Question: 'I've heard a lot of reminders since the beginning of the year to check up on my 401(k) and other retirement plans and rebalance them if they're not diversified correctly. How often do I need to rebalance my portfolio?'

- Albert, Brownsville, TX

Answer: I'll be honest with you, Albert. As much as I enjoy finding the smartest tactics for investing my money, I have to say that rebalancing my 401k plan, IRA, and Roth IRA account is among my least favorite things to do. But it's also one of the most important when it comes to investing.

You can't just leave this one alone if you want to successfully preserve and grow your wealth.

What does portfolio rebalancing mean? Why is it important?

Let's assume that when you first set up your 401k plan or other investment plan, you talked to an advisor or a human resources rep or researched on your own to create just the right portfolio allocation for you -- one that has the perfect mix of investments that fit your own risk tolerance and age.

[Haven't had a chance to set up a portfolio plan? Look at some examples in The Lazy Man's Retirement Portfolio.]

Whether you did that years ago or just a few months ago, it's inevitable that some of your investments will grow in value while others decline. This is fine in the short term, but leaving this alone without rebalancing will throw your portfolio seriously out of whack and could hurt your overall returns over the long term.

For example, let's say your investment portfolio was originally made up of 50% stocks and 50% bonds. Over the years, let's say stocks did poorly and fell in value, while the bonds in your portfolio did well. Your portfolio would end up looking much different -- and you may be left with a much different mix of 40% of your money in stocks and 60% in bonds.

So what's the problem with that? If you don't rebalance your portfolio and get it back to your original mix, you'll miss out when stocks that are out of favor suddenly come roaring back, because you won't have as much of your money in stocks. And that could take a serious bite out of your returns if you missed out on enough of those opportunities over the long run.

It can go the other way, too. Let's again say you started with 50% stocks and 50% bonds. Then let's say stocks did very well over the years, growing in value while bonds fared poorly. If your portfolio warped into a mix of 55% in stocks and 45% in bonds and suddenly there was a stock market crash, you'd suffer heavier losses than you would have if you rebalanced back to the 50-50 mix because more of your money would be in stocks. Enough of those tragedies can hurt your long-term gains as well.

Put simply, when you rebalance, you are essentially reining in the assets that have overperformed and putting more of your money into assets that have underperformed. You're selling off expensive and potentially overvalued assets in favor of undervalued ones that could take off in the future. It's another way of buying low and selling high -- a winning formula.

How often should you rebalance your portfolio?

You'll often hear that you should rebalance once or twice a year (perhaps in January and July), and that's fine for most investors. That said, markets are largely unpredictable, and rebalancing at an arbitrary time of the year could put your money at risk if you leave your portfolio alone after big market moves

Instead, a smarter approach may be to follow a 5% rule -- simply keep an eye on your portfolio every quarter, or at the very least after huge market moves, and make sure your assets are within 5% of where they should be when you last planned your portfolio.

For example, if your portfolio started with 80% in stocks and they do so well over the next four months that your holdings change to 85% or more in stocks, it's time to rebalance. Or, if your stocks do poorly and your holdings change to 75% or less in stocks, it's time to rebalance. The idea is to not let your asset classes change more than 5% of where they're supposed to be. That will keep you on track.

Of course, there are always exceptions. Your 'original' portfolio plan may become outdated every 10 years as you approach retirement -- what was right for you then may not be right for you now.

For example, a 30-year-old may want more stocks (and therefore a more aggressive investment strategy) than a 40-year-old. And a 50-year-old may want more bonds (meaning less risk).

So you may want to research or work with a trusted advisor and readjust your investment mix each decade to fit your age and risk tolerance. But after you've readjusted your plan, keep using that 5% rule and rebalance every time your portfolio needs it.

How to Rebalance Your 401k Portfolio

Now that you know when to rebalance you may be wondering how to go about rebalancing your portfolio back to its original asset allocations.

For 401k plans rebalancing is easy. Simply call or email your 401k plan provider or HR department and ask them to rebalance your investment allocations back to the way they were originally (or if it's been a decade since you last set up your plan, ask them to help you make a new asset allocation mix that's more appropriate for your age and risk tolerance).

Alternatively, you can set up a rebalance online at the same place you log in to look at your 401k balance or tax statements. Just do a search for 'rebalance' and you'll be steered in the right direction.

How to Rebalance Other Investment Portfolios

Often times brokerage firms are full service operations that will rebalance your portfolio whenever you ask them. You simply follow the same steps as with a 401k.

However, if you're 'on your own' to rebalance your portfolio or you don't want the brokerage firm to do it, there are two ways to go about doing the deed.

The first way is to simply sell some of the investments that are over their original allocation percentages. For example, say you were originally 50% stocks and 50% bonds. If you have a $10,000 portfolio that's changed to 60% stocks ($6,000) and 40% bonds ($4,000, you'd need to sell $1,000 worth of your stocks and buy $1,000 of your bonds. That would rebalance you right back to $5,000 worth of stocks and $5,000 bonds for your original 50-50 mix in this example.

The second way, which is more tax-efficient if you're rebalancing outside of a retirement account (more on that next), is to buy more of the underweighted investment.

Let's revisit the original example. If you had originally had a 50-50 stock and bond portfolio worth $10,000, and your stocks went up to 60% (or $6,000) of your portfolio allocation, that would leave you with 40% ($4,000) of the portfolio in bonds.

That means you'd need to buy more bonds to rebalance and get back to 50-50. If you were to buy $2,000 worth of additional bonds, that would bring you to $6,000 in bonds and $6,000 in stocks. Voila, the 50-50 mix without any triggering a potential capital gain from a sale.

How can I avoid triggering capital gains tax when rebalancing?

What happens if you rebalance your portfolio within a taxable investment account? Because rebalancing involves selling investments, a rebalance could trigger unwanted capital gains taxes if you sell investments that made a profit.

That's why rebalancing works best within retirement accounts, which let your investments grow tax free -- even if you sell some along the way -- until you reach retirement age (Roth IRAs actually offer tax-free withdrawals too). So if your investments are in a retirement plan (such as a 401k, IRA or Roth IRA), you may rebalance as often as you'd like without triggering taxes.

Don't like rebalancing your 401k? Use target date funds for simplicity.

One more tip: If you're invested in a 401k plan and rebalancing your portfolio sounds like too much of a hassle, consider simply investing in a target-date fund if your 401(k) provider offers them.

Target date funds are simply mutual funds that are set up to match your age and risk tolerance and automatically rebalance your investments as you approach retirement. You can learn more about these super-simple funds in Target Date Funds: The Hassle-Free Way to Invest in Your 401k.