Objects of Choice: Mean-Variance Portfolio Theory

Both the variance and the semivariance are sensitive to observations distant from the mean
because the mean differences are squared. Squaring gives them greater weight. A statistic that
avoids this difficulty is the average absolute deviation (AAD), which is defined as the expectation
of the absolute value of the differences from the mean:
 
AAD = E Xi − E(X)
 . (11)

For the Bayside Smoke example, the average absolute deviation is

AAD = .1 |(−.2 − .06)| + .2 |(−.1 − .06| + .4 |0 − .06)|

+ .2 |(.2 − .06)| + .1 |(.6 − .06)|
= 16.4%.

Although for the most part we shall measure risk and return by using the variance (or standard
deviation) and the mean return, it is useful to keep in mind that there are other statistics that, in
some situations, may be more appropriate. An understanding of these statistics helps to put the
mean and variance into proper perspective.

B. Measuring Portfolio Risk and Return

From this point we assume that investors measure the expected utility of choices among risky assets
by looking at the mean and variance provided by combinations of those assets. For a financial
manager, the operating risk of the firm may be measured by estimating the mean and variance
of returns provided by the portfolio of assets that the firm holds: its inventory, cash, accounts
receivable, marketable securities, and physical plant. For a portfolio manager, the risk and return
are the mean and variance of the weighted average of the assets in his or her portfolio. Therefore,
in order to understand how to manage risk, it becomes necessary to explore the risk and return
provided by combinations of risky assets.

1. The Normal Distribution

By looking only at mean and variance, we are necessarily assuming that no other statistics are
necessary to describe the distribution of end-of-period wealth. Unless investors have a special type
of utility function (quadratic utility function), it is necessary to assume that returns have a normal
distribution, which can be completely described by mean and variance. This is the bell-shaped
probability distribution that many natural phenomena obey. For example, measures of intelligence
quotients (IQs) follow this distribution. An example is given in Fig. 2. The frequency of a return is
measured along the vertical axis, and the returns are measured along the horizontal axis. The normal
distribution is perfectly symmetric, and 50% of the probability lies above the mean, 15.9% above
a point one standard deviation above the mean, and 2.3% above a point two standard deviations
above the mean. Because of its symmetry the variance and semivariance are equivalent measures
of risk for the normal distribution. Furthermore, if you know the mean and standard deviation (or
semivariance) of a normal distribution, you know the likelihood of every point in the distribution.
This would not be true if the distribution were not symmetric. If it were skewed to the right, for
example, one would also need to know a measure of skewness in addition to the mean and standard
deviation, and the variance and semivariance would not be equivalent.

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Figure 2 A normal f(R)

distribution [E(R) =
.1, σ = .2]. 1.994

1.760

1.210
R
E(R) – 2σ E(R) E(R) + 2σ
E(R) – σ E(R) + σ

The equation for the frequency of returns, R, that are normally distributed is2

1
√ e−(1/2)[(R−E(R))/σ ] .
2
f (R) = (12)
σ 2π

If we know the mean, E(R), and the standard deviation, σ , of the distribution, then we can plot
the frequency of any return. For example, if E (R) = 10% and σ = 20%, then the frequency of a
13% rate of return is
1
√ e−(1/2)[(.13−.10)/.2]
2
f (.13) =
.2 2π
= 1.972.

Often a normal distribution is converted into a unit normal distribution that always has a mean
of zero and a standard deviation of one. Most normal probability tables are based on a unit normal
distribution. To convert a return, R, into a unit normal variable, z, we subtract the mean, E(R),
and divide by the standard deviation, σ :

R − E(R)
z= . (13)
σ

The frequency function for a unit normal variable is

1
f (z) = √ e−(1/2)z .
2
(14)
2π

This could be plotted in Fig. 2. Of course the scales would change.

2. Calculating the Mean and Variance of a Two-Asset Portfolio

Consider a portfolio of two risky assets that are both normally distributed. How can we measure
the mean and standard deviation of a portfolio with a% of our wealth invested in asset X, and
b% = (1 − a%) invested in asset Y ? Mathematically, the portfolio return can be expressed as the

2 Of course π is “pi,” the ratio of the circumference and the diameter of a circle, and e is the base of natural logarithms.

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weighted sum of two random variables:

R  + bY
p = a X .

