The Dividend Cafe - Rebalancing: Because Something Always Underperforms

Episode Date: January 30, 2026

Today's Post - https://bahnsen.co/4toIPdw In this episode of the Dividend Cafe, host David Bahnsen delves into the importance of portfolio rebalancing, a technique that his practice recently undertook with significant impact. Managing approximately $9 billion in client capital, they executed $530 million of buy transactions and $630 million of sell transactions over six trading days. Bahnsen details the benefits of rebalancing as a powerful risk mitigation tool, a potential return enhancer driven by behavioral finance, and an exercise in humility in the face of market unpredictability. He describes the mathematical simplicity of trimming assets back to their target weights and highlights the diversification of asset classes and sectors. Bahnsen underscores how rebalancing helps maintain a balanced risk-reward ratio tailored to the individual investor's goals and tolerance for volatility. Additionally, he addresses the tax implications, arguing that systematic rebalancing reduces the psychological and financial hurdles associated with large capital gains. Ultimately, Bahnsen advocates for rebalancing as a nearly effortless way to optimize a portfolio for both risk and reward. 00:00 Introduction to Dividend Cafe 00:04 The Importance of Rebalancing 01:39 Understanding Rebalancing Mechanics 04:08 Asset Classes and Rebalancing 08:07 Sector Diversification and Rebalancing 12:43 Behavioral Aspects of Rebalancing 19:03 Tax Implications of Rebalancing 21:33 Conclusion and Final Thoughts Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello and welcome to the Dividend Cafe. I'm your host, David Bonson. Today we're going to just be in this pure classic investment mode talking about a peer classic investment technique and tool and one I believe in with every ounce of breath in my body. That tool is what our practice just got done doing this week. Rebalancing. We are currently managing about $9 billion in client capital. And this week, we affected a rebalance that actually lasted about six trading days because of the sheer size and scale of it that resulted in something in the range of $530 million of buy transactions, $630 million of sell transactions.

And so because of us just going through this annual regimen, it was topical for me to address the subject for clients, but also all non-client investors that are listening, watching, and reading the Dividendon Cafe as to why rebalancing exists. I remain stunned, 26 years into my professional life of managing money, that there are advisors who do not do this. and that there are investors who do not want it done. I believe it represents one of the easiest and most, shall we say, elegant ways of optimizing a risk-reward relationship for investors that's ever been invented. What exactly are we referring to? Well, listen, when you talk about rebalancing, I want to position. position this is something that we believe is primarily a powerful risk mitigation tool. We do believe it is a potential return enhancer, but I'm going to talk to you today as to why I believe

its return enhancement is actually a byproduct of something behavioral more than mathematical or portfolio oriented. And then thirdly, it's an exercise in humility. And we're going to explain what I mean by that. I think those who do not rebalance largely have a contempt for risk management, largely have a hubris that they do not deem it necessary, but also operate from an implicit belief. What goes up will always and forever continue going up. And unfortunately, history has not been kind to that belief system. But what are we talking about? We talk about rebalancing. Just to use some simple math get out of the way, you may have a stock that was two and a half percent of the stock portfolio and it has gone up to three percent of the portfolio because it's moved up more than others

have moved up and it is trimming it back down to two and a half percent. And then of course, inversely, you may have a stock that was two and a half percent and it is now two percent because of it's moving down or moving down relative to the way others have moved up. So there's moving parts, that part of the math is, of course, very simple. And rebalancing is a way of essentially trimming things that are above their target weight and adding to things that are below their target weight. And what it is not doing is stating that the target weights are themselves correct. The target weights are a byproduct of the portfolio construction process. So there is a different conversation one could have if a portfolio was not allocated correctly to begin

with or if a portfolio manager within an asset class doesn't have a rhyme or reason for what the weightings may be. But to the extent one has a strategic reason for the asset allocation of the portfolio and to the extent one has a strategic reason for the weightings of how securities within an asset class are allocated, how they are weighted, then rebalancing is simply restoring that risk-reward relationship, restoring a portfolio to its proper place. Now, I want to put a chart up right now that is a table of investment returns in terms of the various primary asset classes. We're not right now looking at like within large-cap growth, what stock A, B, and C may be, or within large-cap growth, what part is weighted to energy versus

