20.3.2 Efficient Frontier

Understanding the Efficient Frontier

One of an investor’s most important decisions is the asset allocation, or asset mix decision. Studies have shown that between 40% and 90% of a portfolio’s volatility can be attributed to asset allocation rather than individual security selection.

Modern Portfolio Theory (MPT) provides the tools necessary for making these crucial asset allocation decisions. By combining various asset classes such as cash, bonds, equities, and non-correlated alternative investments, investors can construct efficient portfolios. These portfolios maximize expected returns for each level of risk by diversifying across asset classes. Further diversification can be achieved through differences in market capitalization, geographic areas, duration, credit quality, currencies, and more.

Defining the Efficient Frontier

The efficient frontier reflects the most efficient portfolios for all levels of risk. All points below the efficient frontier are considered inefficient because by moving the portfolio to the frontier, either risk can be reduced for a similar return potential, or return potential can be increased for a similar level of risk.

The efficient frontier is usually illustrated on a graph with standard deviation (representing risk levels) on the x-axis and expected portfolio return on the y-axis.

    graph TB
	    subgraph Efficient Frontier Diagram
	    A((100% Bonds))
	    X((80% Bonds 20% Stocks))
	    B((100% Aggressive Equities))
	    end
	    A -.->|Low Risk, Low Return| X
	    X ---|Moderate Risk, High Return Potential| B

Figure 20.1 | Efficient Frontier

Many conservative investors believe that a 100% bond portfolio (Portfolio A) is the safest, least risky option. However, the graph indicates that Portfolio X, consisting of 20% stocks and 80% bonds, is superior. Portfolio X has a lower risk and higher return potential due to its diversified components.

Diversification and Risk Management

Stocks are generally riskier than bonds. However, due to the relatively low correlation between stocks and bonds, an overall portfolio risk can be reduced by combining them. This efficient diversification enhances return potential while managing risk levels effectively.

Adding alternative investments, such as hedge funds, which have low correlations with both stocks and bonds, can create a new efficient frontier. This new frontier gives investors the opportunity to increase their expected return without increasing risk, or to maintain their expected return at a lower risk level.

    graph TB
	    subgraph Efficient Frontier With Hedge Funds
	    HF((Hedge Funds))
	    EF((Current Efficient Frontier))
	    NewEF((New Efficient Frontier))
	    end
	    HF -.->|Additional Diversification| NewEF
	    EF ---|Lower Return Potential, Higher Risk| HF

Figure 20.2 | Efficient Frontier with Hedge Funds

Key Takeaways From the Efficient Frontier

• Asset Allocation: A significant factor in explaining portfolio volatility.
• Efficient Frontier: Represents portfolios that yield the highest expected return at each different level of risk.
• Diversification: Reducing risk through a combination of low-correlated assets like stocks, bonds, and alternative investments.
• Inclusion of Alternatives: Adding hedge funds or other alternatives can create a new, more efficient frontier providing better diversification.

FAQs

What is the efficient frontier?

The efficient frontier is a graphical representation of investment portfolios that provide the highest expected return for each level of risk. It forms a boundary line where portfolios below the frontier are deemed inefficient.

Why is asset allocation important?

Asset allocation is crucial because it has a significant impact on a portfolio’s total volatility. By diversifying assets, an investor can manage risk and optimize returns more effectively.

How does Modern Portfolio Theory help in asset allocation?

Modern Portfolio Theory aids in asset allocation by combining various asset classes that maximize expected returns while minimizing risk levels. This theory considers both the return and the correlation between different asset classes to create an efficient portfolio.

Glossary

• Modern Portfolio Theory (MPT): A framework for constructing portfolios to maximize expected return based on a given level of market risk.
• Volatility: A statistical measure of the dispersion of returns for a given security or market index, often measured by standard deviation.
• Efficient Frontier: A line formed by different portfolios, each providing the best possible return at a given risk level.
• Correlation: A statistical measure that describes the degree to which two investments move in relation to each other.
• Diversification: The practice of spreading investments among various financial instruments, industries, and other categories to reduce exposure to risk.

Recommended Readings

• Harry Markowitz’s original papers on Modern Portfolio Theory
• “A Random Walk Down Wall Street” by Burton G. Malkiel