Lower covariance between portfolio securities results in smaller portfolio standard deviation. Risk seeking investors would look at these portfolios, while risk-averse investors would look on those on the left side.įor this model, we consider the standard deviation of the return on the asset as its risk measure. Those on the right of the efficient frontier have higher risk levels for the defined rate of return. Returns depend on the investments combined in the portfolio. Portfolios below the efficient frontier are sub-optimal, as they don’t provide enough returns for their risk levels. The Efficient Frontier is a set of optimal portfolios that give the highest possible expected return for a given risk level or the lowest risk for a desired expected return. The Efficient Frontier concept has its roots in the 1950s, and it’s a pillar of Modern Portfolio Theory. When we plot these, we get the Efficient Frontier. It aims to balance stocks carrying the best potential returns with acceptable risk. The optimal portfolio does not focus on investments with either high expected returns or low risk.
The more out of sync these price developments are, the lower the covariance between two assets is, which translates into lower overall risk. Some prices move in the same direction under similar circumstances, while others go in opposite directions. The relationship between assets is an essential part of the optimal portfolio theory. The optimal portfolio concept represents the best of these combinations, those that provide the maximum possible expected return for a given level of acceptable risk. It satisfies the requirement that no other collection exists with a higher expected return at the same standard deviation of the return (risk measure).ĭifferent combinations of assets produce different levels of return. Optimal PortfolioĪn optimal portfolio is one that occupies the ‘efficient’ parts of the risk-return premium spectrum. We refer to these as optimal portfolios, and they form the efficient frontier curve. The theory relies on the assumption that investors prefer portfolios that generate the most substantial possible return with the least amount of involved risk.
The theory behind the Efficient Frontier and Optimal Portfolios states that there’s an optimal combination of risk and return. There’s a widespread assumption in investing that more risk equals increased potential returns.