Rethinking the Rebalancing Act

In order to get back on track, you would have to sell off some shares of your best-performing funds and use the proceeds to acquire more of your worst-performing ones. But doing this requires a certain amount of intestinal fortitude, as many investors easily succumb to what is known as "anchoring." Anchoring is a psychological term to describe the tendency to rely on one piece of information when making decisions. For investors, this often means overemphasizing recent performance.

"It's a very difficult thing to do," says Willis. "The last thing you want to do is sell your top performers."

At the same time, you don't want to be continually taking money from winners and putting it into losers, if you don't have confidence that your losers will eventually rebound. That's why Willis advocates what he calls investing in the "essentials of life."

That means that you should diversify your investments into categories or sectors that you think people will always need and that have a low correlation with each other. Willis cites real estate, energy and raw materials as examples.

Rebalancing is a time-tested strategy that can help reduce your overall risk, so the question is not whether you should rebalance but when. Making adjustments at the beginning of the year "might be the easiest way to rebalance, but our research suggests it isn't the most effective," Alliance Bernstein says in a 2004 report called "The Science and Psychology of Rebalancing," published on the investment bank's Web site. "After all, the markets can move sharply in between the milestones on the calendar."