What does the efficient frontier illustrate, as introduced by CAPM?

The efficient frontier, as introduced by the Capital Asset Pricing Model (CAPM), represents a crucial concept in modern portfolio theory. It illustrates the set of optimal portfolios that offer the highest expected return for a given level of risk. Essentially, the efficient frontier provides investors with a clear visual representation of the trade-off between risk and return.

When constructing a portfolio, an investor seeks to achieve the best possible returns while managing the associated risks. The portfolios that lie on the efficient frontier are those that have been optimized, meaning they provide the maximum expected return for each unit of risk taken. This means that any portfolio beneath the efficient frontier is considered suboptimal because it either offers lower returns for the same level of risk or entails higher risks for the same level of expected returns.

In summary, the efficient frontier is a foundational framework that helps investors identify the most efficient portfolios, ensuring they make informed decisions about how to allocate their assets in relation to their individual risk tolerance and return expectations.