Question

You’ve just decided upon your capital allocation for the next year, when you realize that you’ve underestimated both the expected return and the standard deviation of your risky portfolio by 4%. Will you increase, decrease, or leave unchanged your allocation to risk-free T-bills?

Short answer

I will decrease allocation to risk-free T bills.

Step-by-step solution

Given Information

Underestimation of expected return and standard deviation by 4%

Definition

Capital allocation is the process through which an organization determines its investment strategy for maximizing values of its shareholder’s equity.

Explanation

Since typically standard deviation exceeds return, a reduction of 4% in each will artificially decrease the return per unit of risk. To return to the proper risk return relationship, the portfolio will need to decrease the amount of risk free investments.