CHAPTER SIX

CAPITAL ALLOCATION TO RISKY ASSETS

CHAPTER OVERVIEW
This chapter describes the process of constructing of an investor portfolio. The two-step process
of constructing an investor portfolio involves selection of a portfolio of risky assets and deciding
how much to invest in that risky portfolio versus risk free assets. The chapter begins by
introducing the concepts of risk aversion and utility. The chapter then develops allocation of
funds between risky and risk-free securities. Finally the concepts of risk aversion and allocation
are brought together showing how investors decide on what proportions go into safe and risky
assets.

LEARNING OBJECTIVES
After covering the chapter, the students should understand the concept of risk aversion and utility.
They should be able to apply the concept of risk aversion in measuring a utility function and
understand how risk aversion affects allocation. Students should be able to work with a portfolio
that allocates funds between a risky asset and a risk free asset and understand how leverage could
be used in allocation. The background g in this chapter is necessary for development of the
CAPM.

PRESENTATION OF MATERIAL
6.1 Risk and Risk Aversion
The concept of risk and return is developed by first distinguishing between speculation and
gambling. For speculation, one perceives a favorable risk-return trade-off, while gambling lacks
commensurate gain. Table 6.1 presents an example of available risky portfolios. Table 6.2
demonstrates the use of utility functions (based on Equation 6.1) to calculate utility scores for
investors with varying degrees of risk aversion.

The possible investor views of risk are presented here. A risk-averse investor will demand
compensation for uncertainty or risk. A risk neutral investor will be willing to accept a fair bet or
would be willing to analyze investments in terms of expected value. A risk seeking investor will
take an unfair bet, that is, would be willing to take on an uncertain investment that has a lower
expected value for the chance of securing a large profit. The concept of trade-off between risk
and return of a potential investment portfolio is displayed graphically in Figures 6.1 while Figure
6.2 introduces indifference curves.

6.2 Capital Allocation across Risky and Risk-Free Portfolios

The development of basic allocation between a risky asset and a risk-free asset begins by
examining behavior of risk-free rates. The most straightforward way to control risk in the
portfolio is through the fraction of the portfolio invested in T-bills and other safe money market
securities versus risky assets. A portfolio which includes risky investments and the risk-free asset
is considered a complete portfolio.

6.3 The Risk-Free Asset

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The risk-free asset is described here. The example of Treasury bills is discussed due to their
short-term nature and price insensitivity to interest rate fluctuations. Money market funds have a
variety of low-risk instruments investors can consider.
6.4 Portfolios of One Risky Asset and a Risk-Free Asset

Section 6.4 develops the allocation of funds between risky and risk-free assets. When this
opportunity set includes borrowing and lending, it creates the capital allocation, displayed, for
example, in Figure 6.3. Under the assumption that investors can borrow and lend at the same
rates, all investors allocate some combination of risk-free borrowing and lending with an
investment in the risky asset. The opportunity set with differential borrowing has different slopes
for borrowing and lending investors, shown in Figure 6.4.

6.5 Risk Tolerance and Asset Allocation

With the development of two-asset allocation, the material in the chapter returns to incorporation
of risk aversion and utility to investor selection. With a given risk aversion coefficient, the level
of utility for various positions in risky assets is demonstrated in Table 6.4 and again as
indifference curves in Figure 6.6. Figure 6.7 illustrates the concept of finding the optimal
complete portfolio by using indifference curves and Table 6.6 lists the expected returns on four
indifference curves and the CAL.

6.6 Passive Strategies: The Capital Market Line

The concept of passive management is developed using return data from Professor Kenneth
French’s website: mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. It avoids
any direct or indirect security analysis. Table 6.7 shows the one set of results from a passive
management strategy and demonstrates the average annual return on stocks and 1-month T-bills;
standard deviation and Sharpe ratio of stocks over time. Capital market line (CML) is presented
as a passive strategy along with a discussion on passive strategies.

Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior
written consent of McGraw-Hill Education.