How is the portfolio determined?

How is the portfolio determined?

To determine the optimal portfolio allocation, we need to look at
the preference of the individual. Utility in this case is a function of
the expected return (Ye) and the risk (Rw). Since expected return is
a good and risk is a bad, the indifference curve in this case is
upward sloping, indicating that a person will be willing to accept
more risk provided it yields a higher return.

The highest indifference curve that is tangent to the expected
return risk relationship line shows the optimal expected return and
risk (K). Dropping a vertical line down from this position to the
lower diagram then indicates the optimal amount of bond holdings
(Bo). The wealth not held as bonds is held in money.

The demand for money is what Tobin terms as “behaviour toward
risk” – the result of attempting to reduce risk below what it would
be if all wealth were held in bonds. An all bond portfolio would
increase the risk to Rw* and an expected return of Ye*. The
individual would be on a lower indifference curve. People choose
to forgo a higher expected return in exchange for a decrease in risk.