Portfolio Drift Can Create Both Investment Risk and Opportunity
Long before The Fast & The Furious made "drifting" popular, the finance world had been talking about the dangers and opportunities caused by drift. Only in this case, the drifting is being done by your investment portfolio.
If you are not careful, portfolio drift can quickly overweight investments in your portfolio, leaving you more greatly impacted by a market downturn.
Once you start investing you’ll notice your asset allocation becomes very fluid. You may start investing with an asset allocation of 60% to stocks and 40% to bonds based on your risk tolerance. Under this allocation, 60% of your money would get invested in stocks and 40% in bonds. But as the stock market does better, the value of your stocks will increase faster than the value of your bonds, taking you away from your 60/40 split.
This is known as drift: the natural tendency for an investment portfolio to become more heavily weighted in the assets that have performed well, and become under weighted in the assets that have done poorly. The problem with drift is that you no longer have an appropriate asset allocation for your timeframe, risk, and goals.
An Example of Drift
For the sake of simplicity, let’s assume a simple 50/50 asset allocation between large cap stocks and government bonds. You’ve invested $1,000 in an S&P 500 index fund (large cap stocks) and $1,000 in a government bond index fund.
Over the year, the stock market dropped significantly, losing 20% of its value. Your S&P index fund is now worth $800. At the same time, your bond fund has increased 30% in value, making your bond fund worth $1,300.
As a result, you no longer have a 50/50 allocation. Only 32% of your portfolio is now invested in stocks and 68% is invested in bonds. This is drift.
In order to combat drift, once a year you should re-balance your asset allocation. Re-balancing means you sell the winners and buy the losers in order to bring your asset allocation back to where you want it to be. For asset allocations you manage yourself, such as your 401 (k) plan, you will have to re-balance regularly to keep your portfolio aligned with your strategy.
Since you are hopefully investing in multiple asset classes, you will have periods of time where some asset classes do very well while others may drop in value. As this happens, your asset allocation will ‘drift’ to a new asset allocation.
An Example of Re-balancing
Going back to our example, you currently have $800 in the S&P 500 index and $1,300 in government bonds. By selling $250 of the bonds and using that money to buy $250 of the S&P 500 index, you end up with $1,050 in stocks and $1050 in bonds. You have re-balanced your portfolio back to your original 50/50 strategy.
Don't Fear Selling Winners & Buying Losers
You may worry that you’ve sold the bonds which did so well, and you bought stocks which just lost you 20%. Two things should allay those worries.
First, your original strategy was the correct strategy for your risk tolerance and your goal. By allowing your portfolio to drift you are either taking on more risk than is necessary or you are lowering growth potential to a point you may not achieve your goal over the long term. Either of these things is disastrous for your long-term investments. And investing is a long-term prospect. Your strategy should not change year to year depending on what the winners and losers are.
Second, just because one asset class did well last year, doesn’t mean that class will do well this year. In fact, history has shown the best performing asset class is almost never the best performer the following year. Being over-emphasized in this year’s winners will leave you open to more risk of those assets under-performing or losing money next year.
The Opportunity in Drift & Rebalancing
When your portfolio drifts, it is because one asset increased dramatically. Investments don't continue to go up forever, so as an asset class increases in value, the chances of a correction, or a drop in value, also increases. By selling off some of the appreciated asset, you are taking your profits and reducing the impact on your portfolio if the asset drops in the following year.
Additionally, drift can occur because another asset class dropped in value. In our example, the S&P 500 just dropped 20%. Yes, a market downturn is scary, but it is also the best time to buy. When an asset class has just dropped in value, you have an opportunity to purchase the investment when it is cheap. And you are buying it with the profits from an asset class which has gone up in value.
Re-balancing allows you to use this year’s profits to buy more potential future profits.
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