classes. Some of the portfolio may be in risk-free Trea- sury bills, some in high-risk stocks. The most straightforward way to control the risk of the portfolio is through the fraction of the portfolio invested in Treasury bills and other safe money market securities versus risky assets. This capital allocation decision is an example of an asset allocation choice- a choice among broad investment classes, rather than among the specific securities within each asset class. Most investment professionals consider asset allocation the most impor- tant part of portfolio construction. Consider this statement by John Bogle, made when he was chairman of the Vanguard Group of Investment Companies:   The most fundamental decision of investing is the allocation of your assets: How much should you own in stock? How much should you own in bonds? How much should you own in cash re- serves? . . . That decision [has been shown to account] for an astonishing 94% of the differences in total returns achieved by institutionally managed pension funds . . . There is no reason to be- lieve that the same relationship does not also hold true for individual investors.1   Therefore, we start our discussion of the risk-return trade-off available to investors by ex- amining the most basic asset allocation choice: the choice of how much of the portfolio to place in risk-free money market securities versus other risky asset classes. We will denote the investors portfolio of risky assets as P and the risk-free asset as F. We will assume for the sake of illustration that the risky component of the investors overall portfolio is comprised of two mutual funds, one invested in stocks and the other invested in     1 John C. Bogle, Bogle on Mutual Funds (Burr Ridge, IL: Irwin Professional Publishing, 1994), p. 235 II. Portfolio Theory 7. Capital Allocation between the Risky Asset and the Risk−Free Asset The McGraw−Hill Companies, 2001         CHAPTER 7 Capital Allocation between the Risky Asset and the Risk-Free Asset 185     long-term bonds. For now, we take the composition of the risky portfolio as given and focus only on the allocation between it and risk-free securities. In the next chapter, we turn to as- set allocation and security selection across risky assets. When we shift wealth from the risky portfolio to the risk-free asset, we do not change the relative proportions of the various risky assets within the risky portfolio. Rather, we re- duce the relative weight of the risky portfolio as a whole in favor of risk-free assets. For example, assume that the total market value of an initial portfolio is