Asset allocation in investing is all about risk and potential reward. Ideally, your asset allocation will be an outgrowth of your financial plan and reflect a combination of the growth potential you need to achieve your financial goals and the level of risk that is appropriate for you.

Different asset classes produce different returns at different times. Invariably, your portfolio will be over- or under-allocated in one or more areas. With the stock market in the midst of a rally that started in March 2009 it’s quite likely that your portfolio is overweight in equities if you haven’t rebalanced at regular intervals.

Asset Allocation: All About Risk

In 2008, the S&P 500 Index lost 37%. Emerging market stocks lost over 53%. On the other hand, bonds on average gained over 5% for the year.

When building an investment portfolio it is wise to allocate money to a variety of asset classes in order to balance out the portfolio’s potential for growth while mitigating some of the downside risk. One method of minimizing risk is to include some asset classes that have a low level of correlation to the rest of the portfolio.

For example, according to data from JP Morgan Asset Management, as of Sept. 30, 2014, U.S. large-cap stocks had an 89% correlation to the EAFE index. which is a proxy for stocks in developed markets outside of the U.S. and Canada. This is a pretty high level of correlation and means that investments in these two asset classes will move largely together. Looking at calendar year 2008, the SPDR S&P 500 ETF (SPY ) lost 36.81%, while the ishares MSCI EAFE ETF (EFA ) lost 41.02%. The loss for SPY was 89% of loss for EFA. (For more, see: 6 Asset Allocation Strategies That Work .)

By contrast, the correlation between U.S. fixed income and domestic large-cap stocks is -26%, meaning that that their movements are negatively correlated and would move in opposite directions 26% of the time. Again, looking at 2008, the ishares Core Aggregate US Bond ETF (AGG ) gained 7.57% for the year in spite of the worst stock market performance since the Great Depression .

In 2008, unlike the downturn of 2001-2002, all manner of equities declined. Bonds with their relatively low correlation to stocks held up quite well on the other hand.

Rebalancing Provides a Level of Discipline

Rebalancing to a target allocation imposes a level of discipline on an investor in terms of selling off a portion of their winners and putting the money back into asset classes that have underperformed in the near term or that haven’t performed as well as some others.

This may seem counter intuitive but market leadership typically rotates over time. For example a few years ago emerging markets equities were the place to be and large-cap domestic stocks were underperforming. Today that situation is just the opposite.

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Rebalancing can help save investors from their own worst instincts. It might be tempting to “let things run” when the markets seem to keep going up. The better approach is to have a written investment policy with target ranges for each asset class. When an asset class violates the upper or lower end of the range it should be brought back into the target range buy adding dollars or selling a portion of the holdings in that asset class. (For more, see: The Role of Rebalancing .)

Rebalance at Reasonable Intervals

Many financial advisers suggest rebalancing your portfolio at least annually. I generally suggest no more frequently than semi-annually when discussing this with 401(k) plan participants whose plan offers auto-rebalancing. In fact I suggest to anyone whose retirement plan offers this feature that they take advantage of it. (For more, see: Achieving Optimal Asset Allocation .)

At some point you can rebalance too frequently. Remember, there can be costs involved. These might include transaction costs for stocks, exchange-traded funds (ETFs) and some mutual funds. Additionally, there might be capital gains taxes to reckon with. Short-term capital gains for investments held for less than one year are taxed at your ordinary tax rate and not the lower capital gains rate pertaining to investments held for at least one year.

Use New Money

New money invested can be a good rebalancing tool, especially if you invest decent sized amounts at various times during the year, say from an annual bonus from work. Before deciding how to invest this money you might take a look at your portfolio’s allocation and invest the new money into spots that need additional dollars as a form of rebalancing. In a taxable account this eliminates the need to worry about the impact of any taxable gains incurred by rebalancing. (For more, see: Types of Rebalancing Strategies .)

Consider Your Entire Portfolio

It’s a good idea to view your portfolio in it’s entirely. This means that you should include tax-deferred accounts such as your 401(k) and IRAs as well as investments held in taxable accounts. Some financial advisers might also counsel you to include income from pensions, annuities and Social Security as a component of fixed income if this represents a significant portion of your retirement income.

When rebalancing, you should not only look at your portfolio as a whole but you should also give thought as to where you might want to buy and sell in order to rebalance. For example if you are selling off some appreciated equity holdings and you have had a good year in terms of taxable income it might make sense to do these rebalancing transactions in an IRA or in your 401(k). I’m not one to let taxes dictate an investment strategy, but if you can avoid taxable transactions when rebalancing so much the better. (For more, see: Minimize Taxes With Asset Location .)

Does It Work?

Using the Hypothetical portfolio simulator in my Morningstar, Inc. (MORN ) Advisor Workstation program I assumed a portfolio consisting of the Vanguard 500 Index (VFINX ) at 60% and the Vanguard Total Bond Market Index (VBMFX ) at 40%, both purchased on Jan. 1, 2000 and rebalanced annually. Through Nov. 30, 2014, that portfolio had gained a cumulative 114.77%.

By contrast, the same portfolio with no rebalancing yielded a cumulative return of 99.02% over the same holding period. Both examples assumed reinvestment of fund distributions and that the investments were held in a tax-deferred account. (For more on portfolio management, see: Portfolio Management Pays Off in a Tough Market .)

This is not the definitive answer regarding the merits of rebalancing but in my experience it does work in terms of reducing risk and often produces a better result for clients.

The Bottom Line

Portfolio rebalancing is about risk control and investment discipline. In a well-balanced portfolio certain asset classes will invariably perform better than others. Letting the allocation to stocks get too large can expose you to more downside risk than you had bargained for. Rebalancing forces you to take some profits and reallocate. On the other hand, in a down market your allocation to stocks might have shrunk limiting your upside potential when the markets move up again. (For more read: Portfolio Rebalancing Made Easy .)