures
– expected return of a portfolio of assets
and the associated risk or volatility of the
specific portfolio. Portfolios situated along
the efficient frontier line represent the most
“optimal” portfolio and mix of assets based
on the expected return of the portfolio for
investors when compared to the level of risk
the investor will assume.
Lower
expected
returns
Lower
risk
Risk/Volatility of asset mix
Higher
risk
FUNDamentals
DISCOVERY INVEST
A portfolio diverting from the efficient frontier line
As the portfolio
moves further
away from the
efficient frontier,
the ratio of
return to risk is
less desirable.
Higher
expected
returns
Expected return of asset mix
Portfolios situated further from the efficient
frontier line are less “optimal” portfolios and
combinations of assets. The expected return
for investors is less when compared to the
relative risk of the portfolio of assets.
Lower
expected
returns
Lower
risk
Risk/Volatility of asset mix
Higher
risk
A portfolio diverting further from the efficient frontier line
Higher
expected
returns
For example,
this portfolio
has a relatively
high level
of risk, for a
relatively small
return.
Expected return of asset mix
As portfolios move further away from the efficient
frontier, their risk and return characteristics
change, leading to high risk for portfolios with low
expected investment returns.
Lower
expected
returns
Lower
risk
Risk/Volatility of asset mix
Higher
risk
Comparing the position of two portfolios
Higher
expected
returns
Lower
expected
returns
When comparing the
risk characteristics
of Portfolio B to the
characteristics of
a portfolio with a
similar risk profile
(Portfolio A), one
sees that the higher
expected return
of Portfolio B
demonstrates a more
optimal mix of assets
than in Portfolio A.
Portfolio
B A
Expected return of asset mix
The efficient frontier helps one determine
whether a portfolio mix is “optimal” in terms of
the expected return when compared to the level
of risk expected for the portfolio of assets.
Portfolio
A B
Lower
risk
Risk/Volatility of asset mix
Higher
risk
FUNDamentals
DISCOVERY INVEST
Asset classes along the efficient frontier line
In addition to using the efficient frontier to plot combinations of portfolios that provide the optimum risk and return
characteristics, broadly speaking, one can also use the efficient frontier to plot asset classes based on the potential returns
that they offer and inherent level of risk. Using the efficient frontier, investors may often see the various asset classes
depicted as follows, which provides a good overview of the performance characteristics of each type of asset.
Cash – includes money held on deposit and also other
money market securities, which can earn interest over
time. Cash is normally considered to be a temporary
haven during periods of market volatility, or in the time
preceding one’s decision to invest.
Property – these are commercial properties such as
offices and warehouses, which are bought and then
leased out to create income from the rent. Returns from
property are generally lower than shares but can be
higher than cash and fixed interest.
Equity – also known as shares are considered one of the
best investments to achieve good long-term investment
returns. Shares can be quite volatile in the short term.
Higher
expected
returns
Equity
Expected return of asset mix
Fixed interest – including different types of bonds
have different levels of risk. Generally fixed interest is
considered lower risk than shares or property.
Lower
Expected
Returns
Property
%
Fixed interest
Cash
Lower
risk
Risk/Volatility of asset mix
Higher
risk
Using the efficient frontier in investment planning
Having evaluated the theory around the efficient frontier line, one may question how this can be used in individual
portfolio and investment planning.
The efficient frontier is used by investment professionals to devise a range of portfolios that suit investors with varying
return and risk requirements. Based on one’s life stage, age, personal circumstances and investment objectives, one
may be looking for a “high growth” investment and is happy for the increased risk required to achieve higher returns, or
one may be risk-averse and require a steady investment with correspondingly lower risk.
Investment professionals use the efficient frontier as a basis for creating pre-designed portfolios with a mix of assets
and different risk and return characteristics. These portfolios are often given names such as balanced income, which
typically provides low risk and lower returns, balanced, balanced growth, growth and finally aggressive growth, which
typically provides the potential for much higher returns at a higher level of risk.
There are no guarantees with any asset class or investment portfolio.
Investors are advised to speak to their financial adviser before making any
investment decisions. Discovery Invest offers a range of investment
funds to provide investors with varying investment objectives and risk
tolerances with optimal portfolios to achieve their long-term financial
planning goals.
GM_16039DI_14/06/2012