Risk, Return and the Capital

Allocation Line

Marriott School of Management

Fin 410
Fall 2014

Rob Schonlau
Last updated September 15, 2014

Your friends temporarily entrust $2 million to

you to invest. They asked you to invest it in
the best possible manner

Earlier lectures discussed the types of assets you could invest in

as well as the return and risk measures used to think about
financial performance.

But nothing has been said thus far about how to best combine
assets into the optimal portfolio. This lecture builds on earlier
intuition about risk and return and considers a simplified situation
where you can only choose between investing in a risk-free asset
and a single risky asset and asks the question: how much of your
wealth should go into the risk-free asset? How much in the
risky asset? Why?

Lecture 5 outline

Introduce the asset allocation choice:

Assume there are 2 assets in which to invest. One is a risky
asset and the other is a risk free asset. The asset allocation
question is how much of your wealth should be invested in
the risky asset? How much in the risk free asset?
Introduce the Capital Allocation Line (CAL) and Sharpe ratio

The asset allocation question restated for

intuition. . .

How much do you punch the accelerator? How fast do you want
to go? How do you make this decision? On some level, you are
balancing the expected risk against the expected enjoyment you
get from speed.

Greater speed can be thrilling but it can also get pretty ugly.
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Human preferences

All else equal, people prefer higher expected returns. Thus

given a choice between two investments of the same risk they will
choose the one with higher expected return.

All else equal, people prefer lower risk investments. Thus given a
choice between two investments with the same expected return
they will choose the one with lower risk.

Consider a simplified framework

You can choose between 2 assets:
A risk-free bond
A risky asset (this could be a portfolio)
You can go long or short in your positions
Shorting the risk-free bond is like borrowing to buy more of the
risky asset.

What is a risk-free asset?

If we define risk in terms of standard deviation then the

standard deviation of the risk-free assets returns should be
zero.
Because a risk free assets returns are not uncertain they are
treated like a constant when using expectations. =
In practice we treat short-term US T-Bills as risk-free assets.

What is a risky asset?

A risky asset has uncertain future returns. (I.e. the expected

0). Conceptually we can think of a portfolio of risky
assets as a single risky asset.
In practice we could consider a single stock, a corporate bond,
or a local government bond as this asset. Similarly we could
combine collections of these assets to form a new single risky
asset (portfolio).

Borrowing as short-selling
You can think of borrowing as short-selling a risk-free bond. See
the cash inflow/outflow comparison below.
Borrowing vs short-selling:
Short-sell 1 bond
Borrow $909.09 at 10%
FV = 1000, Price = 909.09
Get $909.09 now

Get $909.09 now

Pay $1000 in future

Pay $1000 in future

The question again

What fraction of investment equity do you put in the risk-free bond?

What fraction do you put in the risky asset?

The more wealth you put in the risky asset the higher your
expected return.
The more wealth you put in the risky asset the higher the risk of
outcomes far different from the expected return.

We will use Statistics Rules #1 and #2 to think about portfolio

expected return and risk.

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Lecture 5 outline

Introduce the asset allocation choice:

Assume there are 2 assets in which to invest. One is a risky
asset and the other is a risk free asset. The asset allocation
question is how much of your wealth should be invested in
the risky asset? How much in the risk free asset?

Introduce the Capital Allocation Line (CAL) and the Sharpe ratio

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Summarize the portfolios expected return and

standard deviation
Two equations describe the expected return and risk in your portfolio.
Given human preferences, we want to maximize E(rp) and minimize
by choosing the weight (percent) of our wealth we invest in each
asset.

Expected Return:

Standard Deviation:

E(rp ) wE(rS ) 1 w rf

p w S

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Plot the expected return and standard deviation

combinations of different portfolios created by
changing the percent of your wealth invested in the
risky asset.
Assume:
E[rs] = .08
s = .12
rf = .04

Equations:
E[rp] = wE[rS]+(1-w)rf
p = ws
E[rp]

Risky (w) Risk-Free(1-w)

A: 0%
100%
10%
B: 100%
0%
8%
C: 50%
50%
6%
A
4%
D: 150%
-50%

D
B
C

p
.06

.12

.18
13

Capital Allocation
Line (CAL)
What is the equation
for the CAL line on the
previous slide?

What is the intuition for the y-axis intercept?

