Efficient Frontier: Investing on the Edge
The efficient frontier evaluates optimal risk to return ratio in a portfolio. The efficient frontier curve represents the edge between optimal and suboptimal.
The efficient frontier displays the highest return for assets against predefined risk level. The data identifies asset classes that are less optimal. Efficient frontier analysis lets every investor manage to their level of risk vs return.
Every portfolio is a collection of assets. Investments in stocks may bring a higher return but the market is volatile. The risk is high. Successful investors diversify their portfolio by allocating more than one asset type.
An efficient frontier curve identifies the perfect portfolio mix – the highest return for the lowest risk. Each investor can add or subtract assets to hit their sweet spot.
The choice of asset classes – stocks, bonds, real estate, or bitcoin – is based on two factors:
- Time horizon: The length of time you anticipate investing. Assume you stop investing at 65, the gap between your current age and 65 is the time horizon factor. If you begin investing at 30, it’s easier to handle more risk. You’ve got time to recover if you take a hit. If you started investing at 50, you may be more conservative. Your time horizon is much shorter.
- Risk tolerance: Risk tolerance is based on your willingness to lose your investment to get a great return. Aggressive and conservative investors have different approaches. The aggressive will risk more of their original investment. The conservative will avoid risk, protecting their original investment.
It’s easy to see how the two drive the diversification of a portfolio. Risk and reward are the investor’s gamble. Diversification of assets, applying the efficient frontier, lets each investor visualize their preferences. The most common mix of assets is stocks, bonds, and cash.
Cash may not immediately come to mind when considering investments. But the liquidity of cash assets is a compelling selling point. High-yield savings accounts, CDs, money market funds and treasury bills are all insured by the FDIC. The only risk to these assets is inflation.
There are other asset categories – real estate, commodities, precious metals, art and antiquities. While commodities can be volatile, precious metals expose investors to far less risk. Time horizon and risk tolerance point the way for asset allocation.
What Constitutes a Portfolio?
A portfolio is a collection of financial investments. The portfolio contains assets, like stocks or treasuries. The assets have fluctuating values, some more volatile than others. Those fluctuations are the drivers of risk tolerance. The diversification of assets is one method of minimizing risk.
Portfolios require management, whether by the investor or a financial services firm. The mix of assets in the portfolio require periodic rebalancing to maintain alignment. Risk and return, tax liability and liquidity are all factors for consideration.
The purpose of rebalancing is to address alignment with your investment strategy. It’s normal for investments to shift in value. Some will underperform and others over perform. The mix of assets might also shift in terms of diversity. You may see EFTs or mutual funds change their mix, which can affect yours as well.
Rebalancing is not strictly about a single asset. It’s about the weight of the asset classes in the portfolio.
Rebalancing isn’t strictly about asset value or performance. It’s about the mix of asset classes in the portfolio. If you have stocks, bonds and precious metals, the balance between them can get out of alignment.
The first step is to identify the asset classes out of balance with your investment strategy. Then you can take one of three approaches:
- Sell off some investments in the over-weighted classes. Flip the proceeds to buy assets in the underweighted classes. (i.e., too many stocks, sell some and buy more gold.)
- Balance the mix by buying new assets for underweighted classed. (i.e., too few stocks – buy some more.)
- are directed to focus on underweighted classes. (i.e. direct less money to bonds and more to precious metal.)
During rebalancing, It makes sense to look at asset performance value. Efficient frontier analysis is the method to identify them. Discuss tax liability and transaction fees with your CPA or financial adviser.
When to Rebalance
Rebalancing is triggered by calendar or the relative weight of an asset category. It’s just a matter of preference.
Many financial experts recommended a structured timeline for rebalancing, once or twice a year. The timeline puts a reminder on the calendar. Either you or your portfolio manager will check for inconsistencies in the mix.
The other option is to set an alert on the relative weight of an asset class. When the asset class increases or decreases beyond a certain percentage, it triggers a review. The advantage is the asset classes in the portfolio itself are directing the rebalancing.
Just to clarify, rebalancing works best when performed infrequently. Most asset classes are long term investments. There may also be transaction fees or other liabilities to be considered. If you have a portfolio manager, make sure you know the costs of their involvement in the process.
Why is Efficient Frontier Important?
