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”.
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.
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.
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.