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5 mistakes to avoid when rebalancing a portfolio

Any day now, you should receive your year-end brokerage and mutual fund statements, if you haven't already.

With a fresh picture of your 2016 results and how your holdings are divided between stocks, bonds and cash, it should be easy to "rebalance" — sell some holdings and add to others to get back to the proper mix for your long-term plans.

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But maybe this isn't the best time. While most experts agree that the mix of asset classes is key to juggling risk and potential reward for the best long-term results, most also say it may be a mistake to just tinker every January, like ticking off a New Year's resolution. Rebalancing is a crucial matter that requires careful thought and research.

"Rebalancing based on a particular month of the year makes no sense — it's purely arbitrary," said Larry Miles, principal at AdvicePeriod. "It's like saying, 'I'm going to drive in a straight line for 11 miles and then, in the 12th mile, I'll turn right.'

"You need to rebalance as often as the market dictates, to stay on the road."

Many experts recommend setting limits for how far off-target each type of asset can be, rather than following a schedule on a calendar. When, for instance, stocks are 65 percent of your holdings instead of 60 percent.

"If you see your targets are off by more than 4 percent to 5 percent, you should think about a rebalance," said Christy Gatien, certified financial planner and first vice president and portfolio manager at D.A. Davidson & Co. Some even say a 10 percent drift is okay.

"The beauty of an asset-allocation approach is that it forces us to be disciplined investors as long as we stick with it," Gatien said. "As we rebalance, we're trimming the areas that are doing well — selling high — and adding to the areas that are struggling — buying low.

"It can feel counterintuitive, but it works."

Many investors struggle with discipline, and a firm rebalancing strategy helps, according to Jason Lowy, a CFP and first vice president of wealth management at UBS Financial Services.

"It's less about finding the most optimal time — there really isn't one — and more about finding a system that works for the individual investor, so you can stick with it." -Christy Gatien, first vice president and portfolio manager at D.A. Davidson & Co

"It has been my experience that, when markets are good, investors usually want to let it ride because there is a fear of missing out on the potential gains," he said. "In this scenario, they can become too heavily allocated to stocks based on their risk tolerance and may actually take on more risk."

Experts note five key mistakes to watch out for.

1. Obeying the robot overlord
Asset allocation often begins with an online tool that asks questions such as, "If your stocks lost 10 percent, would you sell, stay the same or buy more?" If you say "sell," the tool may conclude you have a low "risk tolerance" and recommend a conservative portfolio. But a professional advisor might say you're worrying too much, that 10 percent corrections are common and you're better off staying the course.

"When markets are going up, we tend to overestimate our tolerance for volatility, and when markets are going down, we tend to be overly fearful," Gatien said.

"These calculators are great at creating a general road map for where you could allocate investments," said Lowy at UBS. "They may not, however, take into consideration individual goals and needs based on the investor's specific situation."

2. Freezing at the wheel
The idea is to stick to a long-term plan tailored to goals such as college and retirement. If your job situation becomes shaky or you come into an inheritance, it might be time to revise the plan to emphasize safety over big returns — to turn the wheel because the planned route looks less inviting.

James B. Twining, a CFP and founder of Financial Plan, said deciding when to rebalance is a judgment call that can vary with the circumstances, allowing for a wider diversion from the goals one time and a narrower one other times. "No one knows how often rebalancing should occur or how big the variance should be before rebalancing," he said.

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3. Being driven by love or hate
Since rebalancing often requires selling a successful holding to buy something else, it can pay to reexamine what you have and could have, so you don't sell a winner that's still promising or buy an asset that will keep going down.

One approach: Ask of every holding, "Would I buy it today?" regardless of how it has done in the past. If the answer is yes, keep it. If not, throw it away.

4. Becoming obsessive
Too often, rebalancing can force you to make a change on Monday only to reverse it on Tuesday as the markets fluctuate, eroding your holdings through fees and taxes. Also, some funds restrict the frequency of trades, so an unnecessary move might be tricky to reverse if you need to soon after.

"Rebalancing too often could result in a lot of transactions" and fees, UBS's Lowy said, adding that too many sales in a taxable account can trigger damaging capital gains taxes.

Even when rebalancing is wise, it's best to use techniques for minimizing taxes that can be triggered by sales.

One approach is to do the bulk of your reallocations in tax-favored accounts such as individual retirement accounts or 401(k) plans where taxes on gains are deferred until you make withdrawals, which may not be for years, or even decades.

So long as your portfolio as a whole satisfies your asset-allocation goal, it may not be necessary for every account to be allocated the same. (Of course, accounts set up for different purposes, such as college costs coming soon versus retirement coming much later, may have different allocations.)

"The tax-favored accounts could be rebalanced more often without regard to taxes," Lowy said, while cautioning that trading costs such as commissions can mount even if taxes don't.

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If you must sell holdings in a taxable account, think extra hard about ones with large gains that could trigger big taxes. And if you're trimming a holding rather than dumping the whole thing, sell the shares that had cost the most, to minimize taxable gains or to book a loss that can offset other gains or reduce your taxable income. First ask your broker or fund company about how to do this.

Another technique in taxable accounts is to confine sales to holdings that had been owned longer than a year, to get the lower long-term capital gains rate, observed Chris Chen, a CFP and founder of Insight Financial Strategists.

Tax matters, while worth considering, need to be kept in their place. "Don't let the tax tail wag the dog," said Gatien of D.A. Davidson & Co. , noting that tax savings can easily be wiped out by a bad investment decision.

5. Losing focus
You won't rebalance effectively if you don't know what's going on. Most brokerages and fund companies have online reports that display the client's asset allocation day by day. Or you can use freestanding software such as Quicken.

"It's less about finding the most optimal time — there really isn't one — and more about finding a system that works for the individual investor so you can stick with it," Gatien said. "Consistency matters more than the actual day or month."

— By Jeff Brown, special to CNBC.com