Efficient Set of Portfolios 🏆📈
If the Feasible Set is the "Menu" of all possible foods, the Efficient Set is the list of only the healthiest and most delicious choices. Investors should only focus on the Efficient Set.
1. Defining the Efficient Set
The Efficient Set (also called the Efficient Frontier) is the collection of all portfolios that satisfy the Mean-Variance Criterion:
- No other portfolio has a higher return for the same level of risk.
- No other portfolio has a lower risk for the same level of return.
2. Locating the Efficient Frontier
On a graph of Expected Return (Y-axis) vs. Risk (X-axis), the Efficient Frontier is the upper-left boundary of the feasible set.
- Minimum Variance Portfolio (MVP): This is the left-most point of the frontier. It is the portfolio with the absolute lowest risk possible.
- Maximum Return Portfolio: This is the top-most point, usually consisting of 100% investment in the single check with the highest expected return.
3. Why the Frontier is Curved
The "bowed" shape of the frontier exists because of Diversification. Because the stocks in the portfolio are not perfectly correlated, the risk drops as we mix them, creating a curve that pushes outward to the left.
Calculated by Harry Markowitz, this frontier proved that you can actually get a Higher Return with Lower Risk by moving from a single stock to an efficient mixture of stocks.
Summary
- The Efficient Set consists of the "best-in-class" portfolios.
- Every point on the Efficient Frontier is a non-dominated portfolio.
- The frontier is the upper-left boundary of the feasible set.
- All rational investors, regardless of their own risk tolerance, will choose a portfolio from the Efficient Set.
Quiz Time! 🎯
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