A method derived from financial portfolio theory to find out, given a set of project proposals, the optimal project portfolio (i.e. selection of projects) that will maximize value for the organisation at each level of investment or available resources.
Very few companies can boast the kind of resources or investment budget to engage in every viable project proposal that they identify. A key question of project portfolio management thus becomes: how do I select the projects I invest in, so that I maximise the value I will obtain from them, given my limited investment budget / resources?
The efficient frontier theory aims at answering that question.
Dr Michael M. Menke offers his perspective on what is the "Efficient Frontier" in the context of Portfolio Management (Watch the video)
Why use the Efficient Frontier?
The Efficient Frontier helps answer some important questions:
- With my current level of budget, what is the best selection of projects to maximise the value of my portfolio? The one on the Efficient Frontier for my current level of budget.
- What is the minimum amount of investment I need to obtain a specific level of returns? The cost of the portfolio on the Efficient Frontier for the level of returns that I need.
- Given our current portfolio, are we over-spending in regards to the expected level of returns? How far away are we from the portfolio on the Efficient Frontier for the level of returns we are at?
- If we decide (because of political reasons or other) to select a sub-optimal set of projects, how much are we over-spending or how much value are we leaving on the table? We are over-paying by the difference between the cost of our selected portfolio, and the cost of the portfolio on the Efficient Frontier for the same level of returns. We are leaving on the table the difference between the returns of our selected portfolio, and the returns of the portfolio on the Efficient Frontier for the same cost.
- Considering our current portfolio, is there a way we could obtain more value with a lower level of investment? Can we change our portfolio selection so as to inch closer to the efficient frontier?
In addition, the visual nature of the Efficient Frontier helps create a different perspective by helping managers and decision-makers understand the relationship between the value created by the portfolio and the costs incurred, and better measure the trade-offs entailed by the decisions they take.
The Efficient Frontier method is particularly useful for industries or business models where:
- projects require very large investments, especially at the beginning of the project or program
- the benefits will be realized several years down the road, and / or
- projects are seldom killed
because it builds the optimal portfolio before the projects are started. So this method is particularly used in the pharmaceutical and biotech, aerospace & defense and chemical industries.