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Lesson 12 of 13 · 14 min

The risk-free asset, the market portfolio and the CML

Mixing a risk-free asset with the best risky portfolio gives a straight line of choices; when everyone agrees on expectations, that portfolio is the market and the line is the capital market line.

In short

  • Combining the risk-free asset with a risky portfolio gives a straight capital allocation line (CAL), because the risk-free asset has zero variance and zero correlation with the risky portfolio.
  • The best CAL is the steepest one. Each investor picks a point on it with their indifference curves: risk-averse investors hold mostly the risk-free asset.
  • With homogeneous expectations, everyone arrives at the same optimal risky portfolio: the market portfolio. With different expectations, optimal risky portfolios differ.
  • The capital market line (CML) is the CAL whose risky portfolio is the market portfolio: E(Rp)=Rf+E(Rm)−RfσmσpE(R_p) = R_f + \frac{E(R_m) - R_f}{\sigma_m}\sigma_p.
  • Passive investors rely on market prices and hold index funds on the CML; active investors trust their own valuations and over- or underweight assets.
  • Points above the CML are unachievable; points below it are inferior (dominated).

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The risk-free asset, the market portfolio and the CML · The Return and Risk of a Financial Portfolio