Rebalancing your portfolio is one of those investment strategies that many investors know but may not understand a lot about it. While some investors rebalance their portfolios frequently, many others let it slide either because they dont know how or lack the time to do so. However, its one of those essential investment tactics thats vital to any successful portfolio and should not be left undone.

Heres how to update and rebalance your investments properly, so you can continue to build wealth for the future.

But first, lets talk about what rebalancing actually means.

What is Rebalancing?

When you first establish an investment portfolio, you a choose certain asset allocation based on a combination of your risk tolerance, your investment goals, and even current market conditions. For example, if you decide to put 60% of your portfolio into stocks, 30% into bonds and 10% in cash. As the market conditions change, those allocations can disappear.

How? During a prolonged bull market in stocks, your stock allocation could rise to 90% or more of your portfolio, simply because your stock positions have dramatically increased in value. At the opposite end of the spectrum, during a bear market, your stock position could fall to 30% of your portfolio, simply because stock prices have fallen substantially.

Rebalancing is the strategy of adjusting your asset allocation to make sure it remains consistent with your investment goals. In its simplest form, it’s a matter of moving money from one asset class that has performed well, over to another that has not.

The Risks of Not Rebalancing Your Portfolio

The biggest risk of not rebalancing your portfolio is the possibility that youll find yourself with too much money in one asset class at the absolute worst time.

Taking the example above, let’s say that your portfolio is comprised 90% of stocks. All of the sudden there is a market reversal, and stocks lose 50% of their value. Because of your excessive stock allocation, the overall value of your portfolio will fall by 45% (the 90% stock allocation X the 50% loss in stocks), wiping out an unacceptably large percentage of your portfolio.

Had you kept your stock allocation at 60%, the overall loss to your portfolio would be no more than 30% (the 60% stock allocation X the 50% loss in stocks).

On the flipside, if your stock allocation was at 30% at the start of a new bull market one which carries stocks higher by 50% over the next two years the overall increase in your portfolio would be just 15% (the 30% stock allocation X the 50% gain in stocks).

Had you kept your portfolio rebalanced, maintaining a 60% stock allocation, the overall increase in your portfolio would be 30% (your 60% stock allocation X the 50% gain in stocks).

Periodic rebalancing is a way of maintaining the desired level of diversification in a portfolio. Failing to do so can expose you to greater risk, whether the stock market is rising or falling.

How to Update Your Portfolio

There are different methods to rebalancing, but here are three of the more common ones:

1. Selling higher allocations and transfering money to lower ones. In this strategy you will sell off the excess portion of your stock position and transfer the money over to bonds and cash. Let’s say a strong market has caused your stock holdings to rise to 75% of your total portfolio. As a result, your bond position falls to 20%, and your cash position to 5%. By selling your stocks back down to 60% (a reduction of 15 percentage points), you could increase your bond position back to 30% (20% plus 10% from the stock position), and your cash position back to 10% (5% plus 5% from the stock position).

2. Reinvesting winning positions into other asset classes. This is a less formal way of rebalancing. It simply involves moving the proceeds of investment trades trades that you will make either to take profits or to halt losses over to other asset classes that have fallen below your desired asset allocation. For example, you might take the proceeds from the sale of a mutual fund or a stock that you sold for a large profit, and reinvest the proceeds in your bond and cash allocations, rather than putting it back into stocks.

3. Investing fresh money into lagging asset allocations. With this method you won’t be dependent on the performance of individual investment classes. Instead, you’ll direct fresh investment capital into any asset classes that fall below your portfolio allocation. For instance, if your stock position is rising in a bull market, newly invested money would be put into your bond and cash allocations, rather than into your stock position.

Rebalancing is a way of making sure that youre pouring capital into underperforming assets. In that way, you’ll be buying assets when they are cheap and selling them (or at least not buying them) when they are expensive.

How Frequently Should You Rebalance?

There are different schools of thought as to the “when” of rebalancing, but here are the main points of how frequently you should rebalance your portfolio.

Time. This involves rebalancing at set times. You can decide to rebalance monthly, quarterly, semi-annually or annually. However, its generally recommended that you rebalance at least annually. It’s also important to understand that the more frequently you rebalance, the more you pay in transaction fees .

Threshold. Rebalancing at certain thresholds is about setting certain percentage levels at which you will need to reallocate. You can decide to rebalance any time a given asset class exceeds the desired allocation by 10% or more (or what ever percentage you choose). If your stock position were to increase from 60% to 70%, you would sell your stock position down to 60% and move the money into other asset classes.

Time and Threshold. This is a hybrid of the two, where you could decide to rebalance at least annually, but choose to do so more frequently if the imbalance were to exceed a certain percentage.

Investment Tools That Rebalance For You

Many investment platforms will take care of rebalancing for you. Examples include Wealthfront. and FutureAdvisor. These platforms will rebalance your portfolio automatically for you. You can simply choose your asset allocation when you begin using the service, and rebalancing will be done without having to change it.

There are also software packages that can assist with rebalancing as well. If you do use one be aware that rebalancing too frequently will increase your transaction costs and lower your investment returns.

Readers: Do you rebalance your portfolio? What methods do you use to do it?