What is Efficient Frontier?

The efficient frontier is the set of optimal portfolios that offer the highest expected
return for a defined level of risk or the lowest risk for a given level of expected
return. Portfolios that lie below the efficient frontier are sub-optimal because they
do not provide enough return for the level of risk. Portfolios that cluster to the
right of the efficient frontier are sub-optimal because they have a higher level of
risk for the defined rate of return.

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Explaining The Efficient Frontier

Understanding Efficient Frontier

The efficient frontier rates portfolios (investments) on a scale of return (y-axis)
versus risk (x-axis). Compound Annual Growth Rate (CAGR) of an investment is
commonly used as the return component while standard deviation (annualized)
depicts the risk metric. The efficient frontier theory was introduced by Nobel
Laureate Harry Markowitz in 1952 and is a cornerstone of modern portfolio
theory (MPT).

The efficient frontier graphically represents portfolios that maximize returns for
the risk assumed. Returns are dependent on the investment combinations that
make up the portfolio. The standard deviation of a security is synonymous with
risk. Ideally, an investor seeks to populate the portfolio with securities offering
exceptional returns but whose combined standard deviation is lower than the
standard deviations of the individual securities. The less synchronized the
securities (lower covariance) then the lower the standard deviation. If this mix of
optimizing the return versus risk paradigm is successful then that portfolio should
line up along the efficient frontier line.

A key finding of the concept was the benefit of diversification resulting from the
curvature of the efficient frontier. The curvature is integral in revealing how
diversification improves the portfolio's risk / reward profile. It also reveals that
there is a diminishing marginal return to risk. The relationship is not linear. In
other words, adding more risk to a portfolio does not gain an equal amount of
return. Optimal portfolios that comprise the efficient frontier tend to have a higher
degree of diversification than the sub-optimal ones, which are typically less
diversified.

KEY TAKEAWAYS
  Efficient frontier comprises investment portfolios that offer the highest
expected return for a specific level of risk.
 Returns are dependent on the investment combinations that make up the
portfolio.
 The standard deviation of a security is synonymous with risk. Lower
covariance between portfolio securities results in lower portfolio standard
deviation.
 Successful optimization of the return versus risk paradigm should place a
portfolio along the efficient frontier line.
 Optimal portfolios that comprise the efficient frontier tend to have a higher
degree of diversification.
Optimal Portfolio
One assumption in investing is that a higher degree of risk means a higher
potential return. Conversely, investors who take on a low degree of risk have a
low potential return. According to Markowitz's theory, there is an optimal portfolio
that could be designed with a perfect balance between risk and return. The
optimal portfolio does not simply include securities with the highest potential
returns or low-risk securities. The optimal portfolio aims to balance securities with
the greatest potential returns with an acceptable degree of risk or securities with
the lowest degree of risk for a given level of potential return. The points on the
plot of risk versus expected returns where optimal portfolios lie are known as the
efficient frontier.

Selecting Investments
Assume a risk-seeking investor uses the efficient frontier to select investments.
The investor would select securities that lie on the right end of the efficient
frontier. The right end of the efficient frontier includes securities that are expected
to have a high degree of risk coupled with high potential returns, which is suitable
for highly risk-tolerant investors. Conversely, securities that lie on the left end of
the efficient frontier would be suitable for risk-averse investors.

Limitations
The efficient frontier and modern portfolio theory have many assumptions that
may not properly represent reality. For example, one of the assumptions is that
asset returns follow a normal distribution. In reality, securities may experience
returns that are more than three standard deviations away from the mean in
more than 0.03% of the observed values. Consequently, asset returns are said to
follow a leptokurtic distribution or heavy-tailed distribution.

Additionally, Markowitz posits several assumptions in his theory, such as that

investors are rational and avoid risk when possible; there are not enough
investors to influence market prices; and investors have unlimited access to
borrowing and lending money at the risk-free interest rate. However, reality
proves that the market includes irrational and risk-seeking investors, there are
large market participants who could influence market prices, and there are
investors who do not have unlimited access to borrowing and lending money.