By using the properties of mean and variance derived earlier, we can derive the mean and variance
of the portfolio. The mean return is the expected outcome:
 
p ) = E a X
E(R  + bY
 .

Separating terms, we have

p ) = E(a X)
E(R  + E(bY
).

 = aE(X),
Using Property 2, that is, E(a X)  we have

p ) = aE(X)
E(R  + bE(Y
). (15)

Thus the portfolio mean return is seen to be simply the weighted average of returns on individual
securities, where the weights are the percentage invested in those securities.
The variance of the portfolio return is expressed as

p ) = E[R
VAR(R p − E(R
p )]2

 + bY
= E[(a X ) − E(a X
 + bY
)]2 .

Again, using Property 2 and rearranging terms, we have

 
p ) = E (a X
VAR(R  − aE(X))
 + (bY
 − bE(Y
)) 2 .

By squaring the term in brackets and using Property 4, we have


p ) = E a 2 (X
VAR(R  − E(X))
 2 + b2 (Y
 − E(Y
))2 + 2ab(X
 − E(X))(
 Y  − E(Y
)) .

You will recall that from the definition of variance and by Property 4,

 = a 2 E (X
VAR(a X)  − E(X))
 2 = a 2 VAR(X).


Also,

) = b2 E (Y
VAR(bY  − E(X))
 2 = b2 VAR(Y
).

Therefore the portfolio variance is the sum of the variances of the individual securities multiplied
by the square of their weights plus a third term, which includes the covariance, COV(X,  Y):
 
p ) = a 2 VAR(X)
VAR(R  + b2 VAR(Y) + 2abE (X
 − E(X))(
 Y  − E(Y
)) ,
 
 Y
COV(X, ) ≡ E (X  − E(X))(
 Y  − E(Y
)) .

The covariance is a measure of the way in which the two random variables move in relation to
each other. If the covariance is positive, the variables move in the same direction. If it is negative,

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they move in opposite directions. The covariance is an extremely important concept because it is
the appropriate measure of the contribution of a single asset to portfolio risk. The variance of a
random variable is really the same thing as its covariance with itself:3

COV(aX, aX) = a · aE [(X − E(X))(X − E(X))]


= a 2 E (X − E(X))2 = a 2 VAR(X).

We now see that the variance for a portfolio of two assets is

VAR(Rp ) = a 2 VAR(X) + b2 VAR(Y ) + 2ab COV(X, Y ). (16)

To provide a better intuitive feel for portfolio variance and for the meaning of covariance,
consider the following set of returns for assets X and Y :

Probability Xi (%) Yi (%)

.2 11 −3
.2 9 15
.2 25 2
.2 7 20
.2 −2 6
 
To simplify matters we have assumed that each pair of returns Xi Yi has equal probability
(Prob. = .2). The expected value of X is 10%, and the expected value of Y is 8%. Then the
variances are

VAR(X) = .2(.11 − 10)2 + .2(.09 − 10)2 + .2(.25 − 10)2

+ .2(.07 − .10)2 + .2(−.02 − .10)2

= .0076;

VAR(Y ) = .2(−.03 − .08)2 + .2(.15 − .08)2 + .2(.02 − .08)2

+ .2(.20 − .08)2 + .2(.06 − .08)2

= .00708.

The covariance between X and Y is

COV(X, Y ) = E [(X − E(X))(Y − E(Y ))]
= .2(.11 − .10)(.03 − .08) + .2(.09 − .10)(.15 − .08)
+ .2(.25 − .10)(.02 − .08) + .2(.07 − .10)(.20 − .08)
+ .2(−.02 − .10)(.06 − .08)
= −.0024.

3 Fromthis point on, the tilde ( ) will be used in the text to designate a random variable only when it is needed to prevent
ambiguity.

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Table 3 Mean and Standard Deviation of Returns

Percentage in X Percentage in Y p ) (%)
E(R p ) (%)
σ (R
100 0 10.0 8.72
75 25 9.5 6.18
50 50 9.0 4.97
25 75 8.5 5.96
0 100 8.0 8.41

Negative covariance implies that the returns on assets X and Y tend to move in opposite directions.
If we invest in both securities at once, the result is a portfolio that is less risky than holding either
asset separately: while we are losing with asset X, we win with asset Y . Therefore our investment
position is partially hedged, and risk is reduced.
As an illustration of the effect of diversification, suppose we invest half our assets in X and half
in Y . By using Eqs. (15) and (16) we can compute portfolio return and risk directly.

