An investor holds a 60/40 equity/bond portfolio in a taxable account. After a strong equity year, the allocation has drifted to 70/30. What is generally the most tax-efficient way to rebalance back toward 60/40?
ASell the excess equities immediately and buy bonds to restore the target weights
BDo nothing — drift of 10 percentage points is within normal tolerance
CDirect new contributions and dividends into bonds rather than selling appreciated equities
DSwitch to annual calendar rebalancing to limit trading frequency
In a taxable account, selling appreciated equities to rebalance triggers realized capital gains taxes, which are a hard cost. Directing new contributions and income (dividends, interest) into underweight assets achieves the same rebalancing effect — restoring target weights — without creating a taxable event. This is not a reason to avoid rebalancing altogether; it is a tax-aware method of executing it. In a tax-advantaged account like an IRA, Option A would be appropriate since there is no tax cost to selling.
Question 2 Multiple Choice
A portfolio holds two uncorrelated, mean-reverting asset classes that alternate in performance. Why does systematic rebalancing generate a 'rebalancing bonus' over the long run?
ARebalancing locks in gains by moving out of volatile assets into stable ones
BBy selling recent outperformers and buying recent underperformers among mean-reverting assets, rebalancing systematically harvests the turn of the cycle
CRebalancing reduces overall portfolio volatility, which compound return mathematics converts into higher terminal wealth
DFrequent trading generates better price execution as the investor builds a track record with brokers
With mean-reverting, uncorrelated assets, the outperformer today tends to underperform tomorrow, and vice versa. Rebalancing forces a sale of the outperformer (near its temporary peak) and a purchase of the underperformer (near its temporary trough), systematically capturing the spread of each cycle. Option C is related — lower volatility does improve compound returns — but it describes a consequence of the mechanism rather than the mechanism itself. The rebalancing bonus arises specifically from the contrarian trades, not from volatility reduction per se.
Question 3 True / False
Calendar-based rebalancing may execute trades even when the portfolio's asset weights are close to their target allocations.
TTrue
FFalse
Answer: True
This is a genuine limitation of calendar rebalancing: it triggers trades on a fixed schedule regardless of whether actual drift is meaningful. If a quarterly rebalance date arrives and weights are only 0.5 percentage points off target, the investor still trades, incurring transaction costs for minimal benefit. Tolerance-band rebalancing specifically addresses this by only trading when weights have drifted beyond a meaningful threshold. Many practitioners use a hybrid: check on a schedule, but only trade if drift exceeds the band.
Question 4 True / False
More frequent portfolio rebalancing generally produces better long-term risk-adjusted returns by keeping the portfolio closer to its target allocation.
TTrue
FFalse
Answer: False
Rebalancing frequency involves a fundamental tradeoff: more frequent rebalancing reduces drift and keeps risk exposure closer to target, but generates more transaction costs and, in taxable accounts, more frequent realization of capital gains. In tax-advantaged accounts with low transaction costs, more frequent rebalancing is relatively cheap and can be beneficial. But in taxable accounts with concentrated positions, over-rebalancing can substantially erode after-tax returns. The optimal frequency depends on account type, asset class liquidity, portfolio size, and the magnitude of drift — there is no universally correct frequency.
Question 5 Short Answer
What is the core behavioral challenge of systematic rebalancing, and why does it tend to add value precisely because it is behaviorally uncomfortable?
Think about your answer, then reveal below.
Model answer: Rebalancing requires selling recent winners (assets that have outperformed) and buying recent losers (assets that have underperformed). This is behaviorally uncomfortable because investors naturally want to hold winning assets and avoid or sell losing ones — following momentum rather than contrarian logic. The discomfort is a signal that the investor is going against market sentiment. With mean-reverting assets, this contrarian discipline adds value: by selling high and buying low at regular intervals, the investor systematically captures the oscillations in relative performance rather than chasing the most recent trend. The behavioral difficulty is not a bug but a feature — it is the mechanism through which the rebalancing bonus is earned.
This question tests whether students understand that rebalancing is not just mechanical weight adjustment but a form of disciplined contrarianism. The connection to behavioral finance — loss aversion, recency bias, momentum chasing — is the reason rules-based rebalancing was codified in the first place: to override the emotional impulse to do the wrong thing at the wrong time.