Harry Markowitz’s Modern Portfolio Theory: The

Efficient Frontier
Modern Portfolio Theory
There’s no such thing as the perfect investment, but crafting a strategy that
offers high returns and relatively low risk is priority for modern investors. While
this hallmark seems rather straightforward today, this strategy actually didn’t
exist until the latter half of the 20th century.
In 1952, an economist named Harry Markowitz wrote his dissertation on
“Portfolio Selection”, a paper that contained theories which transformed the
landscape of portfolio management—a paper which would earn him the Nobel
Prize in Economics nearly four decades later.
As the philosophical antithesis of traditional stock selection, his Modern
Portfolio Theory (MPT) continues to be a popular investment strategy, and this
portfolio management tool—if used correctly—can result in a diverse,
profitable investment portfolio.
Instead of focusing on the risk of each individual asset, Markowitz
demonstrated that a diversified portfolio is less volatile than the total sum of its
individual parts. While each asset itself might be quite volatile, the volatility of
the entire portfolio can actually be quite low.
More than 60 years after its introduction, the fundamentals of MPT ring true.
Let’s delve into this popular portfolio management strategy, and discover what
makes the principles of this revolutionary theory so effective.
Harry Markowitz: The Man Behind MPT
Before we can examine the tenets of MPT, it’s important to understand the
man behind it. Markowitz’s name is an institution in the financial realm; today,
much of what governs modern financial and retirement saving advice is a
result of his work.
Decades before he became a Nobel Laureate, Harry Markowitz built an
illustrious career as an economist.
Born August 24th, 1927, in Chicago, Illinois, Markowitz showed interest in
physics, astronomy, and philosophy early on, and displayed particular interest
in the ideas of David Hume. He would continue to follow his interest in Hume’s
ideologies throughout his undergraduate years at the University of Chicago.
While still a student, Markowitz was invited to join the Cowles Commission for
Research in Economics (now the Cowles Foundation at Yale University), at
the time directed by T. Koopmans.
After receiving his Bachelor’s degree, Markowitz continued his studies at the
University of Chicago with a specialization in Economics. During his time
there, Markowitz took classes under some of the most notable academics of
the time, including Milton Friedman, Jacob Marschak, and Leonard “Jimmie”
Savage.
In 1952, Markowitz joined the RAND Corporation, and in the same year, his
article on “Portfolio Selection” was published in the Journal of Finance. While
with RAND, he worked on a variety of simulation problems, and soon moved
to General Electric. After leaving GE, Markowitz made his return to RAND for
a second time.
While applied mathematics continued to progress, researchers lacked
computer resources that could implement these new, groundbreaking ideas.
Any time an analytical thinker wanted to examine a novel idea, they were
tasked with writing unique pieces of computer code. This inspired Markowitz
and his team to develop SIMSCRIPT, a powerful computer simulation
language that allowed these researchers to take advantage of useful,
reusable code. After departing RAND for the second time, Markowitz founded
Consolidated Analysis Centers, Inc., where he and his team developed a
proprietary, upgraded version of SIMSCRIPT that would eventually be sold
publicly.
Today, Markowitz is both a professor and a consultant. As an adjunct
professor at the Rady School of Management at the University of California at
San Diego, Markowitz casts video lectures and consults out of his Harry
Markowitz Company offices.
 
