{"id":669,"date":"2010-06-23T15:01:57","date_gmt":"2010-06-23T15:01:57","guid":{"rendered":"https:\/\/www.blueleaf.com\/?page_id=669"},"modified":"2019-06-25T20:09:27","modified_gmt":"2019-06-25T20:09:27","slug":"why-your-broker-wants-you-to-trade-more","status":"publish","type":"page","link":"https:\/\/www.blueleaf.com\/articles\/why-your-broker-wants-you-to-trade-more\/","title":{"rendered":"Why Your Broker Wants You To Trade More"},"content":{"rendered":"

By: Christopher Thorpe, Ph.D.<\/a><\/p>\n

Your broker has what economists call \u201cincentive problems.\u201d \u00a0Brokers, like all professionals, want to serve their own best interests (i.e., making money). \u00a0Brokers make money from a number of activities, most notably trading commissions, asset management fees, and lending your liquid assets to others at a price higher than they pay you (just as banks do with your deposits). \u00a0You make more money when your assets increase in value (stock prices go up) and you receive dividends or interest income. Another way you can make more money in your brokerage account is by reducing the commissions, fees, and taxes that you pay to your brokerage house.<\/p>\n

The incentive problem appears because your goals and your broker’s goals are not completely aligned: what makes your broker rich does not necessarily make you rich. The incentive problem is that a broker has a strong incentive to encourage you to trade more while you want to trade less to save on fees and costs. This is called “churning”.<\/p>\n

Incentive Problem #1: Trading.<\/h3>\n

Let\u2019s say that you and your advisor agreed on an asset allocation for your equity investments in a taxable individual account and you have 20 stocks in your $100K portfolio. \u00a0For purposes of discussion, let\u2019s say that $5k=5% of your equity allocation is in each stock, with 5 value stocks, 5 growth, 5 income, and 5 international. \u00a0(In practice, one would probably use a more sophisticated allocation model.)<\/p>\n

Now say in 3 months your value stocks go up by 100% while everything else is unchanged. \u00a0Your portfolio\u2019s up 25% overall, but your asset allocation is wrong: instead of 25\/25\/25\/25 you are now at 40\/20\/20\/20.<\/p>\n

What\u2019s the problem?<\/h3>\n

Here\u2019s where the incentive problem comes in. \u00a0If your broker makes a minimum fee for every trade you take, it has an incentive to encourage you to rebalance in a way that maximizes the number of trades, even if it\u2019s not to your benefit. \u00a0Let\u2019s consider two obvious rebalancing strategies that will return you to a 25\/25\/25\/25 allocation and the incentives implied by each of them.<\/p>\n

The first is to simply rebalance every one of the 20 equities in your portfolio. \u00a0You\u2019ll sell a portion of each of your 5 value stocks, bringing your position back down to $6,250 each, and then buy an additional $1,250 in each of your other stocks. \u00a0Now you\u2019re back at the desired asset allocation: you have $31,250 in each of your 4 \u201cbuckets\u201d.<\/p>\n

The second is to rebalance by asset class, selling off parts of each position in the overvalued asset class, then buying entirely new positions in each of the other \u201cbuckets\u201d. \u00a0This requires just 8 trades instead of 20.<\/p>\n

How much does rebalancing cost you?<\/h3>\n

At a modest $10 commission, you would pay $200 for the first trade \u2013 about 20 basis points \u2013 excluding other transaction costs. \u00a0Do this quarterly, and you\u2019re paying 0.8% of the value of your portfolio just in commissions. \u00a0That may not seem like much, but assuming 10% annual returns compounded over 10 years, 0.8% per year of extra costs is big: the difference between an annually compounded return of 10% and 9.2% amounts to a surprising $18,258 on a $100,000 initial investment.<\/p>\n

