What Is the Efficient Frontier and How Do You Calculate It?

What Is the Efficient Frontier and How Do You Calculate It?

Posted by on Oct 22, 2021

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The efficient frontier is a concept in finance that can help you identify a potential portfolio for any given return requirement and level of risk.

The concept was developed in 1952 by Harry Markowitz, and since then, it's been used to help investors build portfolios with higher expected returns and lower associated risks. By understanding the efficient frontier, you can use it as a tool for making more informed real estate investing decisions.

Definition of Efficient Frontier

An efficient frontier is a group of investment portfolios with the most anticipated return for a given level of risk. A real estate investor’s portfolio is considered efficient when there is believed to be no other option that offers the potential for:

  •   A higher expected return for the same level of risk
  •   A higher expected return for a lower level of risk
  •   The same expected return for a lower level of risk

The degree to which portfolios are placed on an efficient frontier depends on your risk tolerance for your assets. Risk-seeking investors might feel comfortable moving forward with assets on the right end of the frontier, while those who are risk-averse might make investments that land on the left end of the curve.

How to Calculate Efficient Frontier

An efficient frontier is represented by a curved line depicting the various risks and rewards of your assets. To determine the potential return on your portfolio, you must first calculate the expected rate of return based on the weighted average of individual assets. Make your calculations using this formula for efficient frontier.

E(Rp) = w1E(R1) + w2E(R2)

The w represents the weight of each asset, and all assets must add up to 1. The E(R) is the expected return of every asset in the portfolio. As an example, your portfolio has two stocks. Stock A is 25% of your portfolio with an expected return of 5%, and Stock B is 75% of your portfolio with an expected return of 7%. The formula would look like this:

E(Rp) = 0.25(.05) + 0.75(0.7)

After calculating the assets and multiplying by 100, you will get a 53.75% expected return on your portfolio.

If trying to decide between investment opportunities, most investors would select the portfolio that offers a higher return when performing these calculations. 

Why Calculating Efficient Frontier Is Important for Real Estate Investors

Understanding the efficient frontier helps investors analyze the potential returns and risks of an investment portfolio, which means investors may be able to better adjust their individual investments or reallocate their assets accordingly to help manage significant financial losses. As real estate can provide diversity and help manage risk when included in a portfolio with traditional assets, it can be beneficial to incorporate real estate, as the goal of creating an efficient portfolio is for an investor to get the highest return with the lowest amount of financial risk.

The challenge in real estate is that, unlike the stock or crypto markets, the future expected equity of assets is determined from minimal data. At best, measurements of return and risk on real estate values are available quarterly based on appraisals.

It’s also important to realize that while transaction times in other investment areas like the stock market are virtually instant, the process of investing in real estate is much slower, often requiring involvement from lawyers and financial institutions. This is potentially problematic because a longer transaction time can have an impact on the value of the expected returns from your portfolio.

Real estate transactions also come at a cost to investors; expenses include lawyer fees, land transfer taxes, and more. For the transaction to remain profitable, real estate investors must consider these costs against the potential return of the asset before proceeding with the investment. Using the calculation for efficient frontier can help you make these decisions based on hard data.

 

Make Educated Investment Decisions

Knowing about the efficient frontier before making your next investment can help you calculate the risk, reward, and volatility of your portfolio. This can help ensure you select portfolio options designed to maximize returns while managing risks associated with each individual asset.

 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Risk tolerance is an investor’s general ability to withstand risk inherent in investing. There is no guarantee a recommended portfolio will accurately reflect your tolerance to risk. There is no guarantee that the investment objectives of any particular program or concept will be achieved. Unless otherwise noted all investments involve risk, including the loss of principal. Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk.

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