Listen to how Dr. Harry Markowitz believes financial advisors can help with
market uncertainty and what he believes is a common mistake made by many
when investing. This video may have been made in 2010, but the advice and
information is timeless.
Awards and Accolades
Markowitz’s “Portfolio Selection” was published in 1952, but in the 60 years
following, he’s continued to gain accolades and awards in regards to a variety
of topics. His focus, however, has been the application of mathematical and
computing techniques to practical problems—especially business decisions
made under measures of uncertainty.
During his tenure as a professor of finance at Baruch College of the City
University of New York, in 1990, he won the Nobel Memorial Prize in
Economic Sciences for MPT.
The following year, he received the John von Neumann Theory Prize from the
Operations Research Society of America (now Institute for Operations
Research and the Management Sciences, INFORMS) for his contributions in
the theory of three fields: portfolio theory, sparse matrix methods, and
simulation language programming (SIMSCRIPT).
Pensions and Investments Magazine also named Harry Markowitz as “Man of
the Century”.
Markowitz is one of the brilliant minds behind GuidedChoice. As co-founder
and Chief Architect, his theory has informed the backbone of our proprietary
investment model.
The Origins of MPT
In pursuit of his PhD, Markowitz wrote his dissertation on the application of
mathematics in the analysis of the stock market. While completing his
research, Markowitz noticed shortcomings in the then-current understanding
of stock prices.
According to Markowitz’s own account, the basic concepts of what would
become the MPT came to him while reading a passage from John Burr
Williams’s Theory of Investment Value.
Prior to the development of MPT, investing processes were centered on
individual stocks; investors would look through available assets and find “sure
bets”—assets that would produce decent returns without subjecting the
investor to too much risk. Expected net present value (NPV) was used to
distinguish these “sure bet” stocks, while securities were valued by
discounting their future cash flows. Stocks that were capable of generating
more money at a quicker rate were given great value.
Markowitz disagreed with this thinking. The “present value” theory had
shortcomings; selecting the “best” portfolio under this logic meant selecting a
single stock with the highest expected NPV. That approach was risky by
nature, and while economic experts believed a good portfolio was a diversified
one, there was no methodology available for investors to achieve this
diversity.
Markowitz looked to probability and statistics to further his insights; if one
believed a stock’s price changed randomly, statistical tools including mean
and variance could be used to form more diverse portfolios. In the instance of
two or more stocks, an investor could consider correlation
What is MPT?
Markowitz created a formula that allows an investor to mathematically trade
off risk tolerance and reward expectations, resulting in the ideal portfolio.
This theory was based on two main concepts:
1. Every investor’s goal is to maximize return for any level of risk
2. Risk can be reduced by diversifying a portfolio through individual, unrelated
securities
MPT works under the assumption that investors are risk-averse, preferring a
portfolio with less risk for a given level of return. Under this assumption,
investors will only take on high-risk investments if they can expect a larger
reward.
Consider the following example:
A “rational investor” is asked to choose between two investments: Investment
A and Investment B. Both are expected to increase in value by 6 percent each
year. However, Investment B is considered twice as volatile as Investment A,
meaning its value fluctuates at twice the magnitude of Investment A’s value
fluctuations.
MPT suggests that a rational investor will always choose the less volatile
asset, in this case Investment A, so long as both options provide an
equivalent expected return.
A portfolio’s overall risk is computed through a function of the variances of
each asset, along with the correlations between each pair of assets. Asset
correlations affect the total portfolio risk, formulating a smaller standard
deviation than would be found by a weighted sum.
With these insights, Markowitz worked to create a management system that
would transform the landscape of modern investing processes and published
his new theory in the Journal of Finance in 1952.
Under the MPT—or mean-variance analysis—an investor can hold a high-risk
asset, mutual fund, or security, so long as this high-risk investment is
minimized by all underlying assets. The portfolio itself is balanced in a way
that its overall risk is lower than some of its underlying investments. Risk is
defined as the range by which an asset’s price will vary on average, but
Markowitz split risk into two subsequent categories.
Two Components of Risk
According to MPT, there are two components of risk for individual stock
returns.
• Systematic Risk: This refers to market risks that cannot be reduced through
diversification, or the possibility that the entire market and economy will show
losses that negatively affect investments. It’s important to note that MPT does
not claim to be able to moderate this type of risk, as it is inherent to an entire
market or market segment.
