When a portfolio includes two risky assets, the Analyst needs to take into account expected returns, variances and the covariance (or correlation) between the assets' returns. The differences from the earlier case in which one asset is riskless occur in the formula for portfolio variance.How to understand the economics of portfolio construction?
However, to better understand the economics of portfolio construction it is useful to consider the effects of combining two assets to form a portfolio. To economize on notation we omit parentheses. Thus x1 and x2 will be the proportions invested in assets 1 and 2 respectively, and e1 and e2 will be their expected returns.What are the characteristics of a two-asset portfolio?
Characteristics of a Two-asset Portfolio Combining a Riskless Asset with a Risky Asset Combining Two Risky Assets Combining Two Perfectly Positively Correlated Risky Assets Combining Imperfectly Correlated Risky Assets Risk-return Tradeoffs in Mean-Variance Space The Excess Return Sharpe Ratio Characteristics of a Two-asset PortfolioWhat is the expected return of the portfolio?
The expected return of the portfolio is 8.0%, its variance is 81.25, its standard deviation 9.0139 and it provides the Investor in question a utility of 6.375%. The latter can be seen by inspecting the vertical intercept of the green indifference curve.