E(Rp ) = aE(X) + bE(Y ) (15)

= .5(.10) + .5(.08) = 9%.

VAR(Rp ) = a 2 VAR(X) + b2 VAR(Y ) + 2abCOV(X, Y ) (16)

= (.5)2 (.0076) + (.5)2 (.00708) + 2(.5)(.5)(−.0024)


= .00247 or σ Rp = 4.97%.

The advantage of portfolio diversification becomes clear in this example. With half our assets in X
and half in Y , the expected return is halfway between that offered by X and by Y , but the portfolio
risk is considerably less than either VAR(X) or VAR(Y ).
Of course, we may choose any combination of X and Y . Table 3 gives the mean and standard
deviation of returns for some of the possibilities.
Figure 3(a) shows the relationship between (1) the expected return on the portfolio and (2)
the percentage of the portfolio, a, that is invested in risky asset X. Note that the portfolio expected
return is a linear function of the weight in asset X.

dE(Rp )
= E(X) − E(Y ) = 10.0% − 8.0% = 2%.
da

For each 1% decline in a there will be a 2% decline in expected return. The relationship between the
portfolio standard deviation, σ (Rp ), and the weight in asset X is nonlinear and reaches a minimum.
Later on, we will show how to determine the portfolio weights that will minimize portfolio risk.
Figure 4 plots the portfolio mean and standard deviation on a single graph. Each point
represents a different weight in asset X. The solid portion of the line represents all combinations
where the weights in asset X range between 0% and 100%.
If we can sell an asset short without restriction, then the dashed portions of the lines in Fig. 4
are feasible. Selling short means that you sell an asset that you do not already have. For example, it
might be possible to sell short 50% of your wealth in asset X (even though you do not already own

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Figure 3 The portfolio return mean and standard deviation as a function of the percentage invested
in risky asset X.

E(Rp) σ(Rp)

9.0

10.0 8.0

7.0

9.0 6.0

5.0

8.0 a 8.0 a
0 25 50 75 100 0 25 50 75 100
Panel (a) Panel (b)

Figure 4 Trade-off ∼
between mean and E(Rp )
standard deviation. 10.0

9.5

9.0

8.5
∼
8.0 σ(Rp )
2 3 4 5 6 7 8

shares of asset X) and buy 150% of asset Y . If you sell X short, you should receive the proceeds,
which you can then use to buy an extra 50% of Y . This is not possible in the real world because
investors do not receive funds equal to the value of securities in which they sell short. Nevertheless,
for expositional purposes, we assume that short sales are not constrained. The mean and variance
of the above short position are

E(Rp ) = −.5E(X) + 1.5E(Y )

= −.5(.10) + 1.5(.08) = 7.0%.

VAR(Rp ) = (−.5)2 VAR(X) + (1.5)2 VAR(Y ) + 2(−.5)(1.5)COV(X, Y )

= .25(.0076) + (2.25)(.00708) + 2(−.75)(−.0024) = .02143.

σ (Rp ) = VAR(Rp ) = 14.64%.

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Figure 5 Independent Y
returns.

Figure 6 Perfectly Y
correlated returns.

Now that we have developed ways of measuring the risk (variance) and return (mean) for a
portfolio of assets, there are several interesting questions to explore. For example, what happens
if the covariance between X and Y is zero—that is, what happens if the two securities are
independent? On the other hand, what happens if they are perfectly correlated? How do we find
the combination of X and Y that gives minimum variance?

3. The Correlation Coefficient

To answer some of these questions, it is useful to explain the concept of correlation, which is similar
to covariance. The correlation, rxy , between two random variables is defined as the covariance
divided by the product of the standard deviations:

COV(X, Y )
rxy ≡ . (17)
σx σy

Obviously, if returns on the two assets are independent (i.e., if the covariance between them is
zero), then the correlation between them will be zero. Such a situation is shown in Fig. 5, which
is the scatter diagram of two independent returns.
The opposite situation occurs when the returns are perfectly correlated, as in Fig. 6, in which
the returns all fall on a straight line. Perfect correlation will result in a correlation coefficient equal
to 1. To see that this is true we can use the fact that Y is a linear function of X. In other words,
if we are given the value X, we know for sure what the corresponding value of Y will be. This is
expressed as a linear function:

Y = a + bX.

