Combination Fraction of Portfolio in Diversified Stocks Average Annual Return Standard Deviation of Portfolio Return (Risk)
(Percent) (Percent) (Percent)

A 0 2.00 0
B 25 4.50 5
C 50 7.00 10
D 75 9.50 15
E 100 12.00 20

If Rosa reduces her portfolio's exposure to risk by opting for a smaller share of stocks, he must also accept a average annual return. Suppose Rosa currently allocates 25% of her portfolio to a diversified group of stocks and 75% of her portfolio to risk-free bonds; that is, she chooses combination B. She wants to increase the average annual return on her portfolio from 4.5% to 9.5%. In order to do so, she must do which of the following?

a. Sell some of her bonds and use the proceeds to purchase stocks
b. Sell some of her stocks and use the proceeds to purchase bonds
c. Place the entirety of her portfolio in bonds
d. Accept a lower average annual rate of return

Debt or bonds is less risky so it generates lower returns. Stock or equity comprises high risk so it offers high returns to its investors. If Rosa wants to increase her returns from 4.5% to 9.5% then he should sell some of its bonds and invest the proceeds into stocks. The lower returns on the bonds will be replaced by high returns on the stocks.