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Don’t cruise control your portfolio – Portfolio Drift (Concept 4)

Don't cruise control your portfolioI’m sure there’ve been many times during road trips where cruise control saved your sanity—a long, flat road stretching out in front of you for miles and miles, after you’ve been driving for, well, miles and miles. But one click of the “cruise” button, and you’re all set, feet rested and speed in check.

However, you wouldn’t throw your hands behind your head, kick up your feet, and call it a day. You’d (hopefully) keep your hands on the wheel, hitting the brakes when there’s traffic or you need to slow down.

The same applies to your portfolio. Although you have diversified your investments across various equities, bonds and commodities over a number of asset classes, and taken advantage of the Modern Portfolio Theory, your work isn’t quite done yet. Keep your hands on your investments’ constantly drifting wheel.

There’s no “set it and forget it” approach when it comes to investing. It’s imperative to regularly rebalance your holdings, adding and trimming your investments, in order to avoid the potentially hazardous portfolio drift. Believe me, the term is not as cool as drifting with a car.

Portfolio drift occurs when asset classes have varying intermittent rates of return. Over time, weightings tend to drift from their target allocations, which is why it’s crucial to keep this drift in check. For example, an asset class that started with a 15% holding can eventually make up considerably more than 15% of a portfolio after months or years in which it outperforms other asset classes.

Although having a particular asset class outperform seems great at first, it can prove dangerous in the long run when the asset class inevitably corrects itself. Many investors experienced this during the 2008/2009 market correction. Through the years before the correction, equities were considerably outperforming other asset classes, especially bonds, by a significant margin. Although this drift in asset allocation had the short-term effect of increasing investors’ net worth, it also quietly increased the risk their portfolios were exposed to.

Unfortunately, when the crash came, investors who failed to rebalance their portfolios experienced much larger declines in their net worth than they thought possible. This devastated many people’s net worth and forced many to postpone their long-awaited retirements.

As an added bonus, rebalancing not only reduces the risk in your portfolio, but it also adds to your long-term returns. By regularly rebalancing your portfolio (see diagram above), you are trimming securities that have done relatively well and adding ones that have not. Basically, you’re trimming positions that may be expensive and buying ones that may be on sale.

Research has shown that by rebalancing once or twice a year, you will likely add additional returns to your portfolio. The real beauty of this is that you can arbitrarily choose the rebalancing dates in advance and it will still work!

So make sure you protect your portfolios and increase your net worth at the same time by rebalancing. Stay tuned for my fifth and final post in this series: investor psychology and the five common mistakes we make.

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