You will notice that Fund 4 dominates Fund 3 (higher return for less standard deviation), but it is unclear whether Funds 1, 2, or 4 are the best risky choice because none of the points dominates the other. So how can you decide? The question tells us that while we can’t create a portfolios with any of the other risky assets, we CAN combine each fund with the risk-free asset. You should remember that portfolio combinations of a risky asset and a risk-free asset are determined on a line between the two portfolios. Remember that the reason it is a line is that the return of a portfolio is a simple weighted average of its individual assets. Normally, the standard deviation of a portfolio is NOT a simple weighted average because of correlations. However, when one of the assets is risk free hence its standard deviation is zero, we DO have a weighted average. We saw this in Partner’s Healthcare with combinations of the Long-Term Pool (LTP) and the Short-Term Pool (STP). The standard deviation of a portfolio with some investment in the LTP (WLTP) and some in the STP (WSTP) 2222,2pLTPLTPSTPSTPLTPSTPLTPSTPLTP STPwwwwSince the standard deviation of the risk-free asset is 0, the second and third terms above become zero and the standard deviation of the portfolio becomes a simple weighted average.