Questions: Asset Allocation and Rebalancing Strategy

Question 1

Your target allocation is 60% stocks / 40% bonds. After a strong market year, stocks have grown to represent 72% of your portfolio. What does rebalancing require you to do?

• A. Buy more stocks to lock in gains before a possible correction
• B. Sell some stocks and buy bonds to return to the 60/40 target
• C. Do nothing — drift from the target allocation is expected and harmless
• D. Raise the stock target to 72% to reflect the market's signal

Answer: (B)

Rebalancing restores the portfolio to its target by selling what has grown above target (stocks at 72%) and buying what has fallen below target (bonds). This is mechanically counterintuitive — you are selling the winner — but it enforces risk control and produces a 'sell high, buy low' effect without any market prediction. Option A is the classic emotional investor mistake: chasing recent winners increases unintended concentration in stock risk.

Question 2

A critic says rebalancing is 'just market timing in disguise.' Which argument best refutes this?

• A. Rebalancing beats the market on average, proving it generates alpha from timing
• B. Rebalancing is triggered by predetermined allocation rules, not by forecasts about future market direction
• C. Since rebalancing happens annually, it cannot be market timing because timing requires frequent trading
• D. Rebalancing only trims positions — buying and selling are not both involved

Answer: (B)

Market timing means making buy/sell decisions based on predictions about future prices. Rebalancing makes decisions based solely on current allocation relative to a pre-set target — no forecast is required or consulted. When stocks hit 72%, you sell regardless of whether you expect them to keep rising or fall next month. The decision rule is mechanical and pre-committed, which is the opposite of timing.

Question 3

Rebalancing systematically forces an investor to sell assets that have risen in price and buy assets that have fallen.

• T. True
• F. False

Answer: True

True. When an asset class outperforms, its portfolio share grows above the target — rebalancing trims it (selling at elevated prices). When an asset class underperforms, its portfolio share falls below target — rebalancing adds to it (buying at depressed prices). This 'buy low, sell high' effect is automatic: it is a mathematical consequence of reverting to a fixed target after prices have moved, not a prediction that prices will reverse.

Question 4

A higher allocation to stocks is typically better for long-term investors because stocks have historically outperformed bonds.

• T. True
• F. False

Answer: False

False. Stocks have higher long-run expected returns, but a portfolio concentrated in stocks can drop 50–60% in a severe bear market. An investor who panic-sells at the bottom because they couldn't tolerate the loss ends up worse than someone with a 60% stock allocation who stayed the course. The 'best' allocation is the highest one you can psychologically maintain through downturns without abandoning the strategy — not the one with the highest expected return in isolation.

Question 5

Explain how rebalancing produces a 'buy low, sell high' effect without requiring any predictions about future market returns.

Model answer: Rebalancing uses a fixed target allocation as a reference point. When asset prices move, the portfolio drifts from that target. To restore it, you sell whatever has grown above target (which, by definition, has risen in price) and buy whatever has fallen below target (which has fallen in relative price). The contrarian direction of the trades is a mechanical consequence of mean-reverting to a fixed target — no forecast of future price direction is needed or assumed.

This separates rebalancing from speculation. The decision trigger is purely rule-based: is the portfolio more than X% off-target? If yes, trade back to target. The behavioral value is that this discipline forces you to do the opposite of what emotional investors do — they buy winners and sell losers. Over decades, systematic contrarianism executed mechanically is one of the few behavioral edges available to individual investors.