The Efficient Frontier – Simply Explained

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The Efficient Frontier – Simply Explained

 

We want our money to be able to do the best job in making more money for us right? But we also are only willing to take a certain amount of risk. The risk may be specific due to our age, investment style and perhaps time until retirement and even during retirement.

 

If you can achieve the same return you desired but with less risk, than why not? This is where the efficient frontier comes into play. The objective is to get our investment allocation as close to the efficient frontier line as possible.  This is why it’s called efficient; to achieve the best possible return for the level of risk it wants to take.

 

The efficient frontier was first introduced by Harry Markowitz in 1952.  His continued research on portfolio theory won him the Nobel Prize in Economics in 1990. His work also proved the importance of diversification as a portfolio that lies on the efficient frontier is generally more diversified that one that isn’t.

 

 

How Does The Efficient Frontier Work?

 

The efficient frontier has a vertical and horizontal axis.

 

The vertical axis represents the return of the portfolio.

 

The horizontal axis represents the risk, in the form of standard deviation.

 

The efficient frontier line produces the highest expected return for any given level of risk. It is impossible to go above the line, and anything below the line is a sub-optimal portfolio.

 

A sub-optimal portfolio is one that provides less return for the same amount of risk or exposes you to more risk for the same return.

 

The efficient frontier is a curved line. Basic logic would suggest that the line should be a straight one instead of curved because if you invest completely in bonds you’d have the lowest risk and lowest returns. And if you invest completely in stocks you’d have the highest risk and the highest returns.

 

When the efficient frontier was discovered, however, economists determined that you can actually achieve lower risk and higher returns over time by investing in bonds and stocks both. Therefore, an efficient portfolio has a mix of bonds and stocks.

 

The least risk on the efficient frontier is a mix of 25% in bonds and 75% in stocks. This is the starting point of where the efficient frontier originates its curve upward and to the right.

 

efficient frontier simple money man

 

Source: Young Research & Publishing, Inc.

 

This next chart from Investing Answers does a good job explaining the basic working of the efficient frontier.  The dots represent portfolios. The dots closest to the line are the portfolios that provide the best return for the risk or volatility level acceptable by the investor. The dots furthest away are portfolios that don’t.

 

efficient frontier simple money man 

 

The objective of this modern portfolio theory is simply to ensure you get your portfolio as close as you can to the efficient frontier.

 

 

How Can The Efficient Frontier Help?

 

Why do I care about this? Well, I stumbled upon it on my Personal Capital Investment Checkup Screen.

 

According to Personal Capital, I could obtain a higher expected return without taking on more risk:

 

PC efficient frontier smm

 

According to this efficient frontier line and the numbers above, the difference seems minimal. I am at the Current Allocation X point with a return of 9.0% and risk level of 15.1%. I could move to a target allocation and have an 8.9% return with a lower risk of 14.5%.

 

The difference is immaterial for me and so I will remain where I am in terms of my asset allocation. Part of what helped me to accomplish this was capturing some gains in 2017 and diversifying funds into the international space via index funds.

Plus I’m doing a good job as I am pretty much on the efficient frontier per Personal Capital.

 

PC IC SMM

 

Per Personal Capital, at a high level, all asset classes are in alignment with each other. It’s important to make sure you’re taking the appropriate amount of risk for the returns you are seeking to obtain.

 

 

 

The Efficient Frontier Can Be Useful

 

As with everything else, the efficient frontier uses historical data to put together a portfolio. This is combined with an investors risk appetite in terms of bonds and large-cap representing low-risk securities to small-cap and international representing high-risk securities.

 

When we gather up all of the assumptions an efficient frontier is generated for us as a guide on how we should proceed.

Still, the efficient frontier should be taken with a grain of salt. CBS MoneyWatch argues that the efficient frontier seeks to make investments a science, which it’s not. Therefore, constraints should be built in; for example, international equities should not exceed 20% of your portfolio no matter what.

 

 

Continue To Follow The S&P

 

The S&P 500 Index is considered to be the most efficient portfolio. It’s another reason why the S&P 500 Index is used as a benchmark to weigh the stock market.

 

It’s also important to note that fees are not taken into consideration in the efficient frontier construction. You may have an efficient portfolio, but it could cost you more than you think.

 

Remember that the efficient frontier is a just a tool to see how your portfolio is performing based on variables that you may have input. It still may be important to consult with a financial professional to make sure your inputs are appropriate based on your age, investment timeline, and overall financial goals.

 

And finally, here is a short and effective video that wraps this up by one of my favorite resources – Investopedia:

 


 

 

 

Your Thoughts:

  1. Do you use the efficient frontier?
  2. Where does your portfolio lie on the frontier and can you take steps to improve efficiency?
  3. How do you perform your asset allocation? Is it more proactive or reactive?

 

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I use Personal Capital because (1) it’s free, (2) it tracks all of my accounts and overall net worth, (3) my account balances automatically update, (4) it shows how my investments are diversified and allocated in various sectors, and (5) can use built-in tools like “Investment Checkup” to get….wait for it…free personalized advice!

 

10 thoughts on “The Efficient Frontier – Simply Explained

  1. Great explanation and I love how you tie in Personal Capital, as that is one of my favorite applications!!

    I don’t use the Efficient Frontier since my asset allocation has more than 2 dimensions (I have like 1% bonds, and with real estate, some alternative assets, and stocks, there is a lot more to think about where Modern Portfolio Theory falls short.)

  2. Hi SMM, found this concept fascinating when I first studied it at university, and your explanation is much more detailed than the crude picture my buddy Indexing Ian drew a few weeks ago!

    I still struggle to accept the concept in practice however – I think this is because it’s so hard to ‘see’ risk. Return is a much clearer measure that is easier for people to chase at the expense of risk.

    Cheers, Frankie

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