We also use the definition of the correlation coefficient. First, we derive the expected value and
standard deviation of Y by using Properties 1 through 4:

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E(Y ) = a + bE(X),

VAR(Y ) = b2 VAR(X),
σy = bσx .

The definition of the correlation coefficient is

COV(X, Y ) E [(X − E(X))(Y − E(Y ))]
rxy = = .
σx σy σx σy

By substituting the mean and variance of Y , we obtain

E [(X − E(X))(a + bX − a − bE(X))]

rxy =
σx bσx

E [(X − E(X))b(X − E(X))] bσx2

= = = 1.
bσx2 bσx2

Therefore the correlation coefficient equals +1 if the returns are perfectly correlated, and it equals
−1 if the returns are perfectly inversely correlated.4 It is left as an exercise for the student to prove
that the latter is true. The correlation coefficient ranges between +1 and −1 :

−1 ≤ rxy ≤ 1. (18)

For the example we have been working with, the correlation between X and Y is

COV(X, Y ) −.0024
rxy = = = −.33.
σx σy (.0872)(.0841)

By rearranging the definition of the correlation coefficient in Eq. (17), we get another defini-
tion of covariance whereby it is seen to be equal to the correlation coefficient times the product of
the standard deviations:

COV(X, Y ) − rxy σx σy . (19)

This in turn can be substituted into the definition of the variance of a portfolio of two assets.
Substituting (19) into (16), we have

VAR(Rp ) = a 2 VAR(X) + b2 VAR(Y ) + 2abrxy σx σy . (20)

4. The Minimum Variance Portfolio

This reformulation of the variance definition is useful in a number of ways. First, it can be used
to find the combination of random variables, X and Y , that provides the portfolio with minimum
variance. This portfolio is the one where changes in variance (or standard deviation) with respect
to changes in the percentage invested in X are zero.5 First, recall that since the sum of weights

4 The linear relationship between X and Y for perfect inverse correlation is Y = a − bX.
5 To review the mathematics of maximization refer to Appendix: Calculus and Optimization.

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must add to 1, b = 1 − a. Therefore the variance can be rewritten as

VAR(Rp ) = a 2 σx2 + (1 − a)2 σy2 + 2a(1 − a)rxy σx σy .

We can minimize portfolio variance by setting the first derivative equal to zero:

dVAR(Rp )
= 2aσx2 − 2σy2 + 2aσy2 + 2rxy σx σy − 4arxy σx σy = 0
da
a(σx2 + σy2 − 2rxy σx σy ) + rxy σx σy − σy2 = 0

Solving for the optimal percentage to invest in X in order to obtain the minimum variance portfolio,
we get

σy2 − rxy σx σy
a∗ = . (21)
σx2 + σy2 − 2rxy σx σy

Continuing with the example used throughout this section, we see that the minimum variance
portfolio is the one where

.00708 − (−.33)(.0872)(.0841)
a∗ = = .487.
.0076 + .00708 − 2(−.33)(.0872)(.0841)

The portfolio return and variance for the minimum variance portfolio are

E(Rp ) = aE(X) + (1 − a)E(Y )

= .487(.10) + (.513)(.08) = 8.974%.

VAR(Rp ) = a 2 VAR(X) + (1 − a)2 VAR(Y ) + 2a(1 − a)rxy σx σy

= (.487)2 (.0076) + (.513)2 (.00708) + 2(.487)(.513)(−.33)(.0872)(.0841)

= .0018025 + .0018632 − .0012092 = .0024565.

σp = 4.956%.

The minimum variance portfolio is represented by the intersection of the dashed lines in Fig. 4.

5. Perfectly Correlated Assets

Up to this point, we have considered an example where the returns of the two risky assets had a
negative correlation. What happens if they are perfectly correlated? Suppose rxy = 1. Table 4
gives an example of security returns where X = 1.037Y + 1.703. All combinations of X and Y lie
along a straight line and hence are perfectly correlated.
Since we have used the same numbers for the returns on asset Y as were used in the previous
example, its standard deviation is 8.41%. We can derive the standard deviation of X by using
Property 4, and the covariance between X and Y by using the definition of covariance in Eq. (19).
It is also interesting to look at the graph of mean versus variance (Fig. 7). Point A represents the
risk and return for a portfolio consisting of 100% of our investment in X, and B represents 100%
in Y . The dashed line represents the risk and return provided for all combinations of X and Y

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Table 4 Perfectly Correlated Security Returns

Probability X (%) Y (%)
.2 −1.408 −3
.2 17.258 15
.2 3.777 2
.2 22.443 20
.2 7.925 6
σx = 1.037σy = 8.72%,
σy = 8.41%,
COV(X, Y ) = rxy σx σy = .007334.

