## What is the efficient frontier?

The efficient frontier is a concept in investment theory that helps investors optimize their portfolios by finding the ideal balance between risk and return. It represents a set of investment portfolios that offer the highest expected return for a given level of risk, or the lowest level of risk for a given expected return. The efficient frontier helps investors diversify their portfolios and maximise their potential returns while managing risk. By plotting different asset allocations on the efficient frontier, investors can identify the optimal portfolio that aligns with their risk tolerance and investment objectives.

#### Key takeaways

- The efficient frontier is a concept that helps investors find the optimal balance between risk and return in their investment portfolios.

- It represents a set of portfolios that offer the highest expected return for a given level of risk or the lowest level of risk for a given expected return.

- By diversifying investments and finding portfolios along the efficient frontier, investors can maximise potential returns while managing risk.

## Understanding the efficient frontier

Imagine you want to invest your money, and you have various options like stocks, bonds, and real estate. The efficient frontier helps you determine the ideal combination of these investments to achieve the best possible returns while considering the level of risk you're willing to take.

The efficient frontier is depicted as a graph that plots different portfolios along the risk-return spectrum. The vertical axis represents the expected return, and the horizontal axis represents the risk, usually measured by the portfolio's volatility or standard deviation.

The efficient frontier curve shows the range of portfolios that offer the highest expected return for a given level of risk or the lowest level of risk for a given expected return. Portfolios below the efficient frontier are considered suboptimal because they either have higher risk for the same return or lower return for the same risk.

## Real world example of the efficient frontier

Let's say you're an investor with a moderate risk tolerance and a goal of achieving steady long-term growth. You have a choice between two investment portfolios: Portfolio A and Portfolio B.

Portfolio A has an expected return of 8% and a standard deviation of 10%, while Portfolio B has an expected return of 10% and a standard deviation of 12%. By plotting these portfolios on the efficient frontier, you can visually assess their risk-return characteristics and compare them to the optimal portfolios.

Upon analysing the efficient frontier, you discover that Portfolio A lies below the efficient frontier curve, indicating that it offers lower returns for its level of risk. On the other hand, Portfolio B falls on the efficient frontier, meaning it provides the highest expected return for its level of risk within the given set of investment options.

## Using the efficient frontier when investing

The efficient frontier is a powerful concept that helps investors make informed decisions about their portfolios. By diversifying investments and finding portfolios along the efficient frontier, investors can maximize potential returns while managing risk. The efficient frontier graphically represents the trade-off between risk and return, allowing investors to identify the optimal balance for their investment objectives and risk tolerance. By utilizing the principles of the efficient frontier, investors can construct well-balanced portfolios that align with their financial goals and preferences.