Portfolio drift isn’t something that happens when taking a corner too quick in your Ford Mustang on a Sunday drive. It is the natural movement of your share hold in companies across your portfolio.
When you invest in a company the share price is stated. Over the course of time the share price will change, therefore changing the amount of money you have invested.
Summary of Portfolio Drift
This example will help you understand what portfolio drift is and how you can see it in your own portfolio.
Let’s say you have £500, and you invest 50% of your money in Company A, and 50% of your money in Company B. Over time the share prices of these companies will change, and most likely, they will change at different rates.
A month passes and you check your portfolio and you notice Company A’s share price is growing quicker than Company B. Meaning now, 55% of your total portfolio is invested in Company A, and only 45% in Company B. Your portfolio has drifted.
Your allocations were set at 50/50, but after the natural movement of the market, it has turned the allocations to 55/45. You want to be as close to your target allocations as possible.
What are Asset Allocations?
Asset allocation is a way of managing your risk when investing. A lot of online gurus will talk about the perfect allocation, but no one has the right formula. Unfortunately, asset allocations are not an exact science, you need to figure out your goals and plan your allocation accordingly.
Asset allocation is very important, it gives your portfolio structure and instills a discipline in the way you invest.
You are the only one to choose your perfect allocation. I can point you in the right direction if you read my other article: 10 Asset Allocation Strategies That Work For Beginners.
3 Ways of Rebalancing to Fix Portfolio Drift
Portfolio rebalancing is an essential part of investing if you want to be consistently profitable. I don’t think it is wise to blindly invest and let things run wild. If you were trying to lose weight, you would track your calories and plan your exercise. Why, when investing, should you not track your portfolio drift and plan your allocations to the optimal position for your goals.
Rebalancing with Dollar-cost Averaging
If you’re like me, you are building your portfolio every day. Dollar-cost averaging is an investing strategy used by the majority of investors to reduce risk and increase leverage in their portfolios.
The easiest way to deal with rebalancing is to invest using M1 Finance. The software M1 Finance uses allows investors to automatically rebalance portfolios for free.
But if you like doing things the hard way, which I encourage you to learn. This is how…
If you invest $100 in 4 companies, you will set target allocations for each of these companies. For ease during this example we will use the allocation of 25% per company. So you will have $25 invested in each company.
- Company A: $25
- Company B: $25
- Company C: $25
- Company D: $25
- Total Investment: $100
Because you are employing the dollar-cost averaging strategy of investing, each month you will invest a consistent amount of money into your portfolio.
Your asset allocations have drifted:
- Company A: $30
- Company B: $26
- Company C: $29
- Company D: $27
- Total Investment: $112
Companies A & C have grown at a faster rate than Companies B & D. And now you are going to invest your second $100.
Your portfolio balance after month 1 is $112, but your allocations are no longer at 25% each. Using your second $100 investment you need to rebalance the account to get back to your target allocation.
We use a Google Sheet that we give out free to our course members. It is a simple spreadsheet that will help you rebalance your account using additional investments. We are agreeing to give our readers this Google Sheet as a simple download. Just click the button below enter your email address and we’ll get the spreadsheet over to you immediately.
You will also get a link to view a video on how to use and edit the spreadsheet to meet your personal needs.
Rebalancing by Buy/Sell Strategy
This way of rebalancing is for established accounts, meaning you have invested all the money you want and are happy to let it sit and grow.
This is also the simplest way of rebalancing your portfolio. We’ll go through an example where someone has £2,000 invested in their portfolio, between 3 companies.
The allocations will be:
- Company A: 70%
- Company B: 10%
- Company C: 10%
Look at the spreadsheet below showing the portfolio drift after 1 year of market movement.
This drift is exaggerated to show the example clearly, you will most likely see a drift of 3% at most in a general year in the stock market.
This is why it is the simplest rebalancing strategy there is. Company B is ‘overweight’ by 10% and Companies A & C are ‘underweight’ by 5%. So you sell part Company B, and use those funds to buy equal amounts of Companies A & C.
Because Company B is overweight by 10%, 10% of your portfolio is £2,000 x 5% = £200. So you need to sell £200 worth of your holding in Company B, and buy £100 of Company A and £100 of Company C to increase your allocation.
This is something that requires either a portfolio manager or you to manage your portfolio personally. But as I mentioned, it is not difficult to do. As long as you understand the percentages.
Rebalancing by D.R.I.P
DRIP campaigns are Dividend Re-Investment Portfolios. Dividend investors can draw a share of the profit companies in their portfolios make. You can either draw a cash dividend or a stock dividend, it is well debated which is better.
This type of rebalancing is why I love M1 Finance, they do it automatically if you want.
Dividend reinvestment is very similar to the dollar-cost averaging method, you can even use the same spreadsheet we created. You should be able to calculate your quarterly dividend from the companies you are invested in, from this you can use our spreadsheet to organise your reinvestment of these dividends.
For example if you are invested in 4 dividend paying companies, and your quarterly dividend payment is £50, you want to reinvest this £50 inline with your target allocations. So if your allocations of the 4 companies you invest in are 50%, 20%, 20%, and 10%, your $50 dividend would be reinvested in these amounts:
- Company A: £25
- Company B: £10
- Company C: £10
- Company D: £5
This is a simple example. So when your portfolio has drifted away from your target allocations you need to rebalance in both ways… Invest your dividend to meet your target allocations, and invest to rebalance your portfolio.
Again our spreadsheet can be used for this, and we include a video on how to complete the different rebalancing strategies… All for free.
How to Rebalance… A Worked Example
Don’t Fear the Buying and Selling Cycles
You might think it’s weird to sell winning stocks and buy losing stocks (or stocks that aren’t doing as well).
Warren Buffett says… “Be greedy when others are fearful”.
First, your original allocation was the right allocation 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.
Secondly, just because one company does better than others in the first financial quarter, doesn’t mean this is going to continue. So having a bigger allocation in a company that does well in quarter 1 opens you up to risk in quarter 2 because you aren’t sure if this growth will continue.
Rebalancing allows you to use your profits from one year, and build opportunities to make profits in year two.
Join the Pain Free Investing Academy
Pain Free Investing is here to help you achieve your financial goals. Let us be honest from day 1… Chris Race is our owner, lead author, and teacher on our finance & investing courses. Chris’s results are not typical, the stock market carries risk, if you are uneducated and unorganised you will fail at investing in the stock market. So think twice before investing and seek professional advice if you are unsure of anything.
Our investing academy helps you understand the stock market, find good quality investments, and perform sound fundamental & technical analysis. If you want to check the online courses we offer you can head over to our Academy page.