Investors face a trade-off between risk and expected return. Historical data confirm our
intuition that assets with low degrees of risk provide lower returns on average than do
those of higher risk.
Shifting funds from the risky portfolio to the risk-free asset is the simplest way to reduce
risk. Another method involves diversification of the risky portfolio. We take up diversification in later chapters.
U.S. T-bills provide a perfectly risk-free asset in nominal terms only. Nevertheless, the
standard deviation of real rates on short-term T-bills is small compared to that of assets
such as long-term bonds and common stocks, so for the purpose of our analysis, we
consider T-bills the risk-free asset. Besides T-bills, money market funds hold short-term,
safe obligations such as commercial paper and CDs. These entail some default risk but
relatively little compared to most other risky assets. For convenience, we often refer to
money market funds as risk-free assets.
A risky investment portfolio (referred to here as the risky asset) can be characterized by
its reward-to-volatility ratio. This ratio is the slope of the capital allocation line (CAL),
the line connecting the risk-free asset to the risky asset. All combinations of the risky and
risk-free asset lie on this line. Investors would prefer a steeper sloping CAL, because that
means higher expected returns for any level of risk.
An investor's preferred choice among the portfolios on the capital allocation line will
depend on risk aversion. Risk-averse investors will weight their complete portfolios more
heavily toward Treasury bills. Risk-tolerant investors will hold higher proportions of their
complete portfolios in the risky asset.
The capital market line is the capital allocation line that results from using a passive
investment strategy that treats a market index portfolio, such as the Standard & Poor's
500, as the risky asset. Passive strategies are low-cost ways of obtaining well-diversified
portfolios with performance that will reflect that of the broad stock market.
