Efficient frontier is a financial strategy that’s all about gauging return versus risk. It’s a concept that is used by financial advisors to inform which assets or asset classes should be included in a portfolio. The goal of efficient frontier is to maximize returns for the expected level of risk involved.
While it may sound complex, the efficient frontier formula is actually fairly straightforward once you understand what is factored in and how the factors are related. Let’s take a more in-depth look at how this financial strategy works and how it can be applied to improve the performance of portfolios.
What Is Efficient Frontier?
In simplest terms, efficient frontier is a benchmark for portfolios to determine the best expected return for a certain amount of risk. The efficient frontier theory is used to build portfolios that either have the lowest level of risk for an expected return or the highest return for an expected level of risk.
One thing to keep in mind is that efficient frontier applies to a portfolio as a whole rather than to individual assets within a portfolio. A portfolio is considered optimal when the combined returns exceed the combined risk and the portfolio’s combined risk is lower than the risk for individual assets.
What Is an Optimal Portfolio?
A portfolio that hits the efficient frontier benchmarks with expected returns being greater than the expected risk is known as an optimal portfolio. Portfolios that fall out of the efficient frontier range, either by having a high level of risk for the expected return or a low return compared to the risk, are considered sub-optimal portfolios.
How Does the Efficient Frontier Graph Work?
Efficient frontier isn’t just a theory. A calculation is used to create an efficient frontier graph that plots a portfolio’s expected return and risk level.
How to Calculate Efficient Frontier
In order for this financial strategy to work, you have to know how to calculate efficient frontier. The efficient frontier formula requires one metric for return and another for risk. Typically, compound annual growth rate (CAGR) is used as the return metric, and annualized standard deviation is the metric for risk.
Using these calculations, an efficient frontier graph can be constructed that shows a curve, which signifies the efficient frontier range where optimal portfolios lie. The x-axis signifies risk (annualized standard deviation), and the y-axis represents return (CAGR).
The right side of the curve is where there is more risk, and on the other side is less risk. Where you might want your portfolio to be on the curve largely depends on how much risk you’re willing to take. This is the expected level of risk that, according to efficient frontier, should be balanced by return.
One more item factored into the efficient frontier calculation is the covariance of the assets. Covariance refers to the direct relationship between the expected returns for two different assets. When there’s a positive covariance, the returns on both assets move in the same direction. When the returns on the two assets are inverse, it’s considered negative covariance. Risk tends to be minimized when there’s negative covariance.
How Is Efficient Frontier Used?
Financial advisors often use an efficient frontier graph to help clients determine an ideal asset mix and build portfolios that maximize returns for the amount of risk that’s assumed. If the portfolio is in line for the efficient frontier curve, then the portfolio is likely on track. However, if it isn’t in line, that may be a strong indicator the portfolio needs to be reevaluated and adjusted.
The asset allocation of portfolios has a huge bearing on efficient frontier. The plot points on the efficient frontier graph can help you determine how to adjust asset allocation so that your portfolio is within the efficient frontier curve. Generally, diversification helps to lower the standard deviation and improves the return to risk ratio. Diversified portfolios, especially when aiming to minimize risk, may include precious metals and other alternative assets.
Why Is the Efficient Frontier Theory Important?
There’s inherently going to be risk involved whenever building a portfolio. For many portfolio owners, the potential return is what balances out and makes the risk acceptable. The efficient frontier theory may help you decide on the right mix of assets to help achieve a balance between risk and return.
Harry Markowitz, the economist who developed the efficient frontier theory, did so with the aim of improving the risk/reward profile of portfolios. His goal was to create a formula to determine the optimal portfolio—one that perfectly balances risk and return.
While the efficient frontier theory isn’t foolproof, it does provide more evidence for the advantages of portfolio diversification. Diversification is widely considered to be a sound financial strategy for reducing risk. The efficient frontier curve visualizes how diversification of a portfolio can help improve your risk versus return ratio. A portfolio that’s considered optimal in terms of the efficient frontier will typically be more diversified compared to sub-optimal portfolios.
Another realization that came from the creation of the efficient frontier curve was that adding risk does not necessarily increase return in equal measure. There tends to be marginal return for increased risk. Therefore, the efficient frontier theory proves that high risk doesn’t equate to high return.
Efficient Frontier Limitations
No financial theory or concept is perfect, and that includes efficient frontier. Since it was first conceived in 1952, a few limitations have been rightfully pointed out. The key challenge is that the efficient frontier theory is based on assumptions that do not always align with real-world scenarios. Those assumptions include:
- Portfolio owners are rational and have sufficient knowledge of the markets.
- Portfolio owners avoid risk whenever possible.
- There aren’t enough portfolio owners to have an impact on market prices.
- People have unlimited access to lending/borrowing at interest rates that are risk-free.
- People always base their portfolio decisions on expected return and anticipated risk.
None of the points above are wholly accurate in all real-world situations, which can throw off efficient frontier projections.
One common limitation arises when there isn’t a normal distribution of returns. The efficient frontier theory is based on assets having a normal distribution pattern, which isn’t always the case. The distribution can be up to three standard deviations off from the mean.
The efficient frontier theory also doesn’t apply to portfolios that aren’t diversified. In order to be plotted on the efficient frontier graph, a portfolio needs to include different assets.
An alternative to the efficient frontier strategy can be to simply focus on diversification, which can also be used to complement the efficient frontier strategy. For example, a portfolio that only contains stock and REITs may have a higher level of risk for the maximum rate of return. In this case, the portfolio holder may benefit from a diversification strategy that adds assets like precious metals that aren’t tied to market performance and may also help hedge against inflation.
How Precious Metals Can Help a Portfolio Fall Within the Efficient Frontier
Building an optimal portfolio that lies within the efficient frontier curve hinges on diversification that helps minimize risk collectively. One asset class that is known to balance out others is precious metals. Anyone who wants to mitigate risk as much as possible may want to consider a precious metals IRA.
A precious metals IRA comes with the tax advantages of a regular individual retirement account, but it allows the account holder to have more control over the assets that are included. It allows for the inclusion of assets like gold and silver that aren’t impacted by market downturns the way other securities are. Precious metals are also considered insurance against inflation since they aren’t tied to currency valuations. The risk versus return tends to play out well on the efficient frontier given the positive long-term performance of gold and other precious metals.
Request a Precious Metals IRA Information Kit to discover how gold and silver can be used to diversify a portfolio and help bring it in line with the efficient frontier curve.