Figure 7 Risk-return ∼
trade-offs for two assets. E(Rp )
10.0 A

9.5
rxy = –1
9.0 rxy = –.33 rxy = 1
C
8.5
B ∼
8.0 σ(Rp )
2 3 4 5 6 7 8

when they are perfectly correlated. To see that this trade-off is a straight line, in the mean-variance
argument plane, we take a look at the definitions of mean and variance when rxy = 1 :

E(Rp ) = aE(X) + (1 − a)E(Y ),

VAR(Rp ) = a 2 σx2 + (1 − a)2 σx2 + 2a(1 − a)σx σy . (22)

Note that the variance can be factored:

VAR(Rp ) = [aσx + (1 − a)σy ]2 ;

therefore the standard deviation is

σ (Rp ) = aσx + (1 − a)σy . (23)

The easiest way to prove that the curve between A and B is a straight line is to show that its
slope does not change as a, the proportion of the portfolio invested in X, changes. The slope of
the line will be the derivative of expected value with respect to the weight in X divided by the
derivative of standard deviation with respect to the weight in X:

dE(Rp ) dE(Rp )/da

Slope = = .
dσ (Rp ) dσ (Rp )/da

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The derivative of the expected portfolio return with respect to a change in a is

dE(Rp )
= E(X) − E(Y ),
da

and the derivative of the standard deviation with respect to a is

dE(Rp )
= σx − σy .
da

Therefore the slope is

dE(Rp ) E(X) − E(Y ) .10 − .08

= = = 6.45.
dσ (Rp ) σx − σy .0872 − .0841

This proves that AB is a straight line because no matter what percentage of wealth, a, we choose
to invest in X, the trade-off between expected value and standard deviation is constant.
Finally, suppose the returns on X and Y are perfectly inversely correlated; in other words,
rxy = −1. In this case the graph of the relationship between mean and standard deviation is the
dotted line ACB in Fig. 7. We should expect that if the assets have perfect inverse correlation,
it would be possible to construct a perfect hedge. That is, the appropriate choice of a will result in
a portfolio with zero variance. The mean and variance for a portfolio with two perfectly inversely
correlated assets are
E(Rp ) = aE(X) + (1 − a)E(Y ), (24)

VAR(Rp ) = a 2 σx2 + (1 − a)2 σy2 − 2a(1 − a)σx σy , since rxy = −1.

The variance can be factored as follows:

VAR(Rp ) = [aσx − (1 − a)σy ]2 ,

σ (Rp ) = ±[aσx − (1 − a)σy ]. (25a)

Note that Eq. (25a) has both a positive and a negative root. The dotted line in Fig. 7 is really
two line segments, one with a positive slope and the other with a negative slope. The following
proofs show that the signs of the slopes of the line segments are determined by Eq. (25a) and
that they will always intersect the vertical axis in Fig. 7 at a point where the minimum variance
portfolio has zero variance.
To show this result, we can use Eq. (21) to find the minimum variance portfolio:

σy2 − rxy σx σy
a∗ = .
σx2 + σy2 − 2rxy σx σy

Because rxy = 1, we have

σy2 + σx σy σy .0841
a∗ = = = = 49.095%.
σx2 + σy2 + 2σx σy σx + σy .0872 + .0841

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By substituting this weight into the equations for mean and standard deviation, we can demonstrate
that the portfolio has zero variance:

E(Rp ) = .49095(.10) + (1 − .49095)(.08) = 8.92%,

σ (Rp ) = .49095(.0872) − (1 − .49095)(.0841) = 0%.

This result is represented by point C in Fig. 7.

Next, let us examine the properties of the line segments AC and CB in Fig. 7. To do so it
is important to realize that the expression for the standard deviation in Eq. (25a) for a portfolio
with two perfectly inversely correlated assets has both positive and negative roots. In our example,
suppose that none of the portfolio is invested in X. Then a = 0, and the standard deviation is a
negative number,

σ (Rp ) = −(1 − 0)σy < 0.

