Efficient Frontier Flashcards
What is the efficient frontier?
A key concept in MPT is the Efficient Frontier. The attached graph illustrates this in graphical form. Any point on the curve will represent the best return for a given level of risk. Where on the curve the investor should invest will be determined by their attitude to risk and objectives
What do the 3 points on the attached efficient frontier picture represent?
The three portfolios shown on the curve, portfolio A would represent the best combination of risk and return for a lower risk investor, B for a medium risk and C for a high-risk investor. Portfolios under the line would be rejected because they either offer below optimal returns for the risk taken or represent a higher level of risk for a required return
What does Model Portfolio Theory argue?
MPT argues that a rational investor would never invest anywhere other than on this efficient frontier since to do so would mean accepting a lower level of return for a given level of risk than could be achieved through a better optimised portfolio. Basically, between two portfolios offering the same return, an investor would choose the one with the least risk. Higher risk would only be chosen if the returns were greater.
What are the problems with the efficient frontier?
Standard deviation is not a precise tool for investments – returns are not always normally distributed
The model relies on past performance and historic data to give the ‘expected return’ – this is flawed in itself since, as we spend lots of time telling clients, ‘past performance is not a guarantee of future performance’.
The model doesn’t include costs and charges.
An investor doesn’t choose their portfolio based on risk alone, there may be other factors to consider.
It assumes that the portfolio is made up of index funds the same as those used in the model
What is systematic risk?
The systematic risk is the risk that
will impact on the market as a whole – changes in interest rates, terrorist attacks, the global Covid-19 pandemic etc.
will all have an impact on every company within the sector
Diversification cannot reduce systematic risk.
What is non-systematic risk?
The non-systematic risk is the risk that relates to the individual security, for example the risk that the
management of the company will make a bad decision, a new competitor will enter the market etc
While market risk will lead to a general upward or downward movement in allsimilar securities, the non-systematic risk will be specific to the company. Some companies will do better than others even given the same prevailing market conditions. Therefore diversification will reduce non-systematic risk.
How can we diversify out of non-systematic risk?
If we hold shares in only one company and that company goes bust, we stand to lose most if not all of our money. On the other hand, if we spread our investment around 100 different companies, the maximum risk we will be exposed to as a result of the individual risk applying to each company is 1%. Even with this spread of investments, the market risk will remain since events that impact the market as a whole will impact on all 100 of our stocks.
The most recent academic studies suggest that an individual would not need to hold more than 35 different securities to effectively manage non-systematic risk through diversification.
