MPT Efficient Frontier for Portfolio Optimization
Modern Portfolio Theory (MPT) recognizes that investment returns also carry risks.
When assembling a portfolio of risky assets, it is necessary to account for these
two components as well as the correlation among the assets.
When risky assets are combined in a portfolio, the expected return of the
portfolio, E(Rp) is the weighted average of the returns for each asset. If the
asset returns are not perfectly correlated, the expected risk of the portfolio is
somewhat more complicated. By convention, standard deviation, the square root of
the variance, is a proxy for asset risk.
The Efficient Frontier plots in riskexpected return space every possible
combination of assets A, B, and C. The upper edge of the curve represents
each outcome for which the portfolio return is maximized for a given level of portfolio risk.
The ‘blue star’ shows the return along the efficient frontier at the risk level
selected by the slider. Additionally, the shares of assets A, B, and C for the
portfolio that produced this point are displayed to the right of the graph.
