This comprehensive example reviews many concepts learned in this chapter. The example begins with simple information about available assets and builds an optimal investor portfolio for the Lohrmanns.

Suppose the Lohrmanns can invest in only two risky assets, A and B. The expected return and standard deviation for asset A are 20 percent and 50 percent, and the expected return and standard deviation for asset B are 15 percent and 33 percent. The two assets have zero correlation with one another.

1. Calculate portfolio expected return and portfolio risk (standard deviation) if an investor invests 10 percent in A and the remaining 90 percent in B.

2. Generalize the previous calculations for portfolio return and risk by assuming an investment of w_A in asset A and an investment of (1 – w_A) in asset B.

3. Now introduce a risk-free asset with a return of 3 percent. Write an equation for the capital allocation line in terms of w_A that will connect the risk-free asset to the portfolio of risky assets.