The Efficient Frontier

The Efficient Frontier is a tool that enables investors to choose their target asset allocation, or the exposure to each asset class. The Efficient Frontier represents the set of optimal portfolios, those that offer the highest expected return for each level of risk. 

 

A previous article discussed the benefits of portfolio diversification. Choosing a strategic asset allocation, or the exposure to each asset class, is the key investment decision for investors.

 

There are two steps to choosing the best strategic asset allocation. The first step is to limit the range of possible portfolios to a workable set of what are termed “efficient” portfolios.

 

Efficient Portfolios are those that have the highest expected return for a given level of risk. Risk is normally measured as the standard deviation of returns, which is known as volatility.

 

Only efficient portfolios should be considered by investors. This is because any portfolio below the so-called “Efficient Frontier” is less than optimal, in that a superior portfolio is available that offers a higher expected return for the same level of risk.

 

The Efficient Frontier is usually depicted on a graph, which shows the return/risk combinations of all possible efficient portfolios from which an investor can choose.

 

 

 

 

The graph shows the trade-off between the expected return and its volatility (standard deviation of return). An efficient portfolio concentrated in higher-risk assets such as shares offers a higher expected return than one invested mainly in low-risk asset classes such as fixed interest.

 

The Efficient Frontier enables the second step to be taken. The investor chooses the point on the frontier that is most appropriate, based on what level of risk is acceptable. Investors with longer time horizons may prefer higher-risk portfolios, but those sensitive to short-term capital losses are likely to prefer lower-risk portfolios. However, all investors should choose portfolios that lie on the frontier[1].

 

Want to know more?

Trust Management can provide advice to charities about the efficiency of their portfolios, and whether their risk level is appropriate. If you have any questions, or would like to know more about how your portfolio can be tailored to your requirements, please contact John Williams on (09) 550 4046.

 

This paper seeks to provide some detail and explanation about choosing an investment portfolio. The paper aims to provide a basic oversight of the topics mentioned, using simple terminology in easy to understand language. The paper is not intended to be the definitive guide on portfolio construction. We recommend investors seek advice before investing.

 

[1] The frontier is constructed using a range of financial market assumptions as inputs, the expected return and volatility of each asset class and the correlation between these returns. The specific frontier is dependent on the values chosen for these inputs.  

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09 550 4046

 

 

 

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