Efficient Frontier

Understanding and using an efficient frontier can help you build your portfolio.

What’s an Efficient Frontier and How Can I Use It?

If you chart the expected risks and returns of available asset types and the correlations (the degree to which asset classes move in sync) between those returns and draw a line connecting the combinations that land the farthest to the left and the top of the chart, the result is an efficient frontier. The portfolios along the frontier are generally expected to offer the best risk/return tradeoffs.

Using an efficient frontier can be helpful when you are building your portfolio. If your portfolio doesn’t land along an efficient frontier, chances are it can be adjusted to potentially increase return, possibly reduce risk, or both.

Important points to understand include:

  • There are many efficient frontiers, depending on the range of investment opportunities you have and what constraints you want to impose.
  • Using an efficient frontier when building a portfolio can help you determine the asset mix that can potentially offer you the best expected return for the level of risk you are willing to assume.
  • After determining your efficient frontier, keep in mind the numbers behind it are expectations, not certainties, about the future.
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