Sunday, 10 September 2023 05:54

Understanding the ‘Efficient Frontier’

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The efficient frontier is defined as the set of portfolios which maximizes expected return for a given level of risk. The theory was developed by Nobel laureate and economist, Harry Markowitz, and has become an integral part of modern portfolio theory. The most common application of the efficient frontier is to optimize the amount of diversification in each portfolio. 


Efficient frontier is used to figure out the ideal balance between returns and risk through the use of diversification. It’s based on historical data and correlations to calculate theoretical returns and ideal weightings in a portfolio. 


It can help investors figure out how much diversification is necessary given an individual’s risk tolerance. Greater diversification can dampen variance and risk while still maintaining the same level of long-term returns. 


Efficient frontier is used to construct model portfolios to ensure sufficient diversification and appropriate rebalancing. They can also help identify when the portfolio is getting diminishing returns from taking on risk. 


One drawback to the efficient frontier is that all of these calculations are based on historical data, and there is no guarantee that future returns will be similar to that of the past. It also assumes that returns follow a normal distribution, however this has simply not been the case in many years. 

Finsum: Efficient frontier is used by portfolio managers to determine the ideal balance between returns and risk. It’s an integral aspect of modern portfolio management theory.


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