Instead of rebalancing every single equity in the portfolio, in the second method we\u2019re more concerned about overall asset allocation\u00a0than about maintaining the exact portfolio of securities. \u00a0You still reduce your value stocks to $6,250 each \u2013 5 trades \u2013 but instead of distributing the $18,750 of gains across all 15 stocks in the other 3 risk classes, you buy one new growth, income and international equity at $6,250 each. \u00a0This costs only $80 in commissions \u2013 60% less \u2013 and the cost savings over time are commensurate. \u00a0The difference between 10% and 9.68% (using the same starting conditions) costs only $7,447, again around 60% less than the previous method.<\/p>\n

The risk of the second approach is not materially different, provided you\u2019ve taken care to carefully select your new equity investments in terms of portfolio fit. \u00a0You still have your 25\/25\/25\/25 allocation, with 8 investments of $6,250 and 15 investments of $5,000, instead of 20 investments of $6,250.<\/p>\n

The final question is, which method would you suggest to a client if you were a profit-maximizing broker? \u00a0As a client, which would you choose, given the explanation of both options? \u00a0If your answers to these questions differ, then your broker has an incentive problem.<\/p>\n

Notes and assumptions<\/span><\/h2>\n
    \n
  1. We made some simplifying assumptions to arrive at the 0.8% (80 basis points, or 80bp) per year cost of full rebalancing. \u00a0Specifically, this analysis assumes a $100,000 portfolio of 20 stocks with $10 commissions and quarterly rebalancing. \u00a0We also assumed the 80bp did not change over time, even though commission costs would probably not increase at the same rate as portfolio gains. \u00a0Correctly accounting for that difference would lead to a lower long-term cost estimate.<\/li>\n
  2. A full rebalancing in the short term would cost $10,000 in taxes, assuming a 40% tax rate on short-term capital gains. \u00a0That\u2019s $6,250 more than the 15% long-term capital gains rate for the 25%+ marginal tax brackets. \u00a0We\u2019ll look at how taxes relate to incentive problems in a future post.<\/li>\n
  3. A third approach we didn’t cover involves selling most of two of the value stock positions (leaving 3 at $10,000 and two at $625) instead of selling some of all five. \u00a0The cost savings of executing three fewer trades did not seem to me to outweigh the increased portfolio risk of reduced diversification.<\/li>\n<\/ol>\n","protected":false},"excerpt":{"rendered":"

    By: Christopher Thorpe, Ph.D. Your broker has what economists call \u201cincentive problems.\u201d \u00a0Brokers, like all professionals, want to serve their own best interests (i.e., making money). \u00a0Brokers make money from a number of activities, most notably trading commissions, asset management fees, and lending your liquid assets to others at a price higher than they pay…<\/p>\n","protected":false},"author":1,"featured_media":0,"parent":667,"menu_order":0,"comment_status":"open","ping_status":"open","template":"","meta":{"content-type":"","om_disable_all_campaigns":false,"_monsterinsights_skip_tracking":false,"_monsterinsights_sitenote_active":false,"_monsterinsights_sitenote_note":"","_monsterinsights_sitenote_category":0,"_uf_show_specific_survey":0,"_uf_disable_surveys":false,"footnotes":""},"class_list":["post-669","page","type-page","status-publish","hentry"],"aioseo_notices":[],"_links":{"self":[{"href":"https:\/\/www.blueleaf.com\/wp-json\/wp\/v2\/pages\/669","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.blueleaf.com\/wp-json\/wp\/v2\/pages"}],"about":[{"href":"https:\/\/www.blueleaf.com\/wp-json\/wp\/v2\/types\/page"}],"author":[{"embeddable":true,"href":"https:\/\/www.blueleaf.com\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.blueleaf.com\/wp-json\/wp\/v2\/comments?post=669"}],"version-history":[{"count":0,"href":"https:\/\/www.blueleaf.com\/wp-json\/wp\/v2\/pages\/669\/revisions"}],"up":[{"embeddable":true,"href":"https:\/\/www.blueleaf.com\/wp-json\/wp\/v2\/pages\/667"}],"wp:attachment":[{"href":"https:\/\/www.blueleaf.com\/wp-json\/wp\/v2\/media?parent=669"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}