Understanding the Efficient Frontier

The efficient frontier is an integral part of investment portfolio theory and aims to

find the optimal portfolio structure for investors based on different risk tolerances.

This fact sheet outlines some of the key principles about the efficient frontier,

explaining what it means and how it is used in investment planning.

Your financial adviser can further explain how the efficient frontier relates to your

individual investment portfolio.

the efficient frontierUnderstanding

NEWSLETTER

This l

ine rep

resents t

he effi cien

t fronti er

The op

t mal c

ombinat

on of risk

and reward

High expected reward

High risk

For every level of risk, there is some optmum combinaton of investments that

will give you the highest rate of return.

The combinatons of investments exhibitng

this optmal risk/reward trade-off form the

efficient fronter line.

DISCOVERY INVESTFUNDamentals

Harry Markowitz is an American economist born 24 August 1927. He is a recipient of the John von Neumann Theory Prize and the Nobel Memorial Prize in Economic Sciences. Markowitz is a professor of finance at the Rady School of Management at the University of California, San Diego. He is best known for his pioneering work in Modern Portfolio Theory, studying the effects of asset risk, return, correlaton and diversificaton on probable investment portfolio returns.

The efficient fronter is a concept within modern portfolio theory, conceived by Harry Markowitz, a US economist, in 1952. The underlying noton of the efficient fronter is that investment decisions are driven not only by selectng the investment with the greatest return, but the investment that achieves that level of return with the least amount of risk or volatlity.

Risk is an inherent part of higher reward. The efficient fronter theory assumes that given the choice of two portfolios with equal returns, investors will choose the one with the least risk. If investors take on additonal risk, they will expect to be compensated with additonal return. Moreover, different assets experience different levels of risk. To diversify ones portfolio, investors will combine different assets, such as equites, bonds, property, cash and other, in different measures, to form a diversified portfolio of assets that provide the maximum investment return based on ones risk tolerance.

There are endless possible permutatons of investments using the various asset classes that can be incorporated into an investment portfolio allocaton. The efficient fronter represents the series of optmal portfolios derived from the range of combinatons available. It ranges from the asset mix which is the least volatle, or demonstrates the least risk, and subsequently provides the lowest returns, to the asset mix which is the most volatle or risky and has the potental for the highest returns.

There are many portfolio permutatons, theoretcally an unlimited number of asset class combinatons, which are not an optmal portfolio mix based on the risk and return criteria, and therefore not as desirable. These portfolios will not lie along the efficient fronter. Instead they will lie below the fronter on the graph.

What the efficient frontier measures

Lower expected

returns

Expe

cted

ret

urn

of a

sset

mix

Higher expected

returns

Lower risk

Risk/Volatlity of asset mix Higher risk

The line represents the efficient fronter - the optmal combinaton of asset risk and return.

Each dot represents a portfolio with a mix of assets. The dots or portfolios closest to the efficient fronter are expected to show the best return based on the relatve risk.

The efficient fronter uses two measures expected return of a portfolio of assets and the associated risk or volatlity of the specific portfolio. Portfolios situated along the efficient fronter line represent the most optmal portfolio and mix of assets based on the expected return of the portfolio for investors when compared to the level of risk the investor will assume.

Portfolios situated along the efficient frontier


The efficient fronter helps one determine whether a portfolio mix is optmal in terms of the expected return when compared to the level of risk expected for the portfolio of assets.

Lower expected

returns

Expe

cted

ret

urn

of a

sset

mix

Higher expected

returns

Lower risk


When comparing the risk characteristcs of Portfolio B to the characteristcs of a portfolio with a similar risk profile (Portfolio A), one sees that the higher expected return of Portfolio B demonstrates a more optmal mix of assets than in Portfolio A.

Portfolio A

Portfolio B

Comparing the position of two portfolios

Portfolios situated further from the efficient fronter line are less optmal portfolios and combinatons of assets. The expected return for investors is less when compared to the relatve risk of the portfolio of assets.

Lower expected

returns

Expe

cted

ret

urn

of a

sset

mix

Higher expected

returns

Lower risk


As the portfolio moves further away from the efficient fronter, the rato of return to risk is less desirable.

A portfolio diverting from the efficient frontier line

Lower expected

returns

Expe

cted

ret

urn

of a

sset

mix

Higher expected

returns

Lower risk


For example, this portfolio has a relatvely high level of risk, for a relatvely small return.

As portfolios move further away from the efficient fronter, their risk and return characteristcs change, leading to high risk for portfolios with low expected investment returns.

A portfolio diverting further from the efficient frontier line

A

B


Asset classes along the efficient frontier line

In additon to using the efficient fronter to plot combinatons of portfolios that provide the optmum risk and return characteristcs, broadly speaking, one can also use the efficient fronter to plot asset classes based on the potental returns that they offer and inherent level of risk. Using the efficient fronter, investors may often see the various asset classes depicted as follows, which provides a good overview of the performance characteristcs of each type of asset.

Using the efficient frontier in investment planningHaving evaluated the theory around the efficient fronter line, one may queston how this can be used in individual portfolio and investment planning.

The efficient fronter is used by investment professionals to devise a range of portfolios that suit investors with varying return and risk requirements. Based on ones life stage, age, personal circumstances and investment objectves, one may be looking for a high growth investment and is happy for the increased risk required to achieve higher returns, or one may be risk-averse and require a steady investment with correspondingly lower risk.

Investment professionals use the efficient fronter as a basis for creatng pre-designed portfolios with a mix of assets and different risk and return characteristcs. These portfolios are often given names such as balanced income, which typically provides low risk and lower returns, balanced, balanced growth, growth and finally aggressive growth, which typically provides the potental for much higher returns at a higher level of risk.

There are no guarantees with any asset class or investment portfolio. Investors are advised to speak to their financial adviser before making any investment decisions. Discovery Invest offers a range of investment funds to provide investors with varying investment objectives and risk tolerances with optimal portfolios to achieve their long-term financial planning goals.

GM_16039DI_14/06/2012

Cash includes money held on deposit and also other money market securites, which can earn interest over tme. Cash is normally considered to be a temporary haven during periods of market volatlity, or in the tme preceding ones decision to invest.

Fixed interest including different types of bonds have different levels of risk. Generally fixed interest is considered lower risk than shares or property.

Property these are commercial propertes such as offices and warehouses, which are bought and then leased out to create income from the rent. Returns from property are generally lower than shares but can be higher than cash and fixed interest.

Equity also known as shares are considered one of the best investments to achieve good long-term investment returns. Shares can be quite volatle in the short term.

Lower Expected

Returns

Expe

cted

ret

urn

of a

sset

mix

Higher expected

returns

Lower risk


Cash

Fixed interest%

Property

Equity

Documents

Understanding the Efficient Frontier