Because standard deviations cannot be negative, the two roots of Eq. (25a) need to be interpreted
as follows. So long as the percentage invested in X is greater than or equal to 49.095% (which is
a ∗, the minimum variance portfolio), the standard deviation of the portfolio is
σy
σ (Rp ) = aσx − (1 − a)σy if a≥ . (25b)
σx + σy

On the other hand, if less than 49.095% of the portfolio is invested in X, the standard deviation is
σy
σ (Rp ) = (1 − a)σy − aσx if a< . (25c)
σx + σy

We can use these results to show that the line segments AC and CB are linear. The proof
proceeds in precisely the same way that we were able to show that AB is linear if rxy = 1. For the
positively sloped line segment, AC, using Eq. (24), we have

dE(Rp )
= E(X) − E(Y ),
da

and using Eq. (25b), we have

dσ (Rp ) σy
= σ x + σy if a≥ .
da σx + σy

Therefore the slope of the line is

dE(Rp ) dE(Rp )/da E(X) − E(Y ) .10 − .08

= = = = −.117 < 0.
dσ (Rp ) dσ (Rp )/da −(σy + σx ) −(.0872 + .0841)

The slope of CB is negative and CB is linear.

6. The Minimum Variance Opportunity Set

Line AB in Fig. 7 shows the risk-return trade-offs available to the investor if the two assets
are perfectly correlated, and line segments AC and CB represent the trade-offs if the assets are

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perfectly inversely correlated. However, these are the two extreme cases. Usually assets are less
than perfectly correlated (i.e., −1 < rxy < 1). The general slope of the mean-variance opportunity
set is the solid line in Fig. 7. The opportunity set can be defined as follows:
Minimum variance opportunity set The minimum variance opportunity set is the locus
of risk and return combinations offered by portfolios of risky assets that yields the minimum
variance for a given rate of return.
In general the minimum variance opportunity set will be convex (as represented by the solid line
in Fig. 7). This property is rather obvious because the opportunity set is bounded by the triangle
ACB. Intuitively, any set of portfolio combinations formed by two risky assets that are less than
perfectly correlated must lie inside the triangle ACB and will be convex.
The concepts developed in this section can now be used to discuss the way we, as investors, are
able to select portfolios that maximize our expected utility. The portfolio mean return and variance
are the measures of return and risk. We choose the percentages of our wealth that we want to invest
in each security in order to obtain the required risk and return. We have shown the choices that are
possible if two risky assets are perfectly correlated, perfectly inversely correlated, and where their
correlation lies between −1 and +1. We have also seen how we can find the minimum variance
portfolio. Later in this chapter these results will be extended from the two-asset case to portfolios
of many assets, and we will discuss an example wherein a corporate treasurer may use portfolio
theory to reduce the risk (variability) of shareholders’ wealth.

C. T(and
he Efficient Set with Two Risky Assets
No Risk-Free Asset)
The assumption of no risk-free asset is the same as saying that there are no borrowing or lending
opportunities. In other words, this section shows how a single individual (Robinson Crusoe) will
choose his optimal portfolio of risky assets in a world where there is no opportunity for exchange.
As we shall see, the following discussion is analogous to the Robinson Crusoe economy except
that the objects of choice are risk and return rather than consumption and investment. The results
are also similar. Robinson Crusoe’s optimal portfolio will be that where his subjective marginal
rate of substitution between risk and return is exactly equal to the objectively determined marginal
rate of transformation (along his mean-variance opportunity set) between risk and return. At this
optimal portfolio the equality between MRS and MRT determines his subjective price of risk. Later
on, in Section E.5, we shall introduce a marketplace with opportunities to exchange by borrowing
and lending unlimited amounts of money at the risk-free rate. This exchange economy setting will
show the existence of a single market-determined price of risk. All individuals and their agents
(firms, for example) will use the market price of risk for optimal decisions in the face of uncertainty.
In the chapter on utility theory we saw that indifference curves for the risk-averse investor were
convex in the mean-variance plane. Figure 8 shows a family of indifference curves as well as the
convex set of portfolio choices offered by various percentages of investment in two risky assets. If
we know our risk-return trade-off and also know the possibilities offered by combinations of risky
assets, we will maximize our expected utility at point C in Fig. 8. This is where our indifference
curve is tangent to the opportunity set offered by combinations of X and Y . Each indifference curve
maps out all combinations of risk and return to provide us with the same total utility. Moving from

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