# Reading 44 : Portfolio Risk and Return (P.1)

**Describe the implications of combining a risk-free asset with a portfolio of risky assets**

**2. Explain the capital allocation line (CAL) and the capital market line (CML)**

- The line of possible portfolio risk and return combinations given the risk-free rate and the risk and return of a portfolio of risky assets ⇒ Capital Allocation Line.
- Each investor has different expectations about the expected returns of, standard deviations of, or correlation between risky asset returns ⇒ each investor will have a different optimal risky asset portfolio & CAL.

- Assumption under modern portfolio theory (and CAPM) that investors have homogeneous expectations (have same risk, return, correlation) ⇒ have some optimal risky portfolio & CAL. In this case, that portfolio must be the market portfolio.
- Under assumption of homogeneous expectation: CAL ⇒ Capital Market Line (CML)

**3. Explain systematic and non systematic risk, including why an investor should not expect to receive additional return for bearing non_systematic risk**

- The risk that is eliminated by diversification is called
**unsystematic risk.** - The risk that remains cannot be diversified away and is called
(nondiversifiable risk or market risk)**the systematic risk** **Total risk = Systematic risk + Unsystematic risk**- 12-18 stocks in portfolio to achieve 90% of the maximum diversification possible. Another study indicated it took 30 securities.

**Systematic Risk is relevant in Portfolios**

To sum up, unsystematic risk is not compensated in equilibrium because it can be eliminated for free through diversification. Systematic risk is measured by the contribution of a security to the risk of a well-diversified portfolio, and the expected equilibrium return on an individual security will depend only on its systematic risk.