technology. We're talking about the major asset classes, large-cap stocks, bonds, real estate, emerging markets, small-cap, large-cap, international, value, all these major categories. And what you see as this sticks up on your screen for a bit is something that if we were, like right now you might be looking at it and not able to see the numbers and that's a good thing and I'll tell you why. And you might not be able to see the words and that's a good thing and I'll tell you why. Because just the mere color diversity and the pattern of up and down and it could be up a few years and down a few years and what the sort of randomness that would appear to the sequence of returns is enough to illustrate the point without even the specificity of what asset class returned

what in what year. What you see is just by color scheme the fact that asset classes over time with positive rates of return and positive expected rates of return, have periods of being in favor and periods of being out of favor. And if one were to look at how large cap growth did in the late 1990s, you would say it was up at the top every year, you know, how great. And then you look at the beginning part of the 2000s and see large cap growth down over and over again. And the difference between those rebalancing along the way, even if it didn't seem attractive at the time because of the strong momentum and performance, and then what type of risk mitigation that affected? Likewise, right now you see large-cap growth up at the top. It's up five of the last six years up over 18%.

And maybe someone just believes it will always do that. I wouldn't want to enter to such an argument, if that's okay. My point here is you can love asset classes on this chart or dislike them. But you have to acknowledge that there is a sense in which various asset classes that all have positive expected rates of return or there would not be asset classes over periods of time, have seasons of being in favor and seasons of being out of favor. And rebalancing is a way of acknowledging that and rooting a portfolio to an allocation that makes sense for a particular investor. that that allocation was constructed around one's own liquidity needs, income goals, future income goals, return aspirations, the tax ramifications, the variety of circumstances. But then also, two, the tolerance and comfort with volatility.

Because if one said all I care about is maximizing return for infinity, then all you would do is take the asset class with the highest expected rate of return and put 100% there. And you say, well, I don't know what the asset cost return will be. Well, that's the whole point. But you also don't know it after two years of one being really good or five years of one being really good. If you don't know, that's the purpose of some form of diversification. And therefore, the rebalancing is a way of restoring to the proper blend of these things

that meets the tailored goals of a given investor. Now, I'm going to put another chart up here that is not the diversification of asset classes, but the diversification of sectors within the S&P 500. So let's call this large-cap U.S. equities. And again, you can see technology and communication services. At the bottom of the pack, 2006, people that were rebalancing into that really benefited

when it began to recover. And then you see how incredibly strong, wrong it's been here over the last several years, but you also see just a significant randomness to color scheme as some things are in favor at one point, now to favor it another. And it can be very tempting to not rebalance if you think something is permanently affixed to the top of this chart. But the inevitability of this movement is why rebalancing the weightings of your equity exposures is such a prudent idea. I also want to point out, and I'm not trying to be condescending about math here, but some will say, well, look, let's say I have 20% of my portfolio allocated to a certain thing, and it's up 20% per year for five years.

So by rebalancing each year, I'm leaving money on the table because that compounding has been limited. Well, that's absolutely true. It is not true that you've eliminated the exposure. You still have 20% of your portfolio in that hypothetical earning 20% per year. It's just that it didn't earn 22% per year, 26%. It limited some of the upside but maintained a very healthy exposure, which was the exposure you intended to have with a 20% waiting to begin with. And what did you get in exchange for limiting that upside?

you mitigated away a risk that is far more severe, which is one particular year. Now, if you have a 37% correction, it's 37% of a 20% weighting, not something that's grown to a 40% weighting. So you can do the math on that. It is not hypothetical. It is not just something that all makes sense in a spreadsheet. It happens over and over and over again with benefits of rebalance surface. Of course, rebalancing is unnecessary. If you just have the crystal ball, we'll put the chart back up here real quick of the sectors.

