NEW YORK (CNN/Money) - Q. My New Year's resolution was to rebalance my portfolio and replace my stinker mutual funds with index funds. When I reviewed my portfolio's 2003 performance, however, I noticed that many of my losers had 20 to 30 percent gains and my biggest loser had a 60 percent gain. I'm still way below my break even point for these funds, but now I'm wondering if I should continue with my index fund strategy. What do you think?

-- Michael, Baltimore, Maryland

Before I tackle the "to index or not to index" issue, let me say that I applaud you for making rebalancing your New Year's resolution. This simple strategy -- essentially, bringing your portfolio's various asset classes back to your target percentages either through selling shares of better-performing funds and plowing the proceeds into the poor performers or funneling new money into the poor performers -- should be, if not an actual New Year's resolution, then at least on every investor's annual To Do list.

Why? Simple. If you simply let market returns dictate the relative size of your different investments, you can end up with one out-of-whack portfolio.

If starting in 1995, for example, an investor had started with a portfolio of, say, 80 percent stocks and 20 percent bonds and just let it ride year after year, by the beginning of 2000, that portfolio would have morphed into a roughly 90 percent stocks to 10 percent bonds mix, simply because stock returns were so strong in the late 1990s.

Of course, the higher proportion of stocks meant that the investor also would have been holding a much riskier portfolio, a fact that would have become acutely obvious when the market tanked from 2000 through late 2002.

Rebalancing, however, prevents the portfolio from becoming too overweighted in any one asset class, and thus keeps the balance of risk and reward stable over time. And because rebalancing means taking money from better performers and putting into laggards, it also forces us to do what we know we ought to do but rarely pull off: sell high and buy low.

So just as the mantra in real estate is location, location, location, I think investors ought to have a similar mantra: rebalance, rebalance, rebalance.

Now, let's talk about indexing. I think your instincts to consider switching to a portfolio of index funds are good -- but I'm not sure you're going in with the right expectations. To me, the most powerful reasons to consider indexing are certainty and low cost. (Index funds can also have some compelling tax advantages, but I won't get into that here. For more on the overall case for indexing, check out the IndexFunds.com Web site.)

By certainty, I mean you know exactly what you'll be getting. Buy an index fund that mirrors the Standard & Poor's 500, and you know you'll get the stocks in the S&P 500. Buy an index fund that follows the small-company Russell 2000 index, and you know you're getting the 2,000 small firms that make up the Russell 2000. Same goes with the various other indexes out there. You don't have to worry about a large-cap manager dabbling in small stocks because he thinks maybe the small fry will rally, or buying growth stocks when he's supposed to be buying value, etc.

Related Articles • Rebalancing act • 4 lessons from 2003 • Sivy: Stocks vs. funds?

The other reason to consider index funds is cost -- or, more precisely, low cost. Index funds are much, much cheaper to operate than actively managed funds. Annual expenses for the average domestic stock fund run about 1.5 percent per year. Annual expenses for the Vanguard 500 index, for example, are just over a tenth of that amount, or a mere 0.18 percent. Not all index funds have expenses this low, but for the most part their annual expenses are well below those of actively managed funds.

Lower annual costs means you get to keep more of the fund's gross return. And a variety of studies have shown that, over the long-term, say, 10 or more years, index funds tend to outperform the majority of actively managed funds. Not all actively managed funds, of course. But the questions is, can you identify in advance the actively managed funds that will beat the indexers? I believe that's difficult to do.

Now, notice I said that index funds tend to perform over the long term. There will definitely be shorter periods where actively managed funds have the upper hand.

Indeed, that's often true in periods, as in the 1990s, where the stock market is roaring upward in a frenzy because investors are plowing their money into stocks with higher than average volatility -- think tech and other growth stocks. In the early stages of a stock-market recovery index funds can lag too, although in the case of the Vanguard 500 Index fund, it beat about two-thirds of its large-cap blend fund peers over the 12 months through late January.

But the point here is that I don't think you should be basing your decision on short-term performance. Who cares if your funds have had a short-term bounce? Big deal. What you really want is superior long-term performance, and that's the reason to consider index funds.

So my suggestion is that you follow through on your New Year's resolution to move to index funds. I should add that you don't have be a purist about this -- that is, index every single dollar of your holdings. Some people prefer to index their core holdings -- large-cap stocks and their bonds, say -- and then use actively managed funds in areas like small-cap and international stocks where there's a better chance of a manager adding some value. I think either approach can work.

One final note: since your funds are now worth less than you paid for them, you don't have to worry about triggering a tax bill by selling your funds and moving the proceeds to index funds.

Indeed, if you sell at a loss, you can deduct that loss against any gains you have elsewhere in your portfolio or, barring that, against wage income. [For details on deducting investment losses, check out Publication 550: Investment Income and Expenses (Including Capital Gains and Losses) at the IRS Web site (www.irs.gov)].

But others out there considering switching to index who are sitting on gains in their portfolio will want to proceed cautiously to avoid getting swatted with a big tax bill.

One possibility is to sell selectively from your portfolio to minimize gains and also look for any opportunities to use losses to offset those gains. Or you may want to take the partial indexing approach I mentioned earlier, or perhaps first move to indexing in tax-advantaged accounts like 401(k)s and IRAs where selling won't trigger taxable gains. At the very least, though, one can always plow new money into an index fund -- and then watch as the index part of the portfolio gradually overtakes the rest of it.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Mondays.