Question

Suppose you are managing a $1,000,000 portfolio of stocks and bonds with a constant mix strategy of 50% stocks and 50% bonds. If the stock market increases 20% and the bond market increases 10%, rebalancing would require A) selling $25,000 in bonds and buying $25,000 in stocks B) selling $50,000 in bonds and buying $50,000 in stocks C) selling $50,000 in stocks and buying $50,000 in bonds D) selling $25,000 in stocks and buying $25,000 in bonds

Answer 1

Answer is D.

Now, in this question, stating portfolio value is $1,000,000, with 50% in stocks and 50% in bonds.

portfolio value with 50% in stocks = $500,000

portfolio value with 50% in bonds = $500,000

Now, a 20% return in stock market and 10% return in bond market would revise the portfolio value.

New portfolio value of stocks = $500,000 * (1 + 20%) = $600,000

New portfolio value of bonds = $500,000 * (1 + 10%) = $550,000

Hence, total portfolio value = $600,000 + $550,000 = $1,150,000

Now, in order to maintain 50% of portfolio in stocks and rest in bonds, ideal portfolio values for both shoud be 50% * $1,150,000 = $575,000

In order to rebalance,

stocks (which are at higher value from required), you need to sell them = $600,000 - $575,000 = $25,000

bonds (which are at lower value from required), you need to buy them = $575,000 - $550,000 = $25,000

Hence, sell stocks worth $25,000 and buy bonds worth $25,000.