Watch the auction house.
Right now, crafting materials are selling for substantially less gold than all but the worst low level blue items. You'll get far better results selling your blue items and buying Essences from the AH.
For example, current market value for normal mode mats is 20g for Subtle Essence and 45g for Fallen Teeth. So any item worth more than 25g, I sell. If its worth less than 25, I gamble for a shot at a tooth.
So this is a bit of an interesting issue. To answer this, we need to take a closer look at the damage formula:
Base Damage =
(weapon damage range + bonus damage from gear)
× bonus
from primary attribute†
× other class bonuses from skills.
Ability Damage =
Base Damage (as above)
× % Weapon Damage listed on the ability.
†1 primary attribute = +1% bonus damage
For the purpose of this question, we can ignore ability damage and bonuses from skills.
Understanding the Formula
Base Damage has two main components. Weapon Damage (this is the range you get, i.e. 4-6 for many starting weapons) and Primary Attribute bonus (this is 1% for every Primary Stat you ahve. In your case, Intelligence).
Because they are being multiplied, a small weapon range gets less benefit than a large one. 4-6 damage times 200% damage (from 100 intelligence) is only 8-12, whereas a weapon with 6-10 goes up to 12-20. The higher your weapon's average damage, the more valuable the bonus from stats is.
Applying our Findings
In your case, you've got a ton of Intelligence, which is great, and a really low damage weapon, which is less great. This means that really low damage is getting multiplied by a large value, which is still, unfortunately, in your case, a really low final value.
The take away here is that primary stat is not worth more than weapon damage. You need both to maximize your damage, which means you'd probably be best served by dropping your 20 dps weapon and picking up something nicer. As a comparison - My Wizard has a 33 DPS weapon, and she is only in Act III of Normal.
Best Answer
This depends heavily on whether you are playing hardcore or softcore. In softcore, there is no pressure. If you find yourself in trouble and dieing, then you can still lean back and get better gear from the AH (you don't even have to repair the old one ;)
In hardcore, things are very different. You don't get the chance to die once as a reminder to upgrade your gear, so you have to do it more often based on how much life you have left in dangerous encounters and how much damage you did.
Generally, it would be best to have the best gear for your current level. But most players simply can't afford paying outrageous prices in the AH for top-of-the-line gear at every level-up. Therefore, you have to strike a compromise and continuously improve your gear. It might very well happen that you still run with an item that is 10+ levels below your current level, but that item is bound to be replaced as soon as you find something decent in the AH.