How_Money_Works_-_The_Facts_Visually_Explained

The optimal portfolio

A portfolio consists of a selection of different assets. The optimal

portfolio achieves the ideal trade-off between potential risk and likely

reward, depending on an investor’s desired return and attitude to risk.

Efficient frontier

The efficient frontier is considered

the optimum ratio between risk and

reward—that is, 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

suboptimal, either because they do

not provide enough return for that

risk level, or because they have too

high a level of risk for a defined rate

of return. Asset correlation, a

measure of the way investments

move in relation to one another, is

important to the efficient frontier.

A portfolio is better balanced if the

prices of its securities move in

different directions under similar

circumstances, effectively balancing

risk across the portfolio.

How it works

The optimal portfolio is a mathematical model that

demonstrates that an investor will take on increased

risk only if that risk is compensated by higher expected

returns, and conversely, that an investor who wants

higher expected returns must accept more risk.

The optimal portfolio reduces risk by selecting and

balancing assets based on statistical techniques that

quantify the amount of diversification between

assets. A key feature of the optimal portfolio is that

an asset’s risk and return should not be assessed on its

own, but by how it contributes to a portfolio’s overall

risk and return. The main objective of the optimal

portfolio is to yield the highest return for a given risk or

the lowest risk for a given return, these being investors’

most common goals.

AVERAGE ANNUAL RETURNS

E

ff

ic

ie

nt

fr

on

tie

r

$

Investor A is on the efficient frontier and

getting the highest return possible for

their accepted level of risk. This smart

investor is maximizing returns while

limiting exposure to volatility.

1952

the year Nobel Laureate

Harry Markowitz

introduced the

efficient frontier

concept

Th

e^ o

pti

ma

l^ ra

tio^

bet

wee

n^ ris

k^ an

d^ rew

ard

US_194-195_Optimal_Portfolio.indd 194 13/10/2016 16:21