Markowitz Efficient Frontier

Markowitz Efficient Frontier

The risk and return of all portfolios plotted in risk-return space would be dominated by efficient portfolios. Portfolio may be constructed from available securities. All the possible combination of expected return and risk compose the attainable set. The following example shows the expected return and risk of different portfolios.

Portfolio Risk and Return

The attainable sets of portfolios are illustrated in figure. Each of the portfolios along the line or within the line ABCDEFGJ is possible. It is not possible for the investor to have portfolio outside of this perimeter because no combination of expected return and risk exists there.

When the attainable sets are examined, some are more attractive than others. Portfolio B is more attractive than portfolios F and H because B offers more return on the same level of risk. Likewise, C is more attractive than portfolio G even though same level of return is got in both the points; the risk level is lower at point C. In other words, any portfolio which gives more return for the same level of risk or same return with lower risk is more preferable than any other portfolio.

Among all the portfolios, the portfolios which offer the highest return at particular level of risk are called efficient portfolios. Here the efficient portfolios are A, B, C and D, because at these points no other portfolio offer higher return. The ABCD line is the efficient frontier along which all attainable and efficient portfolios are available. Now the question raised is which portfolio the investor should choose? He would choose a portfolio that maximizes his utility. For that utility analysis has to be done.