Let's say, that at the start of last year, you decided to invest $20,000.
You chose to put $10,000 into the broad Australian share market and the other $10,000 into the Australian fixed interest market.
Your objective was to have a 50:50 split between shares and fixed interest (bonds/cash), which in the investment world is known as having a balanced asset allocation strategy.
The purpose of you doing this was to avoid putting all your investment eggs into one asset class basket.
Shares are inherently volatile, so having an equal split with lower-risk government bonds and cash will generally reduce your overall risk exposure.
So, how did this hypothetical investment scenario play out up by the end of 2021?
Your $10,000 investment into Australian shares had risen by 17.7 per cent over the course of the year to $11,774. But, over the same period, your investment into Australian fixed interest had fallen by 2.9 per cent to $9,713.
Overall, taking the returns from both investments, your original $20,000 investment had grown by about 7.4 per cent to $21,487.
Losing your balance
But another thing happened to your portfolio over the course of 2021. As global share markets surged, and bond markets languished, your 50:50 balanced strategy gradually became unbalanced.
By 31 December your exposure to Australian shares had increased to 55 per cent, while your once equal weighting to fixed interest had fallen to 45 per cent.
In other words, you experienced a dose of what's known as portfolio drift.
Portfolio drift occurs when the individual securities in your portfolio gain or lose value because of market movements, which causes your strategic allocation to specific asset classes to move out of alignment.
The example above shows what can happen to a portfolio in the space of just 12 months. What happens over a longer time period can be much more pronounced.
To illustrate that, let's take a look at the 10-year period between the very start of 2012 and the end of 2021.
Using a 50:50 balanced portfolio strategy, again into Australian shares and fixed interest, an initial $20,000 investment would have grown as follows, based on the reinvestment of all income distributions received along the way.
By the end of December 2021, your $10,000 investment into Australian shares would have been worth $28,419. Your $10,000 investment into Australian fixed interest would have been worth $15,020.
That's a total gain of about 117 per cent.
Yet, by then, your initial 50 per cent allocation to Australian shares would have increased to 65 per cent, while your allocation to fixed interest would have dropped to just 35 per cent.
In other words, your 50:50 balanced allocation strategy would have evolved into an allocation that's closer to a growth strategy.
Let's face it, all investment portfolios will experience some drift over time, unless you diligently rebalance them. Rebalancing takes both skill and commitment.
To keep a portfolio true to your intended strategy, you have a couple of options if you're a DIY investor.
You can sell down some of the asset class that has increased in value and then use those proceeds to top up your allocation to the asset class that's experienced lower growth, or has fallen in value.
Or you can maintain your exposure to the asset class that has increased in value and simply top up your investment into the asset that's grown less, or dropped.
There's also a third option, which may ultimately be more appealing. Leave it to the professionals.
How the experts do it
Vanguard offers four core, professionally managed off-the-shelf diversified portfolio products, that are readily available to investors as both managed funds or exchange traded funds (ETFs).
These ready-made products allow you to choose an asset allocation that aligns with your personal risk appetite.
A "balanced" diversified fund product, as outlined in the examples above, provides a 50:50 allocation to shares and fixed income/cash.
A "conservative" diversified fund product provides about a 70 per cent allocation to fixed interest/cash, and 30 per cent to shares.
A "growth" diversified fund product will allocate about 80 per cent to shares, and 20 per cent to fixed interest/cash, while a "high growth" diversified fund product will allocate about 90 per cent to shares and 10 per cent to fixed interest/cash.
Keeping fund products constantly aligned to their allocation strategy is a full-time portfolio management exercise.
As mentioned, all portfolios experience drift due to changes in financial markets.
Portfolio managers rebalance diversified product portfolios on a constant basis, whenever they move out of alignment with their intended strategy, based on set tolerance levels.
But there's a key difference between how a portfolio manager can readily rebalance a portfolio versus the average DIY investor.
Generally, rather than having to sell assets to keep a portfolio aligned, a portfolio manager will use cash inflows to buy additional assets to keep a portfolio within its target asset tolerance levels.
This minimises turnover in a fund's portfolio and greatly reduces the need to realise any capital gains in the fund.
On the other hand, DIY investors choosing to sell assets to ensure their portfolio remains aligned will invariably trigger a capital gains tax event.
DIY investors also don't have the benefit of daily cash flows into their portfolio to top up underweight assets.
Staying balanced
Whether you leave it to the experts through a diversified fund, or do it yourself, there are clear benefits in avoiding portfolio drift as much as possible.
Fundamentally, rebalancing your asset mix keeps you aligned to your chosen investment strategy, based around your risk tolerance.
Ignoring portfolio drift can be detrimental over time. As well as drifting off your chosen investment route, you could also find yourself being exposed to unintended investment risks.
Tony Kaye, Vanguard Australia