(Money Magazine) -- If you haven't taken a peek at your portfolio for several years, chances are it's taken on a shape you don't even recognize.
The tiny slivers of international stocks you bought a few years ago are now big chunks, your large-cap holdings have swelled, and the percentage of your portfolio devoted to relatively secure bonds has been squeezed into a corner.
Not to scare you, but that's a risky situation. If one of your largest asset classes should take a sudden fall - the way emerging markets plunged nearly 60 percent between 1997 and 1998 - your returns will go into a tailspin along with it.
You've heard us say it before, but now's the time for a reminder: The easiest way to avoid such nasty surprises in your portfolio is to rebalance it. That means selling off your best-performing assets and buying more of the laggards so that the percentage of your portfolio devoted to stocks vs. bonds - as well as different subclasses of stocks, such as big-caps, small-caps, growth or value - returns to your ideal.
The biggest benefit of rebalancing: It's a tried-and-true way of reducing the risk in your portfolio. Selling off a chunk of large-cap growth stocks after their runup in the late 1990s, for example, would have made the early 2000s a lot less painful for many investors.
"You get very brave in a bull market," says Richard Ferri, CEO of investment advisory firm Portfolio Solutions. "And bad things can happen to you if you exceed, without realizing it, your tolerance for risk."
Another advantage of regularly rebalancing is that it gives you the discipline to employ the revered investment strategy that is as difficult to implement as it is famous: buying low and selling high.
If your investments are way off from your initial allocation, that's probably because one asset class has done spectacularly better than the others. When you are rebalancing, what you're doing is taking gains among your overperformers and putting more money into underperformers, enabling you to profit from a bounce back.
Despite the benefits, few investors rebalance regularly, if at all. A 2005 Hewitt Associates study found that 60 percent of 401(k) plan participants hadn't touched their accounts for the previous five years.
What's stopping them? Basic human psychology, for one.
Selling your winners can feel like leaving the party just when the fun is getting started, whereas adding money to your losers can feel like throwing good money after bad investments.
"Human nature is to chase what's been successful and cut what's been unsuccessful," says Rob Arnott, chairman of asset manager Research Affiliates in Pasadena. "But investment success requires doing the opposite."
That's why your best bet is to dispense with emotional buy-or-sell decisions and stick to a single rebalancing strategy.
To help you sort through the question of how much and how often, follow the guidelines below.
Before you get started, it's probably a good idea to revisit your asset allocation to make sure it's still in line with your age and appetite for risk.
Since you probably have your money in more than one place, you'll need to total up the assets in all your accounts to get an overview of your portfolio. If you don't want to do this by hand, the portfolio trackers built into Quicken and Microsoft Money software and some brokerage Web sites like Vanguard and Fidelity allow you to upload the information automatically from all your accounts.
Then consider the following options:
Decide how often to rebalance: There are two basic strategies for deciding when to rebalance. You can frequently monitor your portfolio and shift your investments once they have strayed a certain distance from your target allocation. (More on that later.)
Or you can rebalance regularly - say, once a year - on a pre-selected date. Actually, your best bet is to do a little of both.
Some research indicates that you're best off rebalancing every three years, since investments that do well generally continue to outperform for several years in a row.
Trouble is, if you let your portfolio gather dust for several years running, you might never check it at all.
"It's good for people to look at their portfolio once a year," says Ellen Rinaldi, who heads Vanguard's investment counseling and research group. So pick an easy-to-remember annual date, such as your birthday or your anniversary, and find out whether your asset allocation has strayed far enough from your target to merit rebalancing.
(Okay, if you don't want to kill the romance, maybe you'd better wait for the day after your anniversary.)
Pick a trigger point: When it comes to finally moving the money between categories, less is often more. Besides the potential of losing out on short-term momentum gains, the transaction costs of buying and selling assets can offset the benefits of rebalancing.
So unless your asset allocation is out of whack by five percentage points or more (or a hair less for riskier assets), it's fine to keep everything as is.
Even when you hit your trigger point, you don't necessarily want to reset all the way back to the target.
Seth Masters, chief investment officer for blend strategies at Alliance-Bernstein, has found optimal benefits from rebalancing halfway between the trigger point and the target. So, for example, if you have a 70 percent stock target and you're up to 75 percent, dialing it back down to 72.5 percent is fine.
That way you'll lessen potential costs from redemption fees and taxes without incurring much risk.
Minimize tax consequences If you have money in both taxable and tax-deferred accounts like an IRA or 401(k), you should look at it all as one big portfolio for asset-allocation purposes.
But in taxable accounts, selling can incur capital-gains taxes that will eat into your returns. So if you can, limit your fiddling to nontaxable accounts.
If that's not an option, try directing dividends, interest and new contributions into the lowest-performing asset classes. If there's no way to avoid incurring a tax bill, try to match the amount of gains and losses in order to limit the blow.
Make it easy These days many 401(k) plans have online tools that allow you to rebalance with a single click. Some will do it automatically according to a schedule that you preselect.
Another option: investing your entire portfolio in a target-date retirement fund or a lifestyle fund that matches your ideal allocation and appetite for risk.
In these all-in-one funds, the portfolio managers do the rebalancing for you, more often and more attentively than you could ever handle the task. Whatever you do, don't sweat the details.
Says Masters: "Any rebalancing rule you use is better than none at all."
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