If you have the crystal ball right now of what box is going to be best and what's going to be worst when and you can time your way in and out, you don't need to rebalance. The acknowledgement that whether it was the asset class chart we looked at before or the sector chart here, that both at the high level building blocks portfolio categories, asset classes of a portfolio and at the individual sectors within a particular portfolio, that because one doesn't have that crystal ball, the humility of recognizing the lack of perfect prescience around these things, rebalancing becomes a very wonderful tool. The issue at play is risk appetite, comfort level. If something is deemed to be appropriate at a 20% weight,

the portfolio and it grows to 30 or 40 percent, then rebalancing it down to 20 is done because you didn't change. Now, maybe you did. Maybe you said, no, I inherited new money. I now have a higher risk appetite. Or some other internal reality makes it appropriate. That's then for the advisor who's doing their job to customize the portfolio around some change in circumstances. But if you say, well, I didn't change, but the market's up and I just really like this. It keeps, it's going up. That is not a healthy way to formulate a risk appetite. It is River and Mir.

It is the fallacious assumption that what just got done happening is bound to happen again. So to me, not rebalancing is an implicit admission that either the portfolio was constructed poorly or one doesn't believe in the tenets of how it was constructed, that they're making an exception to what they said they believe around market circumstances. And it becomes a form of market timing that skews things. Now, why do I care? Why does this matter? It is fundamentally an issue of behavioral management.

at the end of the day, the math of saying the more of your portfolio weighted to the highest performing asset class, the better, is very good math. If you have one asset class that's going to make 10%, and one that's going to make 5%, if you have 100% in the ones that are going to make 10 versus 80 in the one that's going to make 10 and 20 in the ones going to make 5, the other portfolio is going to do better. So why does anybody put asset classes that they expect a lower rate of return in along with a portfolio of assets that they expect a higher rate of return? You look at it from the vantage point of the Bonson Group. There's a link in the midst of our Dividing Cafe article that goes to our website where it lists out all of the different categories we invest around because we're not real generic vanilla style box investors.

we've created customized building blocks, what we call Operation Magnify, around how we go about putting together a holistic client portfolio. But everybody knows that dividend growth, our bread and butter, it's the asset class, I believe, to have these optimal risk-reward characteristics, liquidity, tax efficiency, the ability to achieve growth, the ability to achieve income, the ability to achieve growth of income, all rolled into one. And in a perfect world with infinity is a timeline, I would love dividend growth is 100% of a weighting. But why do we implement various things, such as ill liquids or alternatives or fixed or boring bonds or whatever the case may be? The reality is that on an individual basis, you might be doing things to put

higher levels of volatility for income enhancements or growth enhancements or largely to limit volatility, the use of other asset classes that you expect to diversify away from equity market volatility. And those things come at a cost. So the notion that we want to have things that have a lower return in the portfolio is not totally irrational. As long as you understand why you're doing it, it is because you're trying to keep yourself within a comfort level that will avoid you abandoning the portfolio that has the higher returns in it, the asset class that is going to deliver the bulk of your future goals. You can't get that return if you're not in it. And if you sell out of it because of the discomfort of high volatility, then you don't

get the return. You don't reap the benefits. So keeping someone on the ship is the goal of asset allocation. So some mitigation of volatility through a portfolio construction process is why we mix and match the way we do. The question then is, from a rebalancing standpoint, are we doing it to enhance returns or reduce risk? And my answer is I don't think they're inseparable from one another because I think in reducing that volatility, I'm making up a number here. But if someone has a comfort level, 60% equities and it grows to be 85% because of a screen, booming bull market, now when they said, I'd be uncomfortable if stocks dropped 30%, but at 60%, if they dropped 30 of 60, you know, that level I can handle.

But now if you're up around 80%, that same potential drop in stocks is going to do what you said you were afraid of before. So therefore, you've called into question your sustainability. In other words, your likelihood of achieving the returns of the very asset classes you're invested in. So rebalancing enables one to stay aligned with their own goals and their own comfort level. It is a governor on human psychology. I believe very thoroughly that no one can benefit from equities they do not own. And most people will not own equities, including great dividend growth ones,

if their downside volatility causes them to jump off the boat. But we capture more upside of volatile risk assets like stocks by minimizing those to jump off the boat. And we minimize boat jumping with asset allocation. Therefore, we maintain asset allocation with rebalancing. So that's the sort of syllogism here as to how we get to a place of using rebalancing to optimize the portfolio, both in terms of the risk and the reward. If one does have, by the way, a hundred percent weighted to, let's say, dividend growth equities,

