So you've established an asset allocation strategy that is right for you, but at the end of the year, you find that the weighting of each fund in your portfolio has changed. What happened? Over the course of the year, the market value of each fund within your portfolio earned a different return, resulting in a weighting change. Mutual fund rebalancing is like a tune-up for your car: it allows you to keep your risk level in check and minimize catastrophe.

**What Is Rebalancing?**

Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each fund in your overall investment back to its original state. In addition, if your investment strategy or tolerance for risk has changed, you can use rebalancing to readjust the weightings of each fund in the portfolio to fulfill a newly devised asset allocation.

**Blown Out of Proportion**

The asset mix originally created by an investor inevitably changes as a result of differing returns among various funds. As a result, the percentage that you've allocated to different funds (and sectors) will change. This change may increase or decrease the risk of your portfolio, so let's compare a rebalanced portfolio to one in which changes were ignored, and then we'll look at the potential consequences of neglected allocations in a portfolio.

Let us run through a simple example. Bob has $100,000 to invest. He decides to invest 50% in a bond fund, 10% in a Treasury fund and 40% in an equity fund.

At the end of the year, Bob finds that the equity portion of his portfolio 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 is more weight on equities than on bonds. Bob might be willing to leave the asset mix as is for the time being, but leaving it too long could result in an overweighting in the equity fund, which is riskier than the bond and Treasury funds. (For related reading, check out * 4 Steps To Building A Profitable Portfolio*.)

**Consequences of Ignoring Disproportion**

A popular misconception 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 - this is 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. Remember, equities are more volatile than fixed-income securities, so last year's large gains may translate into horrible losses over the next year.

Let's continue with Bob's portfolio and compare the portfolio values of his rebalanced fund with the funds 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 rebalanced his portfolio the previous year, his total portfolio value would be $118,500, an increase of 5%. If Bob 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 is the optimal strategy.

However, if the stock market rallies again throughout the second year, the equity fund will appreciate more and the ignored portfolio may realize a greater appreciation in value than the bond fund. Just as with many hedging strategies, 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, tax considerations and personal preferences. Usually, rebalancing about once a year is sufficient; 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 your lifestyle may warrant a change to your asset allocation strategy. Whatever your preference, the basic steps for rebalancing your portfolio are as follows:

**Record**- If you have recently decided on an asset allocation strategy that's perfect for you and purchased the appropriate mutual funds, keep a record of the total cost of each fund at that time, as well as the total cost of your portfolio. These numbers will provide you with historical data for your portfolio, so at a future date you can compare them to current values.**Compare**- On a chosen future date, review the current value of your portfolio and of each individual fund. Calculate the weightings of each fund in your portfolio by dividing the current value of each fund by the total current portfolio value. Compare these figures 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.**Adjust**- If you find that changes in the fund weightings have distorted your 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 fund. The figures you calculate will be the amounts you should have invested in each fund in order to maintain your original asset allocation. Sell portions of mutual funds whose weights are too high and purchase additional units of mutual funds whose weights have declined.

**Conclusion**

Rebalancing your portfolio will help you maintain your original asset allocation strategy or 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.