Asset allocation is a time-tested principle for balancing our investment portfolios among the asset classes - equities, fixed-income, and cash. It provides stability to our investment portfolio by not having “all our eggs in one basket” - in one asset class.

Choosing a well-thought-out allocation lets us spread our portfolio among the asset classes that best fit our investment goals and circumstances. As we age, our portfolios should shift to a more conservative allocation with an emphasis on preservation of principal with income. This is accomplished by increasing the fixed-income portion of our portfolio. This chosen ratio of asset classes also helps us construct an investment portfolio that ‘best fits’ our risk tolerance.

However, many investors forget, that over time their portfolio will drift and move away from their desired allocation. Rebalancing our investment portfolios is necessary in order to keep the portfolio aligned with the desired allocation. Rebalancing enforces a discipline which sells assets that have increased in value, putting the asset class above its desired percentage. Rebalancing will also cause us to buy investments in an asset class that have declined, taking advantage of selling high and buying low.

For example, if an investor desired an asset allocation of:

40% Equities (stocks)
50% Fixed-income (bonds)
10% Cash

and over the year stocks had increased in value to the point where the portfolio was now:

48% Equities
45% Fixed-income
   7% Cash

the investor would rebalance the portfolio back to the original allocation, by:

selling 8% (of the portfolio value) in Equities
buying 5% in Fixed-income
adding 3% into Cash

This rebalancing process smoothes out the fluctuations and enforces the discipline to take profits and buy on declines. Rebalancing should be done on an annual basis without regard to the fluctuations of the markets. Never try to time the market. Review Fear and Greed for insights into market timing. Also, see Chapters 2 and 14 in the book Investing for Retirement - Surviving a Financial Tsunami.