Pros and Cons of an Efficient Portfolio

Using the equations of the Modern Portfolio Theory, investors attempt to create a portfolio that achieves maximum return for minimum risk. The kind of efficient portfolio the theory creates, however, has its benefits and drawbacks.

The benefits

The main benefit of an efficient portfolio is its low volatility risk for a given level of return. By selectively allocating a portfolio's investments to a wide variety of asset classes and securities, an efficient portfolio decreases risk. This process is called asset allocation.

By investing in assets whose performances are not highly correlated with each other, an efficient portfolio performs well despite the ups and downs of specific markets. The degree of volatility for each asset class tends to remain the same over time, so even though investors cannot control the markets, they can control their risk levels in relation to their returns.

The drawbacks

Don't expect an efficient portfolio to beat the market, however. There is no known way to select investments that consistently outperform all other investments in all economic environments. At best, an efficient portfolio will underperform its best asset class holdings while outperforming its worst asset class holdings. However, the tradeoff is found in lower volatility. Like the tortoise and hare, the aim is slow and steady to win the race.

Designed for risk-averse investors, an efficient portfolio can be a valuable investment tool for achieving your financial goals without subjecting yourself to intolerable risks.