Efficient Frontier

Let’s look at two broad representations of asset classes – a stock index and a bond index. If both asset classes are combined into a series of portfolios, a line would be drawn representing different weightings of the two classes. Asset Allocation really comes into play when more and more asset classes are added. Recall Modern Portfolio Theory states that by combining investments that do not always behave the same way one can reduce risk and increase the chances for return. Below is a graph of this effect. The key takeaway in this illustration is the idea of efficiency. If we look at a dot on the red line below, this portfolio is inefficient because for the same level of risk, one can increase return. Conversely, if the investor is comfortable with that level of return, they can significantly reduce their risk. In both cases, it is logical to invest in the more efficient portfolio. Any combination of investments that is below the green line is inefficient so we call this line the Efficient Frontier.

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