• Unsystematic Risk: Also called specific risk, unsystematic risk is specific to
individual stocks, meaning it can be diversified as you increase the number of
stocks in your portfolio.
In a truly diversified combination of assets—or portfolio—the risk of each
asset itself contributes very little to overall portfolio risk. Rather, the
covariances among the individual assets determine more of the overall
portfolio risk.
Therefore, investors can reduce individual asset risk by combining a
diversified portfolio of assets.
The Efficient Frontier
While the benefits of diversification are clear, investors must determine the
level of diversification that best suits them. This can be determined through
what is called the Efficient Frontier, a graphical representation of all possible
combinations of risky securities for an optimal level of return given a particular
level of risk.
• At every level of return, investors can create a portfolio that offers the lowest
possible risk.
• For every level of risk, investors can create a portfolio that offers the highest
return.
Any portfolio that falls outside the Efficient Frontier is considered sub-optimal
for one of two reasons: it carries too much risk relative to its return, or too little
return relative to its risk. A portfolio that lies below the Efficient Frontier
doesn’t provide enough return when compared to the level of risk. Portfolios
found to the right of the Efficient Frontier have a higher level of risk for the
defined rate of return.
At every point on the Efficient Frontier, investors can construct at least one
portfolio from all available investments that features the expected risk and
return corresponding to that point. A portfolio found on the upper portion of the
curve is efficient, as it gives the maximum expected return for the given level
of risk.
The Efficient Frontier offers a clear demonstration of the power behind
diversification. There’s no singular Efficient Frontier, because investors can
alter the number and characteristics of the assets to conform to their needs.
How To Apply MPT
MPT requires an investor take the time to define
• Time horizon
For a person saving for retirement, it might be several years, or even a
decade or more. For an institutional portfolio manager, it might be one to three
years. For a hedge fund, the horizon might be a day, a week, or a quarter. For
an institutional endowment, it can be forever.
• Sources of return
For a person saving for retirement, they probably consist of the asset classes
that the portfolio will comprise. For a portfolio manager hoping to beat a
benchmark, they might consist of sources of return believed to lead to higher
performance (these days the sources are often called “smart betas.”) For an
endowment, they might also include other factors, such as credit or illiquidity.
• Sources’ expected returns
MPT encourages the investor use judgment. If asset valuations seem high,
the experienced investor might reason that future returns may be lower than in
the past. Although the examples in the 1950s paper and book use historical
data for the purpose of illustration, MPT does not tell you how to set expected
returns.
• Sources’ expected covariances with each other
MPT encourages the investor to consider as much historical information as
possible. This does not necessarily mean, however, using a snapshot of the
historical record as the expected risks of the future. Volatility varies with time;
take special care to calibrate volatility expectations from sources whose
historical data are different lengths.
• Sources’ expected ratio of return to risk
MPT is very sensitive to assumptions! When plotted on a graph of expected
return vs. expected risk, are the plots more or less linear? If not, you can
almost guess by visual inspection which sources will appear in the optimal
solution: those with the highest ratio of expected return to risk (however
defined). Consider whether that is reasonable, or whether your assumptions
are overfitted (that is, they depend too much on past results). Repeat the
above steps as often as necessary to limit the degree of overfit in your
assumptions.
• Constraints
Whether legal, regulatory, or cultural, different investors have different
constraints. MPT accommodates different types of constraints, whether based
on absolute weights, relative weights, or transactions.
• Maximize expected utility
This is the step that most people forget about MPT (even practitioners!): The
above steps will generate an efficient frontier, subject to your constraints. Now
MPT recommends you choose the point on the frontier that maximizes
expected utility, a formula stating your preference for return versus risk.
• Rebalance
Rebalancing to your optimal portfolio weights periodically will allow your
portfolio to sell relatively high and buy relatively low. Over time this practice
can reap an extra return that builds over time.
• Review
MPT is sensitive to assumptions. If market conditions change such that you
think your assumptions about risk and return no longer reflect your current
beliefs, re-do the above process.
Why Many Misunderstand MPT
When it comes to information about MPT, confusion abounds. Many confuse
MPT with the Capital Asset Pricing Model (CAPM). Others confuse how they
may have experienced MPT with its actual assumptions.
Confusion with CAPM
CAPM builds on MPT, but it makes several unrealistic assumptions, including:

