Efficient Frontier
Categories: Econ, Financial Theory, Metrics
Captain Kirk was looking for the final frontier. This is something far more boring (unless you're thinking a lot about retirement...in which case it might be more interesting than boldly going where no one has gone before).
The efficient frontier is a mathematical way to express the best possible portfolio for any investor's risk/reward profile. As you probably know, Wall Street is all about the balance between fear and greed. Or risk and reward, to put it in more, well, Vulcan terms.
For any investor, there's a certain amount of risk they're willing to take on. The efficient frontier curve helps them figure out the best mix of investments to achieve the optimal growth for the amount of risk they're willing to tolerate.
Normally, the efficient frontier process gets used by defining your risk tolerance and then letting the math show you the best way to optimize your return. However, you can also use it to target a certain return level and then have the technique show you the best way to minimize your risk. You might do this if you have to make a certain amount for retirement. Just hope the curve doesn't settle on a point labeled "just bet on black and hope for a hot streak..."
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Finance: What is an Expected Return?8 Views
Finance, a la shmoop. what is expected return? Okay we've been experimenting for
months on libertarians with cancer in a gwangju prison. Our drug is gonna do one [ man swallows pill]
of three things. A. it may make the prisoners glow in the dark. Not all that
useful as a drug discovery but it would allow investors to sell the company to [man's face glows]
cirque de soleil who would be thrilled to cut down on bodypaint expenses. All
right well if event A happens investors will get at least a 20% return on our [circus performers shown]
money odds of the the glow must go on happening ? 35% . okay moving on. Event B, our
drug may well just kill them - yeah that's a bunch of libertarians in a gwangju
prison. Who's gonna notice, right? in which case investors lose all of their money [money on fire]
and the glow must go on just folds up tent, and goes away. The return there
would be zero. Odds of this happening? Well, 60% yeah
six out of ten. Probably gonna die. okay event C the drug cures cancer! If that [written explanation shown]
happens while investors get a thousand percent return on their money .Save the
world and in general improve their tinder match ratio by like a zillion.
Odds of this happening, well just 5% but hey it's worth a shot right?
So our adjusted probability chart looks like- this - see we got return and odds and [chart shown]
expect the case 2035, 7 yeah there we go.
So what is all this telling us ? Well that the overall expected return - yeah you
knew we'd get there eventually - is a 57% return on our investment. Great return!
bottom line do it the chance of curing cancer would be well worth the risk. And [people dance]
if not well at least there would be fewer bicycling accidents.