A Balanced Portfolio is a Sign of a Balanced Mind

We touched on rebalancing in the last post. I'd like to address the topic in a bit more detail.
If you have set up your portfolio according to the asset allocation suggestions (see 08/15/07 post Asset Allocation) then once a year you need to make sure you are still within the parameters you wanted. So, for instance, if stocks have had a blistering year, and the total you have in stocks is now 40%, but your allocation model calls for 30%, it's time to rebalance.
Sell off enough of your stock portfolio so that it is now back to 30% of the total. By default, you will be selling some stocks that went up (you're selling high) and buying some other asset class that didn't perform as well, like bonds (you're buying low.)
It's easy, yes?
No. Most people won't do it. Even though they know they should.
Why not?
Human nature. They can't make themselves sell "the good one." Let's say, small cap stocks were the market leader over the prior 12 months. Now it's time to rebalance. You look at your portfolio, small cap has gotten ahead of large cap by a fairly significant amount. You know you need to cut that back and add some money to something that didn't perform as well. Your mind screws you instead.
"But it's doing so well. And that other stuff didn't do anything. I don't want to sell the good one."
Don't be a fool. First, you're not selling all of it, you're only selling some of it. Greed kills. You are not immune. Second, you're adding the money to something nobody else wants. That by itself likely makes it a good value.
There are two rebalances. Within the asset class. If you have large, medium, small and international stocks, you rebalance that. Them there is rebalancing the entire portfolio. If you have 25% in stocks, 25% in bonds, 25% in real estate and 25% in cash (money market) and stocks after 12 months are 30% of the portfolio, then the entire stock allocation should be pared back to 25%.
I use 5% as a guideline. If I should have 25% in stocks, and at the end of the year it's 28%, I don't run up commissions to rebalance for a 3% divergence. If something gets 5% or more out of balance, then I make the adjustments.
Don't be a sucker. Don't say, "I'll let the stocks keep going and sell when they start to fall."
No, you won't. When the stock market pulls back, you'll regret not selling and want to hold on until "it comes back." Then it will fall some more, and then if it starts to plummet, you'll sell at precisely the wrong time out of fear. Sound familiar?
A bit of discipline at the beginning avoids a tsunami of regret in the end.