Graphing your assets using the efficient frontier will keep your portfolio optimized. The ratio of risk to reward is in balance. Efficient frontier analysis captures data on assets in your portfolio. That data is plotted on a graph between a y-axis of risk and x-axis of return. The data points form a curve. That curve visualizes the highest return at the investor’s acceptable level of risk. That is the optimal portfolio.
The efficient frontier curve visualizes investors’ preference for risk and reward.
Harry Markowitz, the creator of Modern Portfolio Theory, is behind the efficient frontier. Markowitz created the idea of a perfectly balanced portfolio that could ride out market volatility. He believed all investors are risk-averse. His theory responded to that premise, suggesting investors could circumvent risk by properly diversifying their portfolios.
Modern portfolio theory appeals to more conservative investors. It is focused on building a portfolio with the least amount of risk. Efficient Frontier finds the portfolio with the highest return, at the lowest risk.
How to use the Efficient Frontier?
Plotting the curve requires data on the assets in your portfolio. Some analysts plot historical data from the late 1970’s up to the present. That’s complicated manually, but some calculators help. Hover over the visualizations of a single, simple portfolio. Then click the example button to see the parameters. Note the resampling visual below, using a more diverse set of assets.
Efficient Frontier in Excel
Charting an Efficient Frontier in Microsoft Excel is not for the faint of heart. The graph plots out all possible portfolios, using the x-axis for risk and the y-axis for return. We recommend starting from a template, like the one at CFI. If you’d rather create your own, save this pdf from Finance Train.
If you prefer video, this will show you how to set up a 2-stock portfolio in excel.
Oracle Crystal Ball is an extension to excel to create data simulations, including efficient frontier models. It’s a premium product for just under $1000 a year for a single user. It’s not limited to investment modeling. Crystal Ball is used for predictive analytics, forecasting, and simulations.
Frequently Searched Questions
What is the efficient frontier curve?
The efficient frontier rates investments on a scale of return (y-axis) versus risk (x-axis). The results are plotted on a curve. Sub-optimal investments fall beneath the curve when the return is too low for the level of risk.
What is efficient frontier analysis?
Efficient frontier analysis is how the curve is calculated. The data for each portfolio is captured. A series of calculations are applied to the assets. The output visualizes the rate of return versus risk. The analysis shows investors their best options based on their risk tolerance and time horizon.
How is the efficient frontier significant in optimizing risk and return?
The efficient frontier models risk and return. Investors use the analysis to identify their best opportunities. The curve is often referred to as the outer edge of risk versus return. Portfolios that fall beneath the curve are not optimal – too much risk for too little return. But the risk tolerance of an individual investor is accommodated. An optimal portfolio is possible for an aggressive or conservative style.
What is an optimal portfolio?
According to Markowitz, there is an optimal portfolio for every investor. That portfolio would be perfectly balanced between risk and reward. Instead of assuming low risk means low return or high risk means high return, the curve plots all options. Each investor’s preferred risk tolerance is plotted against the desired rate of return. An optimal portfolio is visualized with efficient frontier analysis.
What Is the Markowitz Efficient Set?
The Markowitz Efficient Set is simply the optimal portfolio plotted on the efficient frontier.
Beware of the limitations
There are several assumptions associated with Modern Portfolio Theory and the Efficient Frontier. First, they were created in 1952. The investment environment, asset classes, and technology are radically different. The basis of some assumptions no longer apply to today’s markets or investors.
Markowitz believes that all investors are risk-averse and so will behave rationally. In the 1950s, there not enough investors to influence market prices. He relies on standard deviation to measure risk and assumes that correlations are static.
While it may have been true when he developed the concept, there’s evidence it’s no longer accurate. There are plenty of aggressive (irrational) investors who have a high-risk tolerance. There are any number of large market investors who can manipulate the market. Many trades are automated, processed in seconds, and capable of causing a shift in the market.
Both modern portfolio theory and efficient frontier are mathematical tools. Like every other investment strategy – they are no foolproof. Follow the outcomes carefully to see if they align with your goals. If not, step back and adjust.
Final Thoughts on Efficient Frontier
The efficient frontier is a methodology for building an optimal portfolio. It’s created by plotting data points on a graph and applying some calculations. The goal of an optimal portfolio is to identify the highest rate of return for the lowest rate of risk.
Investors need to know their risk tolerance and their time horizon. Use efficient frontier analysis to keep your portfolio balanced and optimized to meet your investment goals.
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