Understanding The Efficient Frontier in Project Portfolio Investment Decision Making
By Eduardo Levenfeld
It’s common when companies are approving project proposals, ordering by priority and then selecting one by one till reach the budget limit, the results they achieve be good but not efficient, or, in other words, the portfolio will not deliver the maximum value with the present cost limit (budget limit).
You are probably wondering to know if there is a well defined way to figure out the most efficient projects combinations according to budget limits and other constraints and, yes, there is a method called Efficient Frontier that’s the scope of this introductory post.
The Efficient Frontier
In 1952, the Nobel Prize winner Harry Markowitz published an article named “Portfolio Selection” in which he defined the Modern Portfolio Theory (MPT), and, according to MPT, he concluded that an optimal portfolio is the one that delivers the maximum return for a given risk level. Further he defined this risk as the standard deviation of the return and suggested the assets diversification in a portfolio as a way to reduce the variance of the return.
This theory (MPT) was adopted widely in finance and, more recently, to project portfolio investments, so, the idea of multiple portfolios, each one optimized for a given level of risk became known as “Efficient Frontier”.
The Efficient Frontier in Project Portfolio Investment Decision Making
Based on the Efficient Frontier concept a graphical model was created where we can visualize a curve derived from the optimal possible combinations between risk and benefits (return), and, in Project Portfolio approach we can see the risk substituted by the cost (cost in the X-Axis and % return/value generated in Y-Axis) and, so, in a simple chart we can analyze the return achieved by each cost increment.
Observing the example in the figure 1 we can see that each efficient proposals combination is represented by a dot, producing a specific % of return with a given cost. In other words, each of these combinations in the curve is the best possible return generators for each cost level, so, having in mind a $100M budget limit, for instance, we could easily find the $88M option that produces 81% of the possible return.
Another important point we can notice is that the relationship between cost and % return generated isn’t the same through the curve. After the $88M for 81% point, the generated return starts to decrease for each cost increment. For achieving the additional 19% return the additional cost would be about $132M, that could be valid if the company wants to achieve all the possible return but, probably would start a discussion about it if the 19% additional return worth the $132M additional cost.
The Efficient Frontier Software Tools
If you have interest for apply the Efficient Frontier concept in your company project portfolio and are wondering if there is a software tool to implement it, come back in the next week for practical example using Microsoft Project Server (EPM) 2013.
Eduardo Levenfeld is a Project Management & EPM / Project Server (Microsoft Certified) experienced professional. For the past decade, Eduardo has managed projects, improved process and built solutions for big players from different countries (Brazil, USA and France) spanning several sectors like civil engineering, infrastructure engineering, IT, retail, cosmetics, fashion, pharmaceutical, furniture, foundry, manufacture and automotive. You can read more from Eduardo on his blog.