Efficient frontier.
In plain English
The efficient frontier is the set of asset mixes that cannot be improved: for any given amount of volatility, no other combination is expected to earn more. Plot every possible mix with risk on one axis and expected return on the other, and the results fill a region with a curved upper edge. Portfolios on that edge are called efficient, and every portfolio below it is inefficient, taking risk it is not being paid for. Moving along the frontier means accepting more volatility for more expected return, which is a choice about tolerance rather than a mistake. The whole picture depends on estimates of return, volatility, and correlation, and small changes in those inputs move the curve.
01Why it matters
A portfolio can be poorly built not because it is too risky, but because it is taking risk that brought no extra expected return with it.
02The math, step by step
One mix has an expected return of 6 percent with 12 percent volatility. Another has the same 12 percent volatility but an expected return of 7 percent. The first sits below the frontier and the second sits on it, so the first is giving up a full percentage point for the same amount of turbulence.
Illustrative example. The amounts here are hypothetical, chosen to show how the math works, not real quoted rates or figures.
03What this is NOT
The frontier is built from estimates, not from certainty. It shows the best expected combinations given the numbers fed into it. Change the assumptions about future returns or correlations and the curve moves, so a portfolio that looked efficient can look ordinary later.
04Receipts
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Plain-English answers from our glossary. Receipts included. Never advice.
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