The Inefficient Frontier

I was in a meeting the other week where someone started talking about “The Efficient Frontier.” I had heard of the phrase, but wasn’t able to immediately recall the exact definition, though it was made clearer as this person charted out the different portfolio mixes the following groups take: founders, private investment funds, and incubators. The optimal place to be on the curve, he argued, was right above the point where the return on investment would be inefficient.

As I read more about the term, I realized it can be different things to different people. Here’s the Wikipedia definition:

The efficient frontier is a concept in modern portfolio theory introduced by Harry Markowitz and others. A combination of assets, i.e. a portfolio, is referred to as “efficient” if it has the best possible expected level of return for its level of risk (usually proxied by the standard deviation of the portfolio’s return). Here, every possible combination of risky assets, without including any holdings of the risk-free asset, can be plotted in risk-expected return space, and the collection of all such possible portfolios defines a region in this space. The upward-sloped (positively-sloped) part of the left boundary of this region, a hyperbola, is then called the “efficient frontier”. The efficient frontier is then the portion of the opportunity set that offers the highest expected return for a given level of risk, and lies at the top of the opportunity set (the feasible set). For further detail see modern portfolio theory.

So, it makes sense that angels, VC firms, and the like want to be on the efficient side of this frontier. But, what then of the folks who are beneath it? It is cliche to say founders take on extremely concentrated risk, but taken within this particular framework, the majority of founders are on “The Inefficient Frontier.” The word “inefficient” isn’t a good word. It implies friction, sub-optimality, and rewards that may not be properly tied to performance. Seen in this slightly different yet powerful perspective, it is a good reminder for me (having been through one of these myself) that a founder’s frontier is often inefficient to begin with, and getting to that point of efficiency requires significant energy to overcome the brutal laws of gravity.

Haystack is written by Semil Shah, and is published under a Creative Commons BY-NC-SA license. Copyright © 2018 Semil Shah.

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