Your broker’s primary goal is to make money.

I’m going to start with a bold statement.  Even if we gave our best tools away and let brokers offer them to their clients, most of them wouldn’t want to.  A big part of giving you complete control of your investments is helping you understand exactly how your broker makes money from managing your assets.  But your broker probably has good reasons for not wanting to make that too easy.

Your broker has what economists call “incentive problems.”  Brokers want to serve their own best interests (i.e., making money).  Brokers make money from a number of activities, notably trading commissions, asset management fees, and lending your liquid assets to others at a price higher than they pay you (like banks do with your deposits).  You make more money when your assets increase in value or pay dividends or interest or your commissions, fees and taxes are lower.  The incentive problem appears because these goals are not completely aligned: what makes your broker rich does not necessarily make you rich.

One of the reasons we’re so excited about Blueleaf is that we can avoid these incentive problems: we don’t make money the way your broker does.  That means that we don’t have any reason to encourage you to trade frequently or to tout one fund over another.  In short, we’re happy to tell you things your broker wouldn’t.

Over the coming few weeks, I’ll be writing about these incentive problems by highlighting areas where your broker’s interests and yours don’t match.  I’ll explain why having an objective third party like Blueleaf helping you is necessary to avoid bias that comes from misaligned incentives.  Today’s incentive problem is that a broker has a strong incentive to encourage you to trade more.

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 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 allocation than 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.

Christopher Thorpe
Co-Founder and CTO

Notes and assumptions

1. I made some simplifying assumptions to arrive at the 0.8% (80 basis points, or 80bp) per year cost of full rebalancing.  Specifically, I assumed a $100,000 portfolio of 20 stocks with $10 commissions and quarterly rebalancing.  I 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.
2. 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.
3. A third approach I considered but omitted for reasons of space 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.