By: Christopher Thorpe, Ph.D.
Your broker has what economists call “incentive problems.” Brokers, like all professionals, want to serve their own best interests (i.e., making money). Brokers 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). You 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.
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”.
Incentive Problem #1: Trading.
Let’s 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. For purposes of discussion, let’s say that $5k=5% of your equity allocation is in each stock, with 5 value stocks, 5 growth, 5 income, and 5 international. (In practice, one would probably use a more sophisticated allocation model.)
Now say in 3 months your value stocks go up by 100% while everything else is unchanged. Your portfolio’s up 25% overall, but your asset allocation is wrong: instead of 25/25/25/25 you are now at 40/20/20/20.
What’s the problem?
Here’s where the incentive problem comes in. If 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’s not to your benefit. Let’s consider two obvious rebalancing strategies that will return you to a 25/25/25/25 allocation and the incentives implied by each of them.
The first is to simply rebalance every one of the 20 equities in your portfolio. You’ll 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. Now you’re back at the desired asset allocation: you have $31,250 in each of your 4 “buckets”.
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 “buckets”. This requires just 8 trades instead of 20.
How much does rebalancing cost you?
At a modest $10 commission, you would pay $200 for the first trade – about 20 basis points – excluding other transaction costs. Do this quarterly, and you’re paying 0.8% of the value of your portfolio just in commissions. That 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.
Instead of rebalancing every single equity in the portfolio, in the second method we’re more concerned about overall asset allocationthan about maintaining the exact portfolio of securities. You still reduce your value stocks to $6,250 each – 5 trades – 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. This costs only $80 in commissions – 60% less – and the cost savings over time are commensurate. The difference between 10% and 9.68% (using the same starting conditions) costs only $7,447, again around 60% less than the previous method.
The risk of the second approach is not materially different, provided you’ve taken care to carefully select your new equity investments in terms of portfolio fit. You 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.
The final question is, which method would you suggest to a client if you were a profit-maximizing broker? As a client, which would you choose, given the explanation of both options? If your answers to these questions differ, then your broker has an incentive problem.
Notes and assumptions
- We made some simplifying assumptions to arrive at the 0.8% (80 basis points, or 80bp) per year cost of full rebalancing. Specifically, this analysis assumes a $100,000 portfolio of 20 stocks with $10 commissions and quarterly rebalancing. We also assumed the 80bp did not change over time, even though commission costs would probably not increase at the same rate as portfolio gains. Correctly accounting for that difference would lead to a lower long-term cost estimate.
- A full rebalancing in the short term would cost $10,000 in taxes, assuming a 40% tax rate on short-term capital gains. That’s $6,250 more than the 15% long-term capital gains rate for the 25%+ marginal tax brackets. We’ll look at how taxes relate to incentive problems in a future post.
- 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. The cost savings of executing three fewer trades did not seem to me to outweigh the increased portfolio risk of reduced diversification.
The article delves into the concept of incentive problems within brokerage services, where brokers may prioritize their gains (through commissions, fees, and trades) over their clients' best interests. As an enthusiast in finance and investment, I'm familiar with the intricacies of brokerage dynamics and the implications for investors.
Incentive Problem #1 discussed in the article focuses on trading and rebalancing within a portfolio. The scenario presented illustrates how a broker might encourage excessive trading (churning) to maximize their commissions, despite it not aligning with the client's best interests.
The piece highlights two strategies for rebalancing a portfolio: the first involves adjusting each individual equity position, resulting in higher transaction costs due to increased trades. The second method suggests rebalancing by asset class, significantly reducing the number of trades required, thus cutting down on costs.
The cost implications of these strategies are detailed, emphasizing the impact of commissions on portfolio returns over time. It breaks down the cost differences between the two methods, showcasing the substantial long-term savings achievable by minimizing the number of trades and associated expenses.
The article also acknowledges assumptions made in the analysis, such as the fixed commission rate, quarterly rebalancing, and tax considerations. It hints at the relevance of taxes in incentive problems but defers their detailed exploration to a future post.
Additionally, it briefly mentions a third approach involving a different strategy of selling specific stock positions to reduce trades but highlights the potential increased risk due to reduced diversification.
Overall, the piece skillfully addresses the conflict of interest between brokers aiming for profits and clients seeking optimized, cost-effective portfolio management. It provokes consideration regarding which rebalancing method a profit-maximizing broker might endorse versus what would be more beneficial for the client, ultimately highlighting the misalignment of incentives between brokers and investors.
