Your friend is facing an important decision. She was recently hired by a large bank, First Global, as a junior associate. Her primary responsibility is reviewing loan applications for completeness and conducting an initial analysis of the credit information. She is very knowledgeable about loans; however, she has come to you with a dilemma. The decision she is facing does not involve a work-related task, rather it involves questions regarding how she should set up her retirement account. She wants to get started investing early in life as she understands the power of compound interest, but she is unclear about where she should allocate her money. She has heard that you have a solid understanding of investments, particularly the risk and return of securities. She has narrowed her options down to three choices and would like your input. The first option is to invest in a mutual fund that is comprised of a wide variety of common stock from large, domestic firms. The second option is to invest in a low-risk government security, such as U.S. Treasury bills (T-bills). The third option is to invest in the common stock of First Global. Your friend is very worried about losing her money and would like to keep her investment choice simple. For that reason she is considering choosing to invest in First Global common stock as she has calculated an average return for the stock that seems acceptable. Currently, your friend has £5,000 to invest.
Your friend likes the idea of holding both the common stock mutual fund and the government security, but she thinks that your suggestion to hold 80% of the former and 20% of the latter is too risky. She mentions that the maximum level of risk she is willing to assume is a portfolio with a standard deviation of 15%. How would you find a combination that meets this requirement? You might want to use Excel to solve this problem, but you should provide the equation(s) showing your calculations of the weights of each security and the expected return. You should also explain to your friend in plain English the approach you are following here.