February 2, 2015
What is the efficient frontier and how can it be used to help you become a more informed investor?
What is the efficient frontier and how can it be used to help you become a more informed investor?
The efficient frontier is a graph depicting a curve that shows the level of return which should be expected from a level of risk. You should use this to become a more informed investor because it will allow you to evaluate whether an investment is earning a return commensurate with the level of risk you are taking. You always want to maximize your return for each level of risk you invest at. For example, when investing in government T-Bills, the risk is almost non existent, but so are the returns, therefore when plotting this investment of the efficient frontier, it will be on the curve near the origin. This result is the expected result of a T-Bill investment and the investment would land on the curve. Alternatively if you evaluate an investment that shows high risk and little return, you would see it on the chart as being to the right of the curve. In evaluating an investment you never want to experience more risk than the return, therefore always make sure that you keep you investments on the curve or at a higher return than the plotted level of risk.
The efficient frontier is a set of portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are not as good, because they do not provide enough return for the level of risk you are putting up with. Because portfolios off of the efficient frontier have a higher level of risk for the defined rate of return you want to have investments that fall in to those groups. You would want a well mixed portfolio. One way that your portfolio may have to much risk for the return would be if you held a large amount of junk bonds or long term bonds that did not pay well. You want to know how much risk you are taking and what you should expect to get off of that risk. If you make risky investments and only can expect a %5 return then those investments are no good. You want a well mixed portfolio and if you want a high yielding portfolio make sure you know the risk that goes along with it. If you have a portfolio that is all stocks and a third emerging markets make sure you know the risk that goes along with that investment and be willing to hold on to it for a long time.
Those were great answers, gentlemen. I have little to add. Well done!