Our first observation is that the variance of the portfolio, unlike the expected return, is not a

weighted average of the individual asset variances. To understand the formula for the portfolio
variance more clearly, recall that the covariance of a variable with itself is the variance of that
variable; that is

Therefore, another way to write the variance of the portfolio is

In words, the variance of the portfolio is a weighted sum of covariances, and each weight is the
product of the portfolio proportions of the pair of assets in the covariance term.
Minimum Variance portfolio – has standard deviation smaller than that of either of the
individual component assets.

Although the expected return of any portfolio is simply the weighted average of the asset
expected returns, this is not true of the standard deviation. Potential benefits from
diversification arise when correlation is less than perfectly positive. The lower the correlation,
the greater the potential benefit from diversification. In the extreme case of perfect negative
correlation, we have a perfect hedging opportunity and can construct a zero-variance portfolio.

Suppose now an investor wishes to select the optimal portfolio from the opportunity set. The
best portfolio will depend on risk aversion. Portfolios to the northeast in above figure provide
higher rates of return but impose greater risk. The best trade-off among these choices is a
matter of personal preference. Investors with greater risk aversion will prefer portfolios to the
southwest, with lower expected return but lower risk.

Asset Allocation with stocks, Bonds and Bills

When optimizing capital allocation, we want to work with the capital allocation line (CAL)
offering the highest slope or Sharpe ratio. The steeper the CAL, the greater is the expected
return corresponding to any level of volatility. Now we proceed to asset allocation: constructing
the risky portfolio of major asset classes, here a bond and a stock fund, with the highest
possible Sharpe ratio.
The asset allocation decision requires that we consider T-bills or another safe asset along with
the risky asset classes. The reason is that the Sharpe ratio we seek to maximize is defined as the
risk premium in excess of the risk-free rate, divided by the standard deviation.

In the case of two risky assets, the solution for the weights of the optimal risky portfolio, P, is
given by

Notice that the solution employs excess returns (denoted R ) rather than total returns (denoted
r ).