Definition
The efficient frontier is a curve in risk-return space representing portfolios that cannot be improved—you cannot increase return without increasing risk, or decrease risk without decreasing return. Portfolios below the frontier are suboptimal (better alternatives exist). The tangent point with the capital market line identifies the optimal risky portfolio.
lightbulb Example
After analyzing 20 stocks, the efficient frontier shows portfolio options ranging from 7% return/8% vol (conservative) to 14% return/22% vol (aggressive). A portfolio earning 9% at 15% vol lies below the frontier—a better 9% return is achievable at only 10% vol.
verified_user Key Points
- Portfolios on the frontier are optimally diversified
- Below the frontier = suboptimal (room for improvement)
- Capital market line extends frontier with risk-free lending/borrowing
- Requires return, volatility, and correlation estimates