even then rebalancing becomes important. And now is not about rebalancing from stocks to bonds, these different building blocks or categories of investment. But within a diversified equity portfolio, there are going to be stocks that perform better than others, which is another way of saying there's going to be stocks that perform worse than others. And to the extent,

that you believe the thesis is still there, the long-term case for value creation is there. In our case, dividend and growing dividend, sustainability is there. Then you benefit from buying more of those companies at lower prices. This becomes a buy, low, sell, high automation. It becomes systematic. It becomes non-emotional. Most things are not emotional make for better investor outcome. Rebalancing is a class.

case of that. So at the end of the day, we think that not only do we benefit by rebalancing the broad categories of investment, but even the internal issues as in a given year, some stocks are going to be up a lot more. We trim down to a target waiting. We revisit our targets. We take an active approach in that process. And you can make mistakes along the way, but you're constantly seeking to mitigate risk and in so doing enhance the likelihood of investors staying invested into a portfolio that will help deliver the returns and results they need for successful outcomes. Finally, the argument that some will make is, well, what about taxes? If you're trimming gains and so forth, you're realizing certain capital gains along the way.

Of course, this doesn't apply to IRA's 401K's significant amount of non-taxable accounts. And then you might, you're going to need the money eventually. But if you just say, I'm going to die with it and get a step up. and basis, then that wouldn't apply to like irrevocable trust or things that are going to not have a basis. But there are certainly just taxable accounts in which is very true. You're realizing certain capital gains on the way. So first of all, I just never believe letting the tax tail wag the investment dog. But secondly, I want to turn this on its head and suggest it's a feature, not a bug. Because to the extent there may be a need to sell the asset at some point, if the entire gain. You've never trimmed along the way and mitigated that. There's a bigger hurdle to overcome

when there is this one large gain to take at one level, not only bracket creep in terms of tax ramifications potentially, but just the psychological hurdle. But it doesn't then become a question of whether or not someone's going to do it. It's usually how that fosters rationalization of not doing it, that, well, I have this big return. The tax hits going to be so big. So low and behold, I now magically believe this stock will continue to perform in a way that you don't actually believe it will or you shouldn't believe it will. But it becomes a sort of cognitive dissonance because the tax hit's so big, where if you mitigate that along the way through the form of annual trimming, it's still a taxable consequence, but less so and marginally turns it into a little

bit less of a headwind psychologically to do the right thing for one's portfolio. The rebalancing technique is not hard, it isn't new, it isn't complicated. What it is is something that goes against the human nature of greed when things are good and it goes against the human nature of saying, why I want to want to buy something that's been a lower performer? But to the extent that over time, the risk is reduced, the behavioral behavior, the behavioral inclinations improved through the systematic task of rebalancing. We believe it is almost free money, almost

just a gift to investors, and we will do it the rest of our days. We'll have any questions you have about this topic. I appreciate you allowing me to go into the evergreen topic of portfolio rebalancing. Looking forward to come. Coming back next week, in the month of February, January, is flown by. In the meantime, thank you for listening. Thank you for watching. And thank you for reading the Dividend Cafe.

The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, and with Hightower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC. This is not an offer to buy or sell securities. No investment process is free risk. There's no guarantee that the investment. process or investment opportunities referenced

torian will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities reference Tyrion may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable. Any opinions, news, research,

analyses, prices, or other information contained in this research is provided as general market commentary and does not constitute investment advice. The Bonson Group in Hightower shall not in any way be liable for claims and make no express or or the representations or warranties as to the accuracy or completeness of the data and other information,

or for statements or errors contained in or emissions from the obtained data and information referenced here in. The data and information are provided as of the date reference, such data and information are subject to change without notice. This document was created for informational purposes only, the opinions expressed, are solely those of the Bonson Group and do not represent those of Hightower Advisors or any of its affiliates. High Tower Advisors do not provide tax or legal advice. advice. This material was not intended or written to be used or presented to any entity as tax advice or tax information. Tax laws vary based on the client's individual circumstances and can change at any time without notice. Clients are urged to consult their tax or legal advisor for any related questions.