Question

Explain the capital allocation line (CAL). Discuss as an analyst, how will you choose CAL based on the risk tolerance of your clients (investors)?

Answer 1

The capital allocation line is the graph of all the possible combinations of risk-free and risky assets. The CAL is plotted with the risk (standard deviation) on the x-axis while the return on the combined portfolio is plotted against the y-axis.

The CAL can be chosen basis the risk tolerance of the investors. For eg., a risk-averse investor might not be comfortable taking any additional risk beyond a point. For him/her, the optimal risk-return ratio is at which the returns are maximized for the risk. The risk tolerance of the investor determines the slope of the CAL line. An extremely risk-averse investor would prefer a low slope CAL. In this CAL, the proportion of risk-free asset is much higher than the risky asset proportion. Alternatively, a low risk averse investor would prefer with a high slope CAL which effectively indicates he/she is comfortable with higher returns for higher risk. Accordingly, the CAL is choosen.