Understanding the Efficient Frontier

The **Efficient Frontier** represents the best possible portfolios—those that provide the **highest return for the least amount of risk**.

How Portfolio Return Works

A portfolio’s return is based on the returns of the stocks it contains, weighted by how much is invested in each.

- The **weight** of each stock determines its contribution to the portfolio. - The **expected return** reflects the potential gain from the portfolio.

Why Correlation Matters

Correlation measures how stocks move in relation to each other. It plays a key role in risk reduction:

• **Low correlation** → Stocks move independently, helping reduce overall risk.
• **Negative correlation** → When one stock goes up, another goes down, creating strong diversification.
• **High correlation** → Stocks move together, reducing diversification benefits.

How Portfolio Risk is Determined

The risk of a portfolio depends on:

• The individual risk of each stock.
• The weight of each stock in the portfolio.
• The correlation between stocks.

Lower correlation leads to better diversification and lower overall risk.