What is a potential downside of rebalancing?

• A. Realizes tax losses
• B. Increases the need to trade more frequently
• C. Decreases diversification
• D. Realizes taxable capital gains

Answer: (D)

Rebalancing primarily creates a tax cost because selling assets that have appreciated to bring the portfolio back to its target mix can realize capital gains. Those gains are taxable in taxable accounts, which reduces the after-tax return even though you’re maintaining your intended risk and diversification.

Realizing tax losses isn’t the inherent outcome of rebalancing—the goal isn’t to harvest losses, and you may or may not incur losses depending on how asset prices move. Rebalancing also doesn’t decrease diversification; it’s the mechanism used to maintain your chosen level of diversification by keeping each asset class close to its target weight. While it does involve trades (and potentially higher trading costs), the most direct downside people focus on is paying taxes on gains when you sell appreciated holdings.