It is possible to calculate the risk/return ratio for every possible portfolio at any given time. This ratio for the stock market portfolio is composed from the risk/return ratio of all stocks in the portfolio AND the risk/return ratio of the stocks to each other. The right combination of stocks can substantially minimize the risk of a portfolio. It becomes possible to compare portfolios with each other. Each dot in the image represents one possible portfolio. As this graph clearly shows, there is only a certain range with regard to the relationship of risk and return, where portfolios can be situated. If the topmost points are connected, a line becomes visible: the efficient frontier line. All portfolios on this line have the optimum combination of stocks, meaning an optimum risk/return ratio.
All those portfolios give the highest return for the amount of risk an investor is willing to take - or defined in another way, have the lowest risk for the return to be achieved. As you can see in the risk return portfolio graph, at a certain level the gradient of the efficient market frontier line drops. At this level you have to risk more for the same profit increase in percentage terms.
Capital Market Line
The method to determine the best position on the efficient frontier line is the capital market line (CML). The capital market line is, graphically, a tangent line that can be drawn on a graph, connecting the return of risk-free-asset with the efficient market frontier. An investor is only willing to accept higher risk if the return rises proportionally. The CML shows where the most efficient portfolio lies on the efficient frontier line.
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