THE OPTIMAL RISKY PORTFOLIO WITH A RISK-FREE ASSET
Instead of two risky assets (bond and stock), we can compose a portfolio with one risky and one risk free assets.

Extending to Include Riskless Asset
-The optimal combination becomes linear
-A single combination of risky and riskless assets will dominate

Figure: Opportunity Set Using Stocks and Bonds and Two Capital Allocation Lines

Dominant CAL with a Risk-Free Investment (F)

CAL(O) dominates other lines -- it has the best risk/return or the largest slope

Slope = [ E(ra)-rf ] / std. dev

[ E(rp) - rf ] / std. dev. p > [ E(ra) - rf ] / std. dev.a
Regardless of risk preferences, combinations of O & F dominate

Optimal Capital Allocation Line for Bonds, Stocks and T-Bills

 The Complete Portfolio

The Complete Portfolio – Solution to the Asset Allocation Problem