Efficient Frontier for a Portfolio of Two Assets

When you plot the risk-return profile of all these portfolios, what you see is the feasible set of portfolios.

Let’s take an example to understand this. Let’s say we have two securities A and B with the following expected returns, standard deviation, and correlation. Below you will also see 6 different portfolios with varying proportions of A and B.

When we plot the risk-return profile of these portfolios, it looks as follows:

Notice that there is a minimum variance portfolio with lowest risk on the efficient frontier.

We can make the following observations from this:

• There are benefits of diversification, as the risk reduces when we combine assets in the portfolio.
• There is a Minimum Variance Portfolio (Portfolio 3) that has the minimum risk.
• The feasible set or opportunity set is represented by the entire curved line.
• The curve bends backwards.
• Investors invest above the Minimum Variance Portfolio (MVP), as any portfolio below it does not have an optimal risk-return profile.