Rebalancing

A client's target allocation is 60 percent stocks and 40 percent bonds. After a strong equity year the actual mix stands at 72 and 28. What does rebalancing accomplish?

1. A.It raises expected return by concentrating in whichever asset has performed best.Wrong. Rebalancing does the opposite, trimming the winners rather than concentrating further in them.
2. B.It eliminates the portfolio's exposure to broad market declines going forward.Wrong. Any equity allocation leaves market risk in place, and rebalancing sets its size rather than its existence.
3. C.It sells part of what has risen and restores the intended level of risk.Correct. Drift has lifted equity exposure above target, and selling back to target restores the chosen risk level.
4. D.It converts systematic risk into nonsystematic risk that can then be diversified.Wrong. The two categories are not interchangeable, and no trade converts one of them into the other.

Why: An allocation is a statement about how much risk the investor intends to carry, and market movements steadily push the actual mix away from it. After a strong equity year the portfolio holds more stock than intended, so it carries more systematic risk than the plan called for. Rebalancing sells the appreciated asset and buys the lagging one, returning the mix, and with it the risk, to target. The point is discipline about risk rather than a prediction that the winning asset is about to fall.

A client policy allocation is 60% equity and 40% fixed income. After three strong years for stocks, the account stands at 74% equity. She objects to rebalancing because, in her words, it means selling what is working. The adviser most accurate response is that rebalancing:

1. A.Is a market-timing decision reflecting the adviser view that equities are now overvaluedRebalancing is mechanical and rule-driven. Framing it as a forecast would turn a risk-control process into a prediction the adviser cannot support.
2. B.Reliably increases long-run returns compared with letting the allocation driftReturn outcomes depend heavily on the period studied, and in a prolonged bull market drifting can outperform. The dependable benefit is risk control.
3. C.Should be avoided in a taxable account because any sale creates a taxable eventTax cost is a real consideration that argues for careful technique, such as directing new cash to underweights, not for abandoning risk control entirely.
4. D.Restores the risk exposure she originally agreed to, since drift has raised her equity risk above the policy levelCorrect. The purpose is keeping actual risk aligned with the stated policy; the contrarian trade is a by-product of that discipline, not a forecast.

Why: Rebalancing is a risk-control discipline, not a market forecast. Left alone, a portfolio drifts toward whichever asset class has performed best, so the client risk exposure quietly rises above what her policy contemplates, usually just as valuations are highest. Selling appreciated assets and buying laggards restores the intended risk profile and imposes a systematic sell-high, buy-low discipline. It is not a prediction that stocks will fall.

The Ardleigh family portfolio carries a 60/40 policy target and sits entirely in a taxable account. Their adviser is choosing between two rebalancing disciplines: calendar rebalancing on the same date every year, and threshold rebalancing whenever any asset class drifts more than five percentage points from its target. Which comparison is most accurate?

1. A.Neither method creates tax consequences, because rebalancing trades inside one portfolio qualify as a like-kind exchange.Incorrect. Like-kind exchange treatment does not apply to securities. Every sale in a taxable account is a realization event.
2. B.Threshold rebalancing always produces fewer transactions and lower taxes, because it trades only when a limit is breached.Incorrect. In a volatile market the band can be breached repeatedly, producing more trades and more realized gains than an annual rule.
3. C.Threshold rebalancing tracks actual market moves and keeps realized risk closer to target, but trades at unpredictable times and can trade more often; calendar rebalancing is simpler but allows larger drift between dates.Correct. This states the genuine trade-off: responsiveness and risk control versus simplicity and predictability.
4. D.Calendar rebalancing keeps risk closer to target at all times, precisely because it is performed on a fixed schedule.Incorrect. A fixed schedule says nothing about what happens between dates, which is when the drift accumulates.

Why: Calendar rebalancing is simple, predictable and easy to administer, but between review dates the portfolio can drift a long way from its risk target, which is exactly what happens in a fast-moving market. Threshold rebalancing reacts to what markets actually did rather than to the date, so realized risk stays closer to the policy target, but trades arrive at unpredictable times and, in a volatile year, more often. Neither method is free: every rebalancing trade in a taxable account can realize capital gains, so the discipline chosen must be weighed against that tax drag.