NASAA Series 66 Uniform Combined State Law ExaminationClient Investment Recommendations and StrategiesMedium
A client has a portfolio consisting of 60% equities and 40% fixed income. Due to a strong bull market, the equity portion has grown significantly, now representing 75% of the portfolio. To maintain their original target asset allocation, the client should engage in which of the following actions?
- ASell a portion of their fixed income holdings.
- BDo nothing, as the increased equity allocation indicates strong performance.
- CSell a portion of their equity holdings and purchase fixed income.
- DPurchase additional equity securities.
Show answer & explanationAnswer & explanation
Correct answer: C. Sell a portion of their equity holdings and purchase fixed income.
To rebalance a portfolio back to its target allocation after one asset class has outperformed, the investor must sell some of the outperforming asset and use the proceeds to buy more of the underperforming asset. In this case, selling equities (which are now overweight) and buying fixed income (which are now underweight) will bring the portfolio back to the 60/40 target.
Why the other options are wrong
- A. Selling fixed income would decrease the fixed income allocation, exacerbating the imbalance.
- B. Doing nothing would allow the portfolio to drift further from its target allocation, potentially increasing risk beyond the client's comfort level.
- D. Purchasing more equities would further increase the equity allocation, moving further away from the target.
Portfolio Rebalancing
The process of adjusting a portfolio's asset allocation back to its original target weights after market movements have caused them to drift.
- Involves selling assets that have grown (overweight) and buying assets that have lagged (underweight).
- Helps maintain the desired risk-return profile.
- Can be done periodically (e.g., annually) or when drift exceeds a certain threshold.
Memory trick: Rebalance: Sell the Winners, Buy the Losers, Keep the Balance.