Portfolio drift occurs when there is a large divergence in returns for the different parts of your portfolio. (UBS)

Portfolio drift occurs when there is a large divergence in returns for the different parts of your portfolio. Over time, portfolio drift leads to a deviation from your target asset allocation, which can lead you to taking more risk than you had planned for. It's important to periodically rebalance your portfolio back to your target asset allocation, rather than letting market fluctuations take control of your investments.

Let's look at a recent example. An investor rebalances to a 60% stock, 40% bond portfolio on 31 December 2019, and keeps their portfolio fully invested through to 31 March 2022. Over this timeframe, the S&P 500 returned about 45%, while US Treasuries have lost about 1%.

Assuming that this investor didn't rebalance or make any additions/withdrawals, their 60/40 portfolio would now be a 69% stocks and 31% bonds.

If another market decline were to happen today, the investor's portfolio is more exposed to downside risk than they had intended when they decided on their investment strategy.

That is because without rebalancing, a "buy-and-hold" approach allows your portfolio to “drift” from its target allocation, which is a pro-cyclical or performance-chasing approach. If equity returns are strong, the portfolio goes overweight stocks; if markets sell off, the portfolio's stock allocation dwindles, leaving it more poorly positioned for a recovery rally.

By contrast, a rebalancing strategy buys low and sells high, resulting in a more consistent level of portfolio risk. Rebalancing isn't a call on whether markets go higher or lower, it's something to help protect you against the risk that markets don't continue in a linear fashion (hint: they rarely do).

CIO recommends that your rebalance your portfolio systematically, such as by checking monthly or quarterly and rebalancing if your stock allocation is more than 5% from your target (e.g. below 55% or above 65%, if your target asset allocation is 60% stocks, 40% bonds).

Going back to our earlier example, the buy-and-hold portfolio would have enjoyed portfolio growth of approximately 26.9%. By contrast, a portfolio that was rebalanced using the "5% rule" (with month-end observations) would have found 4 opportunities to buy low and sell high, resulting in a total return of 47.3% over the same period.

Historically, CIO estimates that systematic rebalancing would have added around 0.5% to annual returns, in addition to reducing portfolio volatility.

How to rebalance amid rising rates?

Check to see if your asset allocation has drifted from your target. Unless you plan to change your asset allocation—a process that should be influenced by changes in your financial goals and needs, rather than recent market performance—you should move to rebalance your portfolio. Given recent performance, it's likely that rebalancing would involve selling some stocks to buy more bonds at this higher interest rate level.

In your IRA and 401(k) accounts, it is possible to rebalance without tax consequences, but in taxable accounts, you may want to consider cash flows into and out of the accounts. If you are adding to your account or putting excess cash to work, you can add to your bond allocation to bring your portfolio back in line with the target allocation. This "tax-free rebalancing" approach can be especially useful for younger investors looking to defer capital gains taxes while keeping their asset allocation in line with the target.

Do not let the recent rise in interest rates deter you from sticking with your investment strategy. While rising rates have created a short-term headwind for bond returns, higher rates are a tailwind to long-term bond returns, turning "reinvestment risk" into your favor by generating the potential for growing income. High-quality bonds are also subject to fewer and more modest drawdowns than equities, and stocks should perform well if bond yields are rising because of strong growth.

For more, read How and why does rebalancing add value?, Don’t let Mr Market decide your allocation for you, and With rates rising, why own bonds?.

Main contributors: Wendy Mock and Justin Waring