Now that we understand the benefits of diversification, the question of how to identify the best level of diversification arises. Enters the efficient frontier.

For every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be plotted on a graph, and the resulting line is the efficient frontier. Figure 2 shows the efficient frontier for two stocks – a high risk/high return technology stock (Google) and a low risk/low return consumer products stock (Coca Cola).

Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum expected return for a given level of risk. A rational investor will hold a portfolio that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line.