Final answer:
An investor can create the optimal portfolio by mixing a risk-free asset with a risky asset, like stocks, in proportions that align with their risk tolerance and investment goals, balancing security and potential for higher returns.
Step-by-step explanation:
To construct an optimal portfolio, an investor can combine a risk-free asset with a risky asset such as stocks. The process involves determining the proportion of each asset type in order to balance the return expectations with the desired level of risk. A risk-free asset like a bank account provides security and a guaranteed return, although typically low. On the other hand, risky assets such as stocks offer potentially higher returns in exchange for the heightened uncertainty and possible losses. An investor's personal risk tolerance, investment horizon, and financial goals are key factors in deciding the allocation between these asset types. For example, a conservative investor may prefer a higher proportion of risk-free assets, while an aggressive investor might opt for a substantial investment in stocks to maximize potential returns over time.