Efficient Frontier Explained: How to Balance Risk and Reward

Introduction: What is the Efficient Frontier?

If you have ever wondered how to get the most return for the least possible risk, you have already brushed up against the concept of the efficient frontier, even if you did not know the term. In simple terms, the efficient frontier is a theoretical curve that maps out the very best portfolios: those that deliver the highest expected return for every possible level of risk, and vice versa. Any portfolio that is not on this line can potentially be improved.

Understanding where your investments sit in relation to the efficient frontier is a key step toward smarter, more calculated investing.

Modern Portfolio Theory Recap

The concept of the efficient frontier is grounded in Modern Portfolio Theory (MPT), developed by Harry Markowitz. MPT formalised the idea that you can combine different assets in a portfolio to achieve an overall risk/return trade-off that’s better than the sum of its parts. By carefully selecting assets that don’t all move together, you can lower the portfolio’s overall risk without sacrificing returns.

Key takeaway: Diversification is not just about owning many assets, it is about owning the right mix of good assets that work together efficiently.

Efficient Frontier Visualisation

The efficient frontier can be visualised on a graph, helping you make smarter investment choices by showing you which portfolio combinations offer the highest possible returns for a given level of risk. This is the essence of the efficient frontier.

On this graph, the horizontal axis (x-axis) represents risk, often measured as volatility or the standard deviation of portfolio returns. The vertical axis (y-axis) represents the expected return, or what you hope your investment will earn over time. The efficient frontier can be imagined as a curve on this graph, tracing the optimal portfolios that deliver the best trade-off between risk and return. Portfolios plotted on this curve are considered “efficient” because, at each level of risk, they provide the highest expected return possible. Portfolios that fall below the curve are suboptimal — meaning you cannot achieve higher returns without taking on additional risk, or reduce risk without sacrificing returns.

For example, a portfolio that lies below the efficient frontier might offer a 6% expected return with a risk level of 12%, while another portfolio on the curve offers an 8% return at the same 12% risk. The latter is more efficient. This curve usually forms an upward-sloping convex shape, created by the non-linear portfolio risk equation and the linear portfolio return equation,  reflecting the principle that increasing returns require accepting greater risk.

Understanding where your portfolio sits relative to the efficient frontier helps you identify whether your current asset allocation is optimal or if there is room for improvement. The efficient frontier is a powerful portfolio visualiser that guides investors toward constructing balanced portfolios — achieving the maximum expected return for their chosen risk level.

By using portfolio visualisation software like Diversiview, you can plot your portfolio against the efficient frontier and explore how adjustments to your asset allocation shift your risk-return profile, moving you closer to an optimal position.

Efficient Frontier Example

Consider this portfolio composed of US and ASX stocks. Each combination of weights assigned to these assets creates a unique point on the risk-return graph. By calculating millions of such combinations, Diversiview can draw the efficient frontier (see below image). 

Rather than blindly guessing, you can use this portfolio visualisation to see the likely impact of increasing equity exposure or adding diversification in real time. This empowers you to make decisions aligned with your financial goals and comfort with risk. The efficient frontier is not static; as markets change, so does the shape and position of the curve, highlighting the importance of regular portfolio analysis and optimisation.

Why You Should Know Where Your Portfolio Sits

• Opportunity for improvement: If your investments are not on the efficient frontier, you may be taking more risk than necessary for the returns you get, or missing out on higher returns for the same risk.
• Personalisation: The “right” place on the frontier depends on your risk tolerance and financial goals. A retiree may prefer a low-risk position, while a younger, aggressive investor may opt for more risk and higher return.
• Data-driven confidence: Knowing your exact position helps you avoid emotional decisions and plan rationally for the future.

How Diversiview Helps You With Efficient Frontier Investing

Calculating your portfolio’s position on the Efficient Frontier — the optimal balance of risk and return — is a complex mathematical process. It involves analysing countless possible asset combinations to identify those that deliver the highest expected return for a given level of risk. Doing this by hand or with basic tools is practically impossible.

That’s where Diversiview comes in. We’ve built powerful, easy-to-use tools that handle this complexity for you, so you can focus on making smarter investment decisions. Here’s how you can calculate your Efficient Frontier positions in just a few simple steps:

1. Upload Your Portfolio: Import your current holdings by linking your broker accounts, uploading CSV files, or entering investments manually. This lets Diversiview understand your unique asset mix and current allocation.
2. Run Portfolio Analysis: Diversiview creates an analysis report of your portfolio. Inside the “Your Portfolio Universe” diagram, shows your current portfolio position, a multitude of potential risk-return positions, and the Efficient Frontier.
3. Select Efficient Frontier Positions to Calculate: Go to the “Calculate Efficient Frontier Positions” section, where you can choose to calculate allocations for different points along the Efficient Frontier. You’ll be prompted to select your desired risk level by dragging a volatility selector, with the expected return updating as you adjust.
4. Run the Optimisation: After selecting the risk-return combination that matches your goals, click ‘Run Analysis’. Diversiview’s advanced algorithms will quickly calculate the asset allocation that positions your portfolio exactly at that point on the Efficient Frontier.
5. Review Your Customised Report: Within minutes, your customised analysis report appears on your Diversiview dashboard. It shows the calculated optimal allocation, expected return, risk metrics, and a visual representation of your portfolio’s new position on the Efficient Frontier.

This is not manual guesswork, Diversiview’s sophisticated calculation does all the heavy lifting, turning complex portfolio optimisation into an accessible process. See how to calculate an efficient frontier allocation with Diversiview.

Conclusion

The efficient frontier is not just a theory for academics, it is a practical, visual way for every investor to make sure they are getting the best trade-off between risk and return. Why settle for less?

Take control of your financial future! Open a free Diversiview account and get one FREE Portfolio Analysis, and discover how smart, data-driven decisions can help you achieve your goals.

Note: Diversiview does not provide financial advice or recommendations. Investment Portfolio Analyses are intended to provide investors with data driven insights and information. You should do your own further research, or speak with a licenced professional before making changes to your investment portfolio.