As a simple example, assume you have $100 in your portfolio. You decide that you would like to split the portfolio between two asset classes: stocks at 50% and bonds at 50%. At the beginning of the year you have $50 in each asset class. Now, let's say that during the year stocks appreciate by 20% while your bond investment remains flat. At the end of the year, you will have $60 in stocks, and still only $50 in bonds. Your bonds now represent only 45% of your portfolio, while stocks now account for 55%. This allocation is different from your intended allocation of 50% - 50%. To re-balance, you need to sell $5 worth of stocks and buy $5 of bonds, such that you have $55 in each asset class.
Why does re-balancing make sense? Re-balancing is a method that is supposed to help you automatically buy low and sell high. You buy those discounted assets that have declined or that have failed to appreciate as much, while taking some profits out of those segments that have seen a run-up in value. When re-balancing you should watch out for the following:
Timing the market is counter-productive - the whole idea of re-balancing is to remove judgement and emotion from the asset allocation process. You are not supposed to try to out-guess the market or try to determine when would be the right time to buy or sell. It is better to pick a date in advance, say December 1st of each year, and decide that no matter what the market does, you will re-balance your portfolio on that day. Trying to time the market is akin to stock-picking: it is not likely to work out very well.
Tax liability - re-balancing, by definition, involves selling winning asset classes, in which you are likely to have capital gains. For this reason, the act of re-balancing is likely to create a tax liability for you. One way to address this issue is to re-balance your portfolio by only using assets within tax advantaged accounts such as IRAs and 401k's. In my opinion, re-balancing that creates a tax liability may defeat the whole purpose of the exercise, which is maximize your returns in the long run. I have another solution to this tax liability issue: I re-balance by adding assets, without selling. I know what my target asset allocation is, and as my portfolio shifts away from this asset mix, I invest any new money I saved in the asset classes which are now under-represented in my portfolio.
Cost - don't re-balance every day, every week or every month. Even once a quarter could be considered excessive. Trading is expensive. One of the best ways to destroy your returns is to increase your costs by excessive buying and selling. If you want to re-balance, once or twice a year is sufficient.
Hassle - wouldn't it be easier to just forget the whole thing? I mean is it really worth the hassle to sell a few stocks or buy a few bonds? Is there really enough value in this exercise? Frankly, I am not sure. However, one of my previous employers offered an excellent solution to this problem: in its 401K plan it offered an automatic quarterly re-balancing option. This addressed both the hassle and market timing issues I mentioned above.