What is an Efficient Frontier?

In the world of finance, an efficient frontier is a term for a certain kind of investment. The status for an efficient frontier relates to expected return and expected risk. The term has become common among finance professionals and investors.

As a portfolio analysis, the efficient frontier is a specific point on a risk/return graph. If this sounds cryptic, looking at it another way will likely make the efficient frontier more transparent. The best way to see what this term is all about involves looking at a diagram of a risk/return chart.

In a risk/return graph, there is a curved line going up and toward the right. It indicates that as risk rises, so does potential reward. The curve represents “optimized portfolios” where the heightened risk brings the maximum complimentary reward. Still, not all portfolios, or sets of investments, are optimized to bring the highest reward. Only those on the curved line will deliver the corresponding reward according to risk, and that’s why they are called part of the efficient frontier.

The efficient frontier is a hugely useful tool for anyone looking to use complex investments to generate the most capital gains possible. Traditional stock market and asset investing was tied to a simple idea that time would bring gains when a company or sector was productive. New and improved investing methods use a whole range of “hedges” and risk management tools to secure more gains more effectively. That’s what terms like efficient frontier are all about.

The term “efficient frontier” comes from a portfolio theory of Harry Markowitz who postulated ideas about best yields and returns in the middle of the twentieth century. Markowitz’s Modern Portfolio Theory advances several very useful ideas about how to generate capital with investing tools. Finance pros have paid attention to the ideas involved in this theory, and using aspects of it can result in some practical gains.

In the end, this term for an optimized portfolio is a real representation of a very basic investing and stock trading concept. Everything about securities trading and many other kinds of asset investment is about risk and reward. Comparing the risk to the potential payoff is a huge part of the “due diligence” that investors perform long before they commit to a specific path of action. Knowing more about how to attain this kind of set of holdings is part of what makes a successful investor.