Conventional wisdom suggests that diversifying your holdings in your investment portfolio reduces risk because one bad year for one type of investment vehicle won't kill your net worth. Conventional wisdom also suggests that different allocations are appropriate for different stages of life, with more volatile investments being appropriate at a younger age and more predicable, but less flashy, investments being more important at an older age.
So, in order to maintain the “proper” ratios of whatever investment vehicles you own, you rebalance your portfolio — meaning that you buy and sell to re-adjust the allocations to what they “should” be.
Taking this a step further, either through discipline or through an investment house's charter for a particular fund, your portfolio can be rebalanced automatically and regularly. The US Federal Government recently introduced the Lifecycle Funds; these rebalance automatically.
According to a study by the Charles Schwab brokerage, as recently mentioned in US News and World Report (2/13/2006, page 52), an investor starting with a mixtire of 60% stocks, 30% bonds, and 10% cash in 1978 would have earned 11.2% per year without rebalancing and 11.5% with rebalancing. A 0.3% difference isn't exactly anything to write home about — it may not even be statistically significant! — but I guess it's better than nothing.
My main point is this: Rebalancing should not replace thinking. Just because your fund is rebalanced every year for you or because you've been told that you should have 40% stocks at this point in your life doesn't mean that you mechanically sell or buy stocks to get back to 40%. If stocks are on a tear and they've risen to 45% of your portfolio's value, and you think they'll continue to go higher based on sound principles, forget the rebalancing and buy more! The guidelines were wrong. Likewise, if they've fallen to 35% and you think they'll fall further, you may want to sell what you have and buy later. Or not. It's up to you. And it should be up to you, not up to a bunch of percentages.
Also, rebalancing alone encourages you to limit your investments to vehicles that you already have. What about other investments, like gold, other currencies, real estate, or capital for a side business? Or training for yourself? These can end up returning much more than what you may already own, and you wouldn't have considered them if you were just rebalancing.
Regardless of how you buy or sell your investments, the main point is to think. If it makes sense to rebalance, then rebalance. If it doesn't, then don't!
Ultimately one should pick the allocation that provides the risk/return he is comfortable, and stick with it.
Study after study has shown that market timing is a losing proposition, particulary for an individual investor. Short-term changes in allocation due to perceived valuation inefficiencies is market timing in sheep’s clothing.
Of course you are absolutely correct, one does need to think. But one needs to think about appropriate allocation targets and how to achieve them, lest one confuse emotion due to market momentum with rational thought!