Capital Allocation Line - CAL

Wall Street types have many ways of assessing the risk involved in their investments. One popular way is to draw a capital allocation line (CAL) on a graph (using an Excel program most of the time). The line will show all possible combinations of low-risk assets (such as Treasury notes) and more risky assets (such as stocks). The capital allocation line helps investors decide what combination of low-risk assets vs. more risky assets to invest in.

Using the graph, you can find your personal sweet spot of risk vs. return. The Y-axis is the expected return and the X-axis is the amount of risk, as measured by the standard deviation from the mean. If you pick a preferred risk level, the graph will show you the expected return. Or you can target a return level and see what kind of risk you'll have to stomach.

So let's say trader Calvin wants to determine the best combination of low-risk investments and more risky ones. He has two assets: a Treasury note and a stock of a recent initial public offering (IPO). Calvin expects the Treasury note to return 3% with a risk of (essentially) zero. His analysis shows the stock will return 11%, but the risk factor is much higher than with the Treasury (and higher than Calvin is willing to deal with).

After trying different combinations in the CAL program, Calvin decides that his optimal mix is to invest 30% in the virtually-risk-free Treasury note and 70% in the more risky stock. That gets him a healthy-enough return and a risk level that will allow him to sleep at night.

An example of a capital allocation line can be found at http://breakingdownfinance.com/finance-topics/modern-portfolio-theory/capital-allocation-line/.