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Don't Leave Your Investments on Autopilot

For some investors, simplicity is everything. If you suggest doing anything too complicated, they'll say it's not worth it, even if it might make them a little more money in the long run. One popular way to keep things simple is to use mutual funds and allocate your money among various asset classes. Some mutual fund managers and employer-sponsored retirement plans will let you set things up so that your contributions will be automatically divided among funds in those asset classes.

While keeping things simple is a praiseworthy goal, your portfolio is likely to get out of balance if you just set up those automatic options and forget about it. With the way that the financial markets move up and down out of step with each other, it's quite possible that your actual asset allocation percentages are much different from what you want them to be. An occasional readjustment is all that's needed to get things back to where they belong.

How portfolios get out of balance
Keeping your portfolio perfectly balanced is an impossible task. The day after you make your first purchases, you'll probably find that some went up and others went down. Even if they all move in the same direction, some will move more than others. Keeping your portfolio perfectly in balance is not an attainable goal.

However, if you let your portfolio go for months or years without any changes, things can get really out of whack. As an example, say you set up your portfolio at the beginning of 2003, with 60% of your money in stocks and 40% of your money in bonds. Out of the 60% in stocks, you had half in U.S. companies and split the other half between international stocks and real estate investment trusts.

Using some index funds to represent these asset classes, you can look at what would have happened to this theoretical portfolio between the beginning of 2003 and the end of 2006. Over that four-year period, bond yields were relatively low, and the bond portion of your portfolio would have grown by less than 16%. The stock portion of your portfolio, on the other hand, would have down extraordinarily well, rising by almost 120%. As a result, if you had made no changes to your portfolio in those four years, the percentage of your portfolio in stocks would have risen to 74%, while you'd have only 26% in bonds.

Looking at the allocation among different types of equities shows additional imbalances. While U.S. stocks did well between 2003 and 2006, international stocks did quite a bit better, and real estate investment trusts did better still. By the end of 2006, the combined value of your international stock and REIT funds would have risen to almost half again the value of your domestic stocks.

The dangers of imbalanced portfolios
Initially, you may wonder why having your portfolio allocations change over time is a bad thing. Since it's impossible to keep your allocations in line with exact targets for any significant period of time, it makes sense that some investments would rise to the top. Furthermore, since the imbalances tend to favor the investments that have done the best over time, it's appealing to let your winners ride and hope that they'll continue to outperform, letting you benefit more because of your overweighted position.

The downside of not keeping your portfolio in balance, however, is that your new portfolio may no longer reflect your tolerance for risk. In the above example, a 60/40 asset allocation between stocks and bonds would generally be considered to be moderately risky, but a 74/26 allocation is quite a bit more aggressive. While you should generally expect to earn a higher return from the 74/26 allocation, the risk of suffering a substantial loss in portfolio value is also correspondingly higher.

Given that historical returns have favored stocks over bonds over significant periods of time, leaving your portfolio imbalanced is almost certain to leave you with a higher percentage of stocks than you originally intended. The sharpness of any subsequent losses that occur can leave you surprised and annoyed that you didn't take steps to fix the problem when you had the chance.

Rebalancing ideas
Because of these dangers, many financial planners recommend that their clients rebalance their portfolios on a regular basis. If you don't make additions or withdrawals, rebalancing every year or so is probably enough to help you avoid straying too far from your target allocations.

If, however, you add or remove money from your accounts, you can use those opportunities to put your portfolio back in balance. In the above example, for instance, if your bond holdings fell below your targeted level, you could add more new contributions toward bonds while taking withdrawals mostly from stocks. Similarly, with equity money, you would contribute a larger fraction toward domestic equities, while selling REITs and international stocks to provide cash for withdrawal.

Successful investing can be simple, but that doesn't mean you should ignore your investments. By taking an occasional look at your portfolio and how it has changed over time, you can avoid some unpleasant surprises down the road.

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Fool contributor Dan Caplinger looks at his portfolio every month, but that's just because he thinks it's fun. He owns some of the Vanguard index funds he used to come up with return calculations. The Fool's disclosure policy never gets out of balance.

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