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At the end of the year, Bob finds that the equity portion of his portfolio has dramatically outperformed the bond and Treasury portions. This has caused a change in his allocation of assets, increasing the percentage that he has in the equity fund while decreasing the amount invested in the Treasury and bond funds.

More specifically, the above chart shows that Bob's $40,000 investment in the equity fund has grown to $55,000—an increase of 37%. Conversely, the bond fund suffered, realizing a loss of 5%, but the Treasury fund realized a modest increase of 4%.

The overall return on Bob's portfolio was 12.9%, but now, there's more weight on equities than on bonds. Bob might be willing to leave the asset mix as it is for the time being, but leaving it for too long could result in an overweighting in the equity fund, which is riskier than the bond and Treasury fund.

The Consequences Imbalance

A popular belief among many investors is that if an investment has performed well over the last year, it should perform well over the next year. Unfortunately, past performance is not always an indication of future performance—a fact many mutual funds disclose. Many investors, however, remain heavily invested in last year's "winning" fund and may drop their portfolio weighting in last year's "losing" fixed-income fund. But remember, equities are more volatile than fixed-income securities, so last year's large gains may translate into losses over the next year.

Let's continue with Bob's portfolio and compare the values of his rebalanced portfolio with the portfolio left unchanged.

At the end of the second year, the equity fund performs poorly, losing 7%. At the same time, the bond fund performs well, appreciating 15%, and Treasuries remain relatively stable, with a 2% increase. If Bob had rebalanced his portfolio the previous year, his total portfolio value would be $118,500—an increase of 5%.

But if Bob had left his portfolio alone with the skewed weightings, his total portfolio value would be $116,858—an increase of only 3.5%. In this case, rebalancing would be the optimal strategy.

However, if the stock market rallies again throughout the second year, the equity fund would appreciate more, and the ignored portfolio may realize a greater appreciation in value than the bond fund. Just as with many hedging strategies, the upside potential may be limited, but by rebalancing, you are nevertheless adhering to your risk-return tolerance level.

Risk-loving investors are able to tolerate the gains and losses associated with a heavy weighting in an equity fund, and risk-averse investors, who choose the safety offered in Treasury and fixed-income funds, are willing to accept limited upside potential in exchange for greater investment security.

How to Rebalance Your Portfolio

The optimal frequency of portfolio rebalancing depends on your transaction costs, personal preferences, and tax considerations—including what type of account you are selling from and whether your capital gains or losses will be taxed at a short-term versus long-term rate. Usually, about once a year is sufficient; however, if some assets in your portfolio haven't experienced a large appreciation within the year, longer time periods may also be appropriate.

Additionally, changes in an investor's lifestyle may warrant changes to his or her asset-allocation strategy. Whatever your preference, the following guidelines are the basic steps for rebalancing your portfolio:

1. Record — If you have recently decided on an asset-allocation strategy that seems perfect for you and purchased the appropriate securities in each asset class, keep a record of the total cost of each security at that time, as well as the total cost of your portfolio. These numbers will provide you with historical data of your portfolio, so at a future date you can compare them with current values.
2. Compare — On a chosen future date, review the current value of your portfolio and of each asset class. Calculate the weightings of each fund in your portfolio by dividing the current value of each asset class by the total current portfolio value. Compare this figure to the original weightings. Are there any significant changes? If not—and if you have no need to liquidate your portfolio in the short term—it may be better to remain passive.

3. Adjust — If you find that changes in your asset class weightings have distorted the portfolio's exposure to risk, take the current total value of your portfolio and multiply it by each of the (percentage) weightings originally assigned to each asset class. The figures you calculate will be the amounts that should be invested in each asset class in order to maintain your original asset allocation.

Of course, you may want to sell securities from asset classes whose weights are too high, and purchase additional securities in asset classes whose weights have declined. However, when selling assets to rebalance your portfolio, take a moment to consider the tax implications of readjusting your portfolio. In some cases, it might be more beneficial simply not to contribute any new funds to the asset class that is overweighted while continuing to contribute to other asset classes that are underweighted. Your portfolio will rebalance over time without you incurring capital gains taxes.

The Bottom Line

Rebalancing your portfolio will help you maintain your original asset-allocation strategy and allow you to implement any changes you make to your investing style. Essentially, rebalancing will help you stick to your investing plan regardless of what the market does. 

Source: https://www.investopedia.com/investing/rebalance-your-portfolio-stay-on-track/