What is the 'Capital Allocation Line  CAL'
The capital allocation line (CAL), also known as the capital market link (CML), is a line created on a graph of all possible combinations of riskfree and risky assets. The graph displays to investors the return they might possibly earn by assuming a certain level of risk with their investment. The slope of the CAL is known as the rewardtovariability ratio.
BREAKING DOWN 'Capital Allocation Line  CAL'
The capital allocation line aids investors in choosing how much to invest in a riskfree asset and one or more risky assets. Asset allocation is the allotment of funds across different types of assets with varying expected risk and return levels, whereas capital allocation is the allotment of funds between riskfree assets, such as certain Treasury securities, and risky assets, such as equities.
Constructing Portfolios With the CAL
An easy way to adjust the risk level of a portfolio is to adjust the amount invested in the riskfree asset. The entire set of investment opportunities includes every single combination of riskfree and risky assets. These combinations are plotted on a graph where the yaxis is expected return and the xaxis is the risk of the asset as measured by standard deviation.
The simplest example is a portfolio containing two assets: a riskfree Treasury bill and a stock. Assume that the expected return of the Treasury bill is 3% and its risk is 0%. Further, assume that the expected return of the stock is 10% and its standard deviation is 20%. The question that needs to be answered for any individual investor is how much to invest in each of these assets. The expected return (ER) of this portfolio is calculated as follows:
ER of portfolio = ER of riskfree asset x weight of riskfree asset + ER of risky asset x (1 weight of riskfree asset)
The calculation of risk for this portfolio is simple because the standard deviation of the Treasury bill is 0%. Thus, risk is calculated as:
Risk of portfolio = weight of risky asset x standard deviation of risky asset
In this example, if an investor were to invest 100% into the riskfree asset, the expected return would be 3% and the risk of the portfolio would be 0%. Likewise, investing 100% into the stock would give an investor an expected return of 10% and a portfolio risk of 20%. If the investor allocated 25% to the riskfree asset and 75% to the risky asset, the portfolio expected return and risk calculations would be:
ER of portfolio = (3% x 25%) + (10% * 75%) = 0.75% + 7.5% = 8.25%
Risk of portfolio = 75% * 20% = 15%
Slope of the CAL
The slope of the CAL measures the tradeoff between risk and return. A higher slope means that investors receive higher expected return in exchange for taking on more risk. The value of this calculation is known as the Sharpe ratio.

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