What is Markowitz’s Efficient Frontier?
The Markowitz efficient set, also known as the efficient frontier, is a mathematical concept that depicts the combinations or portfolios that produce the highest predicted return for a given amount of risk.
Usually represented graphically, the expected return on the y-axis is plotted against the standard deviation as a measure of risk on the x-axis to create this frontier. It demonstrates how a portfolio’s risk and return trade-off works.
Three crucial things must be considered when constructing the frontier:
- Expected return,
- Variance/ Standard deviation as a measure of the variability of returns, also known as risk and
- The covariance of one asset’s return to that of another asset.
Example of Markowitz Efficient Frontier:
Effects of Correlation on Portfolio Risk:
Efficient Frontier revolves around the correlation between securities. Broadly, we can have three scenarios for correlation.
- Correlation= 1 provides no diversification benefits and results in a weighted average of individual deviations in the portfolio.
- Correlation<1When portfolio variation falls below the weighted average of individual variances, diversification occurs. The greater the benefit, the lower the connection.
- Correlation = −1, it is indeed possible to structure a portfolio with zero variance [i.e., a synthetic risk-free asset.
Why is Markowitz Efficient Frontier critical?
Markowitz Model is a valuable tool in portfolio selection, at least theoretically. It is a quantitative technique that allows an investor to manage resources based on the risk-reward trade-off. This tool assists investors in getting the most out of their money by assessing the risk and returns associated with an investment portfolio and helping the investor make appropriate asset allocation or individual investment adjustments.