The phrase
"efficient frontier" refers to the optimal balance between risk and return that can be achieved in an investment portfolio. It represents the set of investment options that provide the greatest possible return for a given level of risk or the lowest possible risk for a given level of return. The
efficient frontier helps investors optimize their investment choices to attain the best possible outcome based on their risk tolerance and desired return.
Full definition
One of the most fundamental ideas in portfolio design is the so -
called efficient frontier — the sweet spot where you'll enjoy the highest rate of return for each unit of risk.
My portfolio is fairly complex but it understood my portfolio perfectly and drew the correct expected return lines and
efficient frontier plane.
Both the height and the steepness
of efficient frontiers signal the degree to which markets are offering future reward for taking on risk.
Forward - looking
efficient frontier portfolios based on user - specified, expected returns and volatility use historical asset class correlations.
This online tool uses mean - variance optimization to generate forward - looking
efficient frontiers based on user - specified expected annual return and volatility of assets combined with historical asset correlations.
While not as attractive as that of the financial crisis, this
steeper efficient frontier reflected recent falling prices and rising probabilities of an economic slowdown in nearly every non-U.S. market.
Assuming Morgan Stanley's long - term forecasts are met with average levels of volatility, investors are looking at a much
flatter efficient frontier.
I've chosen this plus an equity glidepath with having a bond / cash allocation to start and weening up to an all - equity,
efficient frontier weighted portfolio.
Most efficient frontier portfolios (portfolio with highest expected return per unit of risk) and long term strategic allocations with the highest sharp ratio are ~ 60 - 70 % U.S. domestic, 20 - 30 % Int» l Developed, and 5 - 10 % Emerging Markets (ticker VWO)
The tools also allow you to run Monte Carlo simulations, find
historical efficient frontiers, and test quantitative and factor based investing models.
A
steeper efficient frontier would indicate a «risk - on» environment, as each step out on the risk spectrum would meaningfully increase expected return.
What results is an upward shift in
the efficient frontier, providing an enhanced return for a given level of risk, or conversely, a similar return at a lower risk profile.
The chart below illustrates how alternative investments can impact
the efficient frontier.
The degree of curvature of
the efficient frontier is due to the covariance, or lack thereof, of the assets within a portfolio.
Based on modern portfolio theory and
the efficient frontier, return is maximized for a given level of risk through asset class diversification.
Shown below,
the efficient frontier is a set of optimal investment portfolios that offer the highest level of return for a given level of risk.
Illustrated graphically, Harry Markowitz, a pioneer of modern portfolio theory, introduced
the efficient frontier in 1952 as the representation of the relationship between risk and return in the context of a portfolio of assets.
And, according to the theory, the best way to identify optimal diversification is through something called
an efficient frontier.
The efficient frontier is made of portfolios that offer the greatest expected returns for a given level of risk... or vice versa, the lowest risk for a given level of expected returns.
They define the boundaries of
the efficient frontier.
I see your points about maximizing return with a lower risk portfolio along
the efficient frontier, but I'm happier taking on a larger portion of risk to pull myself up the curve when it comes to equities.
The distinguishing feature of
the efficient frontier is its non-linearity.
Depending upon your allocation of stocks to bonds, Betterment adjusts the allocation of each individual ETF to meet
the efficient frontier.
It'll show where your portfolio is on
the efficient frontier.
Remember,
the efficient frontier represents the set of allocations offering the highest expected return for each level of risk.
Chart
the efficient frontier to explore risk vs. return trade - offs based on historical or forecasted returns.
In this instance, a CAPM model might aim to estimate returns for investors at various points along
an efficient frontier.
This theory urges you to move your portfolio of holdings closer to
the efficient frontier.
The «
efficient frontier» will be much flatter across most assets and regions, Morgan Stanley strategists predict.
Portfolios that fall below
the efficient frontier provide less return for each level of risk.
The efficient frontier calculation, based on the recent five years, takes into the account the poor performance of European assets during the economic downturn.
In plain English, the optimal portfolio recommended by
the efficient frontier model recommended borrowing shares in two funds and buying them back if the price decline, a very risky investment strategy (short selling).
The theory is that, using relationships between risk and return such as alpha and beta, and defining risk as the standard deviation of return, an «
efficient frontier» for investing can be identified and exploited for maximum gain at a given amount of risk.
-LSB-...] note: if you remember our post from a few weeks ago, you never raise cash to reduce risk, but rather walk along
the efficient frontier, most likely by -LSB-...]
Over the period that includes the commodity supercycle dating back to 1995,
the efficient frontier would have arrived at a very different conclusion: potentially much higher allocations to Canadian stocks at higher levels of volatility.
Thus, risk reduction is never done by raising cash, but rather by keeping cash at 0 % and changing the asset mix along
the efficient frontier, the efficient frontier plot below and our analysis here.
PC has
an efficient frontier analyzer built in as well as Monte Carlo projection to look at failure risk.
If you find yourself on
the efficient frontier past the tangency point (see above), one can easily show that reducing risk involves no cash holdings, but rather keeping all of your portfolio in risky assets.
If instead you walk along
the efficient frontier you can reach the same expected risk level but with a higher expected return (or alternatively the same expected return but lower risk) than the portfolio with emergency cash.
It all comes down to
the efficient frontier analysis.
But by definition, this line cuts into the interior of
the efficient frontier.
-LSB-...] Side note for the Finance wonks: if you pick any point along
the efficient frontier past the tangency point you have to hold zero cash.
Specifically, you simply move along
the efficient frontier and into other risky assets with lower risk and more diversification, e.g. bonds.
I bet you can juice up the optimizer with some international stocks and say 5 % EM exposure... More expensive funds, but I bet it will push
the efficient frontier out.
Investors should move along
the efficient frontier, not to the interior of the efficient frontier!
With a 1.05 % cash yield and still the 10Y bonds, the Emergency fund would lag behind by 0.17 % p.a. (5.98 % for
efficient frontier, 5.81 % for Emergency Fund) With 30Y bonds and higher yield the Emergency Fund would have lagged behind by 0.29 %.
The efficient frontier is now contorted to such a degree that traditional empirical views are no longer relevant.