=8.7.* A stockbroker, Richard Smith, has just received a call from his most important client, Ann Hardy. Ann has $50,000 to invest and wants to use it to purchase two stocks. Stock 1 is a solid blue-chip security with a respectable growth potential and little risk involved. Stock 2 is much more speculative. It is being touted in two investment newsletters as having outstanding growth potential, but also is considered very risky. Ann would like a large return on her investment, but also has considerable aversion to risk. Therefore, she has instructed Richard to analyze what mix of investments in the two stocks would be appropriate for her. She also informs him that her plan is to hold the stock being purchased now for three years before selling it.

After doing some research on the historical performances of the two stocks and on the current prospects for the companies involved, Richard is able to make the following estimates. If the entire $50,000 were to be invested in stock 1 now, the profit when sold in three years would have an expected value of $12,500 and a standard deviation of $5,000. If the entire $50,000 were to be invested in stock 2 now, the profit when sold in three years would have an expected value of $20,000 and a standard deviation of

$30,000. The two stocks behave independently in different sectors of the market so Richard’s calculation from historical data is that the covariance of the profits from the two stocks is 0.

Richard now is ready to use a spreadsheet model to determine how to allocate the $50,000 to the two stocks so as to minimize Ann’s risk while providing an expected profit that is at least as large as her minimum acceptable value. He asks Ann to decide what her minimum acceptable value is.