After a strong stock market rally, your 60% stock / 40% bond portfolio has drifted to 75% stock / 25% bond. Why is this a problem that rebalancing addresses?
AThe portfolio is now underperforming its benchmark because bonds are underweighted
BThe portfolio now carries more market risk than you intended when you chose 60/40
CThe portfolio is now too diversified, making it harder to generate returns
DThe bonds have declined in absolute value, creating unrealized losses
Rebalancing is not about chasing returns — it is about maintaining your intended risk profile. A 75/25 portfolio is more volatile than a 60/40 portfolio: if stocks fall sharply, you lose more than you planned for when you originally set your allocation. The drift happened because stocks performed well, which is desirable, but it shifts the composition away from your deliberate risk decision. Rebalancing restores the risk level you actually want.
Question 2 Multiple Choice
Why does rebalancing a portfolio embody 'buy low, sell high' behavior without requiring the investor to predict future market movements?
ABecause calendar rebalancing schedules purchases to coincide with market bottoms
BBecause selling assets that have risen and buying assets that have lagged structurally means selling high and buying low
CBecause threshold rebalancing filters out assets that are overvalued relative to their fundamentals
DBecause the investor sells winners before they decline and holds losers until they recover
Rebalancing forces a structural buy-low, sell-high discipline: you sell the asset class that has risen (relative to target) and buy the one that has lagged. No prediction is required — the decision is triggered purely by drift from target allocation. This implicitly bets on mean reversion (outperformers don't perpetually outperform) without requiring a forecast. Option D describes active trading based on prediction, which is the opposite of systematic rebalancing.
Question 3 True / False
Portfolio rebalancing is a form of market timing because it involves selling assets after they have already risen.
TTrue
FFalse
Answer: False
Market timing involves predicting future price movements to decide when to buy or sell. Rebalancing makes no such prediction — it sells what has grown beyond its target weight and buys what has fallen below it, based solely on current allocation drift. The selling happens after a rise, but the trigger is rule-based (target allocation), not a forecast that the asset will fall. The distinction matters because market timing consistently fails for most investors, while systematic rebalancing provides structural discipline without requiring predictive skill.
Question 4 True / False
In a tax-advantaged account like an IRA or 401(k), you can rebalance by selling overweighted assets without immediately triggering capital gains taxes.
TTrue
FFalse
Answer: True
Tax-advantaged accounts shelter gains from immediate taxation — transactions inside the account do not create a taxable event. This makes rebalancing straightforward: you can freely sell the overweighted asset class and buy the underweighted one. In contrast, taxable accounts create capital gains taxes on profitable sales, which introduces friction and requires strategies like directing new contributions toward underweighted classes or prioritizing long-term-gain-eligible assets to reduce the tax cost of rebalancing.
Question 5 Short Answer
Why is portfolio rebalancing psychologically difficult for most investors, and what structural discipline does it provide despite that difficulty?
Think about your answer, then reveal below.
Model answer: Rebalancing requires selling recent winners and buying recent underperformers — the opposite of what feels natural. Investors are psychologically drawn to assets that have been rising (recency bias, momentum thinking) and reluctant to add to ones that have lagged. Selling a winner feels like leaving gains on the table; buying a loser feels like throwing good money after bad. The structural discipline it provides is twofold: it maintains the intended risk level (preventing unintentional overexposure to any asset class) and it enforces a mechanical buy-low, sell-high pattern. By anchoring decisions to target allocations rather than recent performance, rebalancing removes emotion from the timing of buy and sell decisions.
The psychological difficulty is real and documented — most investors chase performance rather than rebalance. Understanding that the purpose is risk control (not return maximization) helps reframe the counterintuitive act of selling winners as prudent rather than irrational.