Thus, it stands to reason that the virtues of traditional rebalancing--among asset classes--are greatest for investors who value that risk reduction the most. On the short list are those investors who, unnerved by market volatility, have tended to reduce their portfolios' risk levels after the market has fallen a great deal. Such investors would be particularly well served by rebalancing--or perhaps better yet, employing funds that do that rebalancing for them--such as target-date or allocation funds.

Meanwhile, younger investors--say, those under 50--who aren't overly flummoxed by volatility in their stock-heavy portfolios can probably get by with infrequent rebalancing, or none at all. They may benefit more from intra-asset rebalancing, however--for example, periodically scaling back their large-cap weightings after such stocks have outperformed and adding the money to small- and mid-caps.

For pre-retirees and retirees, however, rebalancing is essential--regardless of risk tolerance. Not only can it help them sidestep all sorts of ill effects from overly heavy equity weightings in the years leading up to retirement, but it can aid them in extracting their desired in-retirement cash flows, too.

Risk Tolerance Versus Risk Capacity: What Difference Does It Make?

The reason rebalancing matters more for pre-retirees and retirees than it does for younger investors gets back to the distinction between risk tolerance and risk capacity. Risk tolerance describes an investor's ability to psychologically cope with periodic losses in his or her portfolio. Risk capacity relates to whether those losses will be so significant that the investor will need to change his plan.

It's not uncommon for people in their 50s, 60s, and beyond to have high risk tolerances: They've been stress-tested by two major bear markets in the space of 20 years, the market has recovered, and so have their portfolios. What many investors fitting this description may not realize, however, is that their risk capacities have declined even as their risk tolerances have remained the same or even grown. And when a too-high equity allocation is combined with higher equity valuations and a shortened time horizon before spending, the results can be disastrous.

Take, for example, a then-58-year-old investor whose $1 million portfolio had a 60% equity/40% bond portfolio in early 2009, at the outset of the current bull run for equities. Assuming our hypothetical investor has taken a hands-off tack since then, the portfolio would now be worth nearly $2.7 million and would feature an 80% stock stake. Such a heavy equity weighting might be appropriate for a 65-year-old with other sources of in-retirement income during retirement, such as a pension. But for a 65-year-old who planned to begin spending from the portfolio imminently, that large stock stake makes him vulnerable to what retirement planners call sequence-of-return risk. In a nutshell, that's the risk of encountering punishing losses in the early years of retirement. Combined with ongoing drawdowns from a portfolio, such heavy losses can lead a retiree to prematurely deplete capital or force a reduction in spending to help avoid a shortfall.

Let's imagine the 80% equity/20% bond portfolio subsequently ran headlong into an equity market sell-off similar to the financial crisis of 2007-2009, when stocks dropped about 50% and high-quality bonds gained a little bit of ground. The total portfolio would lose about 38% of its value. In contrast, if our hypothetical soon-to-be retiree scaled back the equity weighting to 60% and plowed the money into bonds, the portfolio would have dropped less than 30% over the same punishing stretch.

Rebalancing Can Help With Cash Flows, Too

Protecting against market downdrafts isn't the only reason retirees should consider rebalancing. A subtype of rebalancing--whereby the proceeds from appreciated assets are spent rather than reinvested--can also prove advantageous as a means of unlocking cash flow from a portfolio during retirement. Such a strategy also serves to reduce risk. That's a neat trick when you consider that today's low yields make it difficult to subsist on yield alone and have forced income-centric retirees to venture into risky securities. By incorporating rebalancing at both the asset-class and intra-asset-class levels, a retiree can extract cash flow even when the income gods are not delivering it.

A rebalancing strategy that allows for intra-asset-class rebalancing can be particularly powerful when it comes to shaking cash flow from a portfolio. By that I mean a retiree can give herself latitude to prune an outperforming investment and use that money for living expenses, even if the portfolio's exposure to the whole asset class hasn't exceeded preset thresholds. In 2015, for example, a retiree's equity holdings in aggregate may not have performed especially well but her healthcare fund was on a tear; cutting back that holding could provide cash flow while also reducing the portfolio's risk level.