A portfolio holds 60% stocks (historical average return: 10%) and 40% bonds (historical average return: 5%). What is its expected annual return?
A7.5% — the simple average of 10% and 5%
B8.0% — the weighted average using the portfolio proportions
C10% — stocks dominate so the portfolio earns the stock rate
D6.0% — bonds reduce the return proportionally more than stocks increase it
Expected portfolio return is the weighted average: (0.60 × 10%) + (0.40 × 5%) = 6% + 2% = 8%. Option A (7.5%) is the unweighted average, which ignores the different allocations. The key insight is that each asset contributes proportionally to its weight — a larger stock allocation raises expected return but also raises volatility.
Question 2 Multiple Choice
A 65-year-old retiree and a 25-year-old early-career professional both have $200,000 saved. Which allocation is more appropriate for the retiree, and why?
A80% stocks / 20% bonds — the higher expected return maximizes wealth regardless of age
B40% stocks / 60% bonds — the shorter time horizon means less ability to recover from large drawdowns
C100% bonds — retirees should never hold stocks because stocks can lose value
DThe same allocation — expected return, not age, should determine allocation
The retiree's time horizon is short: they may need to draw down savings soon and cannot wait out a 40% market drop. The 25-year-old has decades for compounding and recovery, so they can tolerate higher short-term volatility in exchange for higher expected long-run returns. Option A reflects the misconception that higher expected return is always better — it ignores sequence-of-returns risk, where a large early loss permanently impairs withdrawals.
Question 3 True / False
A portfolio with higher expected return is the better choice for any investor, since more wealth is typically preferable to less.
TTrue
FFalse
Answer: False
Higher expected return comes with higher volatility and larger potential drawdowns. For an investor with a short time horizon or low risk tolerance, a severe downturn at the wrong time can cause permanent harm — forcing the sale of assets at depressed prices, or failing to meet income needs. Expected return is a long-run probabilistic average, not a guarantee. The 'better' portfolio depends on the investor's time horizon, income needs, and psychological tolerance for seeing their balance drop sharply.
Question 4 True / False
Periodic rebalancing of a portfolio — selling assets that have grown beyond their target weight and buying those that have fallen below — naturally implements a mild 'buy low, sell high' discipline.
TTrue
FFalse
Answer: True
If stocks rise significantly, they become a larger share of the portfolio than intended, meaning you sell some at elevated prices to restore the target weight. What has lagged (say, bonds) is bought at relatively lower prices. This rebalancing process isn't primarily about market timing — it's about maintaining your intended risk level — but the buy-low-sell-high effect is a genuine side benefit that has been documented historically.
Question 5 Short Answer
Why should asset allocation shift toward more conservative mixes as an investor approaches the date they need the money?
Think about your answer, then reveal below.
Model answer: As the time horizon shortens, there is less time to recover from a severe market downturn. A 30-year investor can absorb a 40% drop because markets have historically recovered over long periods, and compounding has time to rebuild wealth. A retiree drawing down their portfolio in 2–3 years cannot wait for recovery — a large loss locks in permanently reduced balances at the worst possible time. The shorter the horizon, the more stability matters relative to expected return.
This is the core logic behind 'target-date funds' that automatically shift toward bonds as a retirement year approaches. Expected return is a long-run property; the relevant question for near-term withdrawals is not 'what will I have in 30 years?' but 'can I meet my expenses if markets drop 30% next year?' These questions have different answers, and allocation must match the actual time horizon of the need.