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/.
Related or Semi-related Video
Finance: What is a Current Asset?16 Views
Finance, a la shmoop. What is a current asset? Current yeah it's kind of a [Picture of a currant on a plant]
socialist raisin there, you know they all look about alike but that's a [Soldiers marching in front of Stalin with currants for heads]
currant and has nothing to do with current as cur-rent remember it like
your rent comes due soon, you rent a place for a year or less usually or at [Guy sticks his head out of pile of overdue bills]
least that's how long, you know lock in your rental rate. So if your [Someone signing a contract]
asset is current then it can be turned into cash within a year. That's how we
remember it here around Shmoop. Examples? A bond coming due in a year or less. [Bond document]
Companies store their cash all the time in short term paper like certificates of
deposit or Bank CDs which come due in less than a year. that's a current asset. [List of short-term paper]
And companies buy these kinds of bonds so they get a little more interest than
from their banks you know checking account. They buy stocks as well, shares [New interest rate is very small]
of goog can be easily converted into cash quickly. Shares in Google are a [Current asset stamp]
current asset. Ounces of gold, yep easily a current asset. All right you get the
idea, so what's not current well fourteen thousand acres of solar panel land that [Huge fields full of solar panels]
your company owns. If you ever had to sell it while there are very few buyers
and it likely would take more than a year just to figure out all the [Calendars popping up]
regulatory restrictions on selling it. A big old factory well can't sell that on [Red cross appears on a factory]
Amazon or Ebay, definitely not current. Your brand equity
in your corporation like the relationship you've developed with your
consumers, yeah it's another non-current asset you can't exactly go to the bank [Guy going up to the bank and pleading]
and convert brand loyalty to USD. So that's it current assets they live here [Arrow pointing to current assets on a balance sheet]
on this side of the balance sheet way up top in the good view seats high on the [Current assets in a tree]
vine of the tree. So put down those currants, stop ranting about the [Stalin holding a currant]
proletariat and for God's sake just buy some raisins. [Guy pointing to a box of raisins]
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