CAPM assumptions MPT

All investors share the same Use your own assumptions for your own purposes
expectations

Investors may borrow at the Use realistic assumptions

risk-free rate

There is only one source of Apply MPT using any reasonable set of return assumptions you believe are
expected return, that of the relevant.
global capital market
portfolio. All other apparent
sources are spurious and
should be diversified away.

For a person saving for retirement, the assumptions might pertain to asset classes

For an equity portfolio manager seeking to beat a benchmark, they might instead
pertain to sources of extra return (aka “alpha”), such as Value, Size, Momentum
Earnings Quality, or Low Volatility.

This versatility is why MPT is embedded in so many investment software

applications: its framework is generic enough to be useful to different parties
seeking to achieve different goals.
Other sources of confusion
Too often, persons confuse how they experienced MPT being applied with
how it’s meant to be applied.
 Confused beliefs MPT

Believes using standard deviation as the risk measure Makes no assumption about the shape of return
means it assumes all investment returns are normally distributions.
distributed, when in fact they are not.

Believes standard deviation is a bad risk measure MPT allows for using “downside risk” measures
because it punishes “upside risk” instead. The 1959 book, “Portfolio Selection” has an
entire chapter titled “The Semi-variance.”

Believes MPT requires using sample historical data MPT recommends you consider as much data as
over some recent period, as-is, as the MPT inputs. possible and use judgment when making
assumptions.

An obvious example of this being illogical for return MPT is silent on exactly how to develop return
expectations is that bond returns rise when bond yields assumptions, other than to use judgment, preferably
fall. It seems unreasonable to expect the same high that of a knowledgeable investor.
returns in the future when starting from a lower yield.

An example of this being illogical for risk expectations By using as much data as possible (which for many
is after a benign return period. For example, based only asset classes, dates back to the early 20th and
on the period 2012 – 2017 you could never predict such sometimes the 19th Century), you would never be
stressful periods as the 1987 crash or the 2008 global surprised that crashes occur.
financial crisis

Which information is relevant is different for

different investors. A highly leveraged hedge fund
might care only about the next day, week, or quarter
and might shift its risk assumptions very frequently.
An investor
In 2008, the stock market unexpectedly plunged almost 40 percent. Did MPT
hold up during that financial crisis? Yes, because the theory itself predicts it,
as Markowitz explains in his interview with The Finance Professionals’ Post.
Does MPT Work in Recessions?
As asset classes go down, correlations tend to increase. Historically, asset
classes shift proportionally to their betas. The beta measures how risky an
individual security is in relation to the overall stock market. Consider an asset
with a beta value of 1. In the event of a market decline, any stock that has a
beta value greater than 1 stands to lose more money than a stock with a beta
value less than 1.
So how did this play out in the Great Recession of 2008? According to
Markowitz, investors that limited risk during the recession kept a percentage
of their portfolios in lower-risk U.S. Treasure bonds; these investments were
top performers, while stocks and corporate bonds took a dive.
Using MPT for Retirement Investing
An estimated $7 trillion in institutional assets are invested under the tenets
laid out by MPT. This financial tool permits a financial or retirement advisor to
create a client’s optimal portfolio by balancing risk and return.
Once you’ve informed your adviser about the level of risk you’re comfortable
with, he or she can construct a portfolio using MPT that maximizes the
expected return for the defined risk.
Investors who diversified their portfolios still saw a loss, but a significantly
smaller loss than investors who didn’t.
Ultimately, using MPT for your portfolio management is dependent on your
desires as an investor. If you’re looking for greater return on average, you’ll
have to accept greater risk. If you want to incur fewer month-to-month or year-
to-year fluctuations, you’ll have to accept less return over time. Either way,
MPT can identify the optimal allocation to assets according to your
preference.
Markowitz remains an active member of GuidedChoice, responsible for
leading our investment committee. GuidedChoice continues to incorporate
Modern Portfolio Theory into our investing methodology, ensuring our clients’
investments are set up for success