What is the slope? Rise-over-run for any two points.
Point 1 (x,y): p = 0, E[rp] = rf
Point 2 (x,y): p = s , E[rp] = E[rs]

Rise E[rs ] rf

Run
s
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Capital Allocation Line

This is just the equation for a line!

E (rp ) rf

E (rS ) rf

Slope
Y variable

Intercept

X variable

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CAL Example
E[rs] = .08
s = .12
rf = .04

Sharpe Ratio
E[rp]

E[rp ] rf

E[rp] = wE[rS]+(1-w)rf
p = ws
Risky
Risk-Free
A: 0%
100%
B: 100%
0%
C: 50%
50%
D: 150%
-50%

6%
A
4%

10%
8%

E[rs ] rf

B
C

p
.06

.12

.18
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Sharpe Ratio

Sharpe Ratio =

This ratio is also called the reward-to-volatility or reward-tovariability ratio. As you add more of the risky asset to your
portfolio the expected risk premium increases but so does the
denominator.
All else equal, given a choice between two Sharpe ratios you
would prefer the larger one because the expected financial return
would be higher for each unit of risk.

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Capital Allocation Line

How much do you punch the accelerator? You make the call . . . .

Risk-averse investors will invest more in the risk-free asset.

Risk-tolerant investors will invest more in the risky asset.

But everyone should always prefer portfolios with higher

Sharpe ratios.

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Targeting E[r] with Vanguard

Assume:
The expected return on a Vanguard fund is 12% and the
standard deviation is 0.16.
The risk-free rate is 7%.
Assume you can borrow and lend at this rate.

What portfolio weights would you use if you wanted to allocate your
wealth between the risky asset (the fund) and the risk-free asset in
such a way that your portfolio had an expected return of 17%?

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Targeting E[r] with Vanguard

rp wrs (1 w)rf

First write the portfolio return formula:

Then use statistics rule 1 to apply expectations:

E[rp ] wE[rs ] (1 w)rf

0.17 w0.12 (1 w).07
.17 .07 .05w
2w
Invest 200% of investment equity in risky portfolio by borrowing
at risk-free rate.

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Targeting E[r] with Vanguard

With a weight of 2.0 in the risky asset, the standard deviation of

the portfolio would be 2.0*0.16 = 0.32.

What is the intercept and slope of the CAL?

Intercept = 0.07
Slope = (0.12-0.07)/0.16 = 0.3125

17% = 0.07+.3125*.32

E[rp ] rf

E[rs ] rf

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Targeting E[r] with Vanguard

Position
Stdev
100% in risky portfolio
0.16
Desired position
0.32

E[r]
.17

.12

.07
.16

.32

p
22

Targeting E[r] with Vanguard (continued)

Suppose you have $1000 to invest (investment equity) and the

price of the risky asset is $18/share

Then, according to our calculations, you should buy $2000 of

the Vanguard Fund.
Buy 2000/18 =111 shares
You have to borrow $1000 at 7% to help buy these shares

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Targeting with Vanguard

Suppose you want the standard deviation of your portfolio to be

0.25. Remember that the standard deviation of the risky asset by
itself is .16. How much should you invest in the risky asset?
Use statistics rule 2

0.25 w0.16
0.25 / 0.16 1.56 w

Invest 156% of investment equity in risky portfolio by borrowing at

risk-free rate.

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Targeting with Vanguard

With a weight of 1.56 in the risky asset,

E[rp ] 1.56 * 0.12 (.56) * .07 14.8%

We can also use the equation for the CAL line to find the
expected return:
14.8% = 0.07+.3125*.25

E[rp ] rf

E[rs ] rf

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Targeting with Vanguard

Position
Stdev
100% in risky portfolio
0.16
Desired position
0.25

E[r]
.148

.12

.07
.16

.25

p
26

Targeting with Vanguard

Suppose you have $1000 to invest (investment equity) and the

price of the risky asset is $18/share.
Then, according to our calculations, you buy $1560 of the
Vanguard Fund.
Buy 1560/18 =87 shares
You have to borrow $560 at 7% to buy these shares

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Passive Investing Approach

Select the passive portfolio with the highest Sharpe Ratio

possible
Benefits of passive investing:
No need to spend time researching stocks
No need to pay someone else to do research
Indexing is one of the most common passive strategies.
The CAL drawn between the risk-free rate and a broad index of
common stocks is called the capital market line (CML).

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