Discussion and 1 reply

  Respond to one of the following topic to present to your peers in a professional analysis using a minimum of 350 words. 

• Risk versus Return.  Investors will choose among various portfolios based upon their individual risk tolerance.  Using our text and external sources, explain how investors can create an efficient portfolio?

 

Your critical response should have a minimum of two sources published in the last 12 months which should be used to support the content within the postings, proper in-text citations.  Your responses should be professionally written and correctly formatted references should be prepared consistent with the APA. The list of references should be physically positioned at the end of the postings.

Post by classmate

 

According to NASDAQ.COM an efficient portfolio is a portfolio that provides the greatest expected return for a given level of risk (i.e., standard deviation), or, equivalently, the lowest risk for a given expected return (Efficient Portfolio Definition, n.d.).

One way is diversifying the assets in your portfolio leads to increased returns and decreased risks, which leads to a portfolio that is located on the efficient frontier. Therefore, diversification can create an efficient portfolio.

Another tool that is used is the efficient frontier theory that was introduced by Nobel Laureate Harry Markowitz in 1952 (Ganti, 2024).  An efficient frontier is a set of investment portfolios that are expected to provide the highest returns at a given level of risk. A portfolio is said to be efficient if there is no other portfolio that offers higher returns for a lower or equal amount of risk.

Efficient Frontier helps investors understand the potential risks and returns in their portfolios and analyze how they compare to the optimal set of portfolios that are considered to be efficient. Doing so helps investors to accordingly change their investing strategies by understanding the level of risk that pertains to each portfolio. It should be noted that there is no single efficient frontier for everyone. Each one is different for every investor because it depends on multiple factors – such as the number of assets in the portfolio, the industry of the assets, and the degree of the investor’s risk tolerance.

How Does an Efficient Frontier Work?

It is represented by plotting the expected returns of a portfolio and the standard deviation of returns.  A portfolio is then plotted onto the graph according to its expected returns and standard deviation of returns. The portfolio is compared to the efficient frontier. If a portfolio is plotted on the right side of the chart, it indicates that there is a higher level of risk for the given portfolio. If it is plotted low on the graph, the portfolio offers low returns. In our example, there are two assets. The first asset’s expected return is 15%, and the other shows an expected return of 7%. The standard deviation of the first asset is 18%, whereas the second asset shows a standard deviation of 10%. The table below shows the standard deviation and expected returns for a portfolio that consists of both assets. When data points in the table are plotted, it shows an efficient frontier.

Limitations of an efficient frontier is that it is built on assumptions that may not accurately portray realistic situations. For example, it assumes that all investors think rationally and avoid risks. It also assumes that fluctuations in market prices do not depend on the number of investors and that all investors enjoy equal access to borrowing money at a risk-free interest rate. (C. Team, 2024)

Reference:

Efficient portfolio Definition. (n.d.). Nasdaq. https://www.nasdaq.com/glossary/e/efficient-portfolioLinks to an external site.

Ganti, A. (2024, June 22). Efficient Frontier: What it is and how investors use it. Investopedia. https://www.investopedia.com/terms/e/efficientfrontier.aspLinks to an external site.

Team, C. (2024, May 22). Efficient Frontier. Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/efficient-frontier/#:~:text=A%20portfolio%20is%20said%20to,frontier%20is%20a%20curved%20lineLinks to an external site..