A more risk-averse investor should prioritize minimizing volatility and securing returns through diversification or risk-free assets like T-bills. When integrating additional stocks, diversifying with negatively correlated or low-correlation assets can help reduce overall portfolio risk while achieving risk-adjusted returns. Incorporating T-bills offers risk-free returns that stabilize the portfolio. Conversely, risk-tolerant investors might accept higher volatility for greater return potential and may invest more heavily in high-risk, high-return stocks, even if correlations are higher, betting on achieving higher expected returns .

Correlation coefficients between assets are crucial in portfolio diversification. They indicate whether asset returns move in the same or opposite directions, influencing overall portfolio variance. To reduce risk, investors typically look for assets with low or negative correlation. For example, if adding stocks to a portfolio of stock A, choosing stock C with a negative correlation (-0.60) to A would enhance diversification more effectively than stock B (Corr(A, B) = 0.85), which has a strong, positive correlation to A. By selecting assets with lower or negative correlations, an investor can achieve better diversification, thus potentially achieving higher risk-adjusted returns as overall portfolio volatility decreases .

This statement is not accurate. While the standard deviation of a portfolio involves the standard deviations of the individual assets, it is not a simple weighted average due to the correlation between assets. Portfolio standard deviation is calculated taking these correlations into account: σ_p = sqrt(w_1² * σ_1² + w_2² * σ_2² + 2 * w_1 * w_2 * Cov(R_1, R_2)). The covariance term (which includes the correlation between assets) means the portfolio standard deviation can be lower than a weighted average of individual standard deviations, particularly if the assets are less than perfectly positively correlated. Thus, the diversity effect, due to diversification, reduces risk .

Plotting the investment opportunity set of two risky funds helps investors visualize the potential risk-return combinations available from different portfolio compositions. This plot typically forms a curve called the efficient frontier, which represents portfolios offering the highest expected return for a given level of risk. By drawing a tangent from the risk-free rate to this opportunity set, the point of tangency represents the optimal risky portfolio—the portfolio providing the highest Sharpe ratio (greatest risk-adjusted return). This tangent line is the Capital Allocation Line (CAL) and showcases the best combination of risky assets to maximize expected return for any given level of total portfolio risk .

The Sharpe ratio measures the excess return per unit of risk of an investment, defined as (E(R_p) - R_f) / σ_p, where E(R_p) is the expected portfolio return, R_f is the risk-free rate, and σ_p is the portfolio's standard deviation. The best feasible CAL is the one with the tangent maximum Sharpe ratio, indicating the highest expected excess return per unit of risk. A higher Sharpe ratio suggests a more desirable investment because it implies that the investor is rewarded more for each unit of risk taken. This is important for assessing the trade-off between risk and return, allowing investors to identify portfolios that maximize returns for a given level of risk .

Introducing T-bills, which have a risk-free rate of return, into a purely stock-based portfolio alters the risk and return dynamics significantly. T-bills help lower the portfolio's overall risk, represented by standard deviation, since they have zero correlation with stocks. This shift allows for the construction of a Capital Allocation Line (CAL) that combines the risk-free rate with the optimal risky portfolio to achieve the desired balance of risk and return. The inclusion of T-bills enables investors to fine-tune the risk profile by adjusting the weight of T-bills in the portfolio, which achieves the desired level of expected return without substantially increasing risk .

Understanding the correlation between paired stock assets is critical in portfolio management as it directly affects portfolio risk through diversification. Correlation quantifies the degree to which stock returns move together. A low or negative correlation between assets enables better risk diversification, as movements in one asset can offset movements in another, reducing overall portfolio volatility. Ignoring correlation can lead to suboptimal asset mixes where diversification is not effectively achieved, resulting in higher portfolio risk and potentially lower risk-adjusted returns. It is fundamental to construct portfolios with an awareness of asset correlations to optimally balance risk and return .

To calculate the proportions of each asset in an optimal risky portfolio given specific return requirements, you typically use the Capital Asset Pricing Model (CAPM) framework and the formula for the optimal portfolio weights. First, determine the excess returns of the risky assets over the risk-free rate. Using the formulas for the optimal weights that maximize the Sharpe ratio, adjust for the correlation among assets. Given an expected portfolio return requirement, such as 14% in this case, equate it to the returns equation: E(R_p) = w_S * E(R_S) + w_B * E(R_B) + w_f * R_f, where w_S and w_B are the weights of the stock and bond funds respectively, and w_f is the weight of the risk-free asset. Solve these equations with the constraints that the portfolio weights sum to 1 and non-negativity across assets. Assumptions regarding borrowing/lending at the risk-free rate adjust the weights accordingly to see which composition meets the specified return efficiently .

According to standard investment theory, particularly the Capital Market Theory (CMT), when expected returns and standard deviations of all securities are known, all investors derive the same optimal risky portfolio because they all operate under the same efficiency assumptions. The optimal risky portfolio, as shown on the Capital Market Line (CML), is obtained when investors maximize their Sharpe ratio given the known parameters. The choice of the optimal risky portfolio does not vary among investors; instead, it is the risk-free borrowing and lending that adjust individual portfolios to meet personal risk preferences, allowing the composition of risky assets to remain constant across investors .

To determine the investment proportions in the minimum-variance portfolio of the two risky funds, you use the formula for the weights of each fund that minimizes variance. For two funds, these weights depend on their variances and the covariance between them. The formula for the weight of the first fund is: w_S = (σ_B^2 - Cov(R_S, R_B)) / (σ_S^2 + σ_B^2 - 2 * Cov(R_S, R_B)), where σ_S^2 and σ_B^2 are the variances of the stock and bond funds respectively and Cov(R_S, R_B) is their covariance. Once you have the weights, you can calculate the expected return of the minimum-variance portfolio as E(R_min) = w_S * E(R_S) + (1 - w_S) * E(R_B). The standard deviation is found using the formula σ_min = √(w_S^2 * σ_S^2 + (1-w_S)^2 * σ_B^2 + 2 * w_S * (1-w_S) * Cov(R_S, R_B)). In this case, using the given data for expected returns, standard deviations, and correlation, compute the covariance and apply these formulas to find the investment proportions, expected return, and standard deviation of the minimum-variance portfolio.