Just like the tires on a car, the mutual funds in your portfolio must be rebalanced regularly to keep your financial goals aligned. And many advisers will insist that the beginning of the year is the time to rebalance. But is it?

"Why run up fees and taxes just because the Earth has gone around the sun?" says Michael Willis, president and fund manager of Colorado Springs, Colo.-based Giant 5 Funds. "We don't think it's relevant to do solar or lunar rebalancing. We like what we call 'relevant asset allocation,' where the trigger is performance-related."

Because some of your mutual funds will perform better than others, your investment allotment will likely skew from your original goals over time. Rebalancing is the process of selling off and buying investments in your portfolio in order to get back to your original allocation and to reduce your risk.

Basing your investment decisions on the calendar is overly simplistic and can eat away at your returns. A more logical approach is to rebalance when your allocation skews by a certain percent. How far off-balance to allow your investments to skew depends on how much risk you are willing to tolerate.

For example, let's say that at the beginning of the year you had several different mutual funds spread out over a range of sectors. Your mutual funds holding gold or large-cap companies -- sectors that did particularly well in 2006 -- would likely have outperformed your other funds. This would mean that those funds represented a higher percentage of your overall portfolio than your original allocation.

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."

The report adds that "setting a calendar-based approach that's too short can lead to costs -- for transactions and taxes -- that outweigh the benefits."

Rebalancing is a necessary component in portfolio management for mitigating risk and counteracting the strong emotions of fear and greed, Willis says. "But using an astrological event as a trigger? That makes little sense."
Michael Katz joined TheStreet.com in 2007. Michael has previously worked as a reporter at Forbes and an editor for two custom publishers, SmartMoney Custom Solutions and HNW Inc. He also worked in London as a freelance media reporter and correspondent for Broadcasting & Cable magazine. Michael has a B.A. in English from the University of Virginia.