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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.
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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
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DISCOVERY INVESTFUNDamentals
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
Risk/Volatlity of asset mix Higher 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
Risk/Volatlity of asset mix Higher 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
Risk/Volatlity of asset mix Higher 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
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DISCOVERY INVESTFUNDamentals
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
Risk/Volatlity of asset mix Higher risk
Cash
Fixed interest%
Property
Equity