The term “efficient” has a very specific definition in the context of portfolio management. An efficient portfolio is a specific set of investment assets, including stocks, bonds, commodities and money market instruments that create the highest possible rate of return for a given desired level of risk. This is the most essential feature of an efficient portfolio, however, there are other elements that each type of efficient portfolio will have.
Expected Return on Investment
The most essential feature of an efficient portfolio is the expected return on investment. This represents the amount of risk that an investor is willing to accept in exchange for a return on their invested money. Usually expressed in relative terms to the risk-free rate and inflation. The risk free rate is the yield that can be obtained by investing in US government securities .. For example, if an investor can get an annual return of 3% to invest only in US government securities then an expected ROI of 10% is equal to 7% of the risk-free rate, or 10% – 3% = 7%. Due to the fact that inflation erodes the value of money and assets over time, it is important to have some idea or inference about the future level of inflation, so that it can be considered a matter provisional in the expected rate of return . If the expected inflation is 2% and the expected return on investment above the risk-free investment is 7%, then the ROI after inflation will be 7% – 2% or 5%.
An efficient portfolio is not risk free. Risk is a feature of an efficient portfolio. Unsystematic risk represents specific risks attributable to assets individual within the portfolio. Every action, corporate bond, government bond and investment has its own risks. For example, if an efficient portfolio includes shares of IBM, then IBM particular hazards are present in the portfolio. Unsystematic risk can be mitigated by diversification. The greater variety and quantity of assets is in the portfolio will be more diversified. This diversification will reduce or eliminate unsystematic risk. Systematic risk refers to the general risks found in markets economies and actions. This is the risk that an investment in a portfolio aims to understand and quantify.
Another essential feature of an efficient portfolio is its liquidity. This refers to the speed at which the portfolio can be converted into cash. Liquidity requirements must be logically linked to the specific circumstances of the investor . If the investor is using their investments as mode of life, then it must be very fluid. If the portfolio of the investor serves the purpose of creating wealth for future retirement, then there has to be liquid in the short term.