Tuesday, September 29, 2020

Rebalancing When There are No Trading Fees

Index investors usually choose some target allocation percentages for the different asset classes of stocks and bonds in their portfolios.  As markets move, these percentages can wander, so investors need to make trades to get back to their target percentages, a process called rebalancing.  Long-time reader JC asked how rebalancing changes when there are no trading fees.

Younger people with smaller portfolios typically rebalance only when they add new money to their portfolios.  This can be as simple as buying more of whichever asset class is furthest below its target percentage.  Those with larger portfolios can’t always keep balanced with new money; sometimes they have to sell an ETF that’s been rising to buy another that’s fallen behind.  One way to do this is to rebalance based on the calendar, perhaps once per year.  With this approach, having no trading fees makes little difference in how investors rebalance.

More ambitious investors may try “threshold rebalancing,” which means rebalancing whenever asset classes get too far from their target percentages.  This is best done in some automated way, such as with a spreadsheet.  Doing a bunch of calculations by hand every day to see if rebalancing is necessary isn’t my idea of a fun way to live.  In fact, I’ve set up my spreadsheet to email me if I need to rebalance, so I don’t even have to look at the spreadsheet.

Earlier this year, I wrote a post and an associated paper describing a set of rules for choosing rebalancing thresholds.  It’s somewhat complicated, but once coded into a spreadsheet, the complexity is hidden.  However, this work assumes investors pay trading commissions.  What happens when there are no trading commissions?

The first thing to understand is that commissions aren’t the only trading costs.  Traders also have the implicit cost of the bid-ask spread.  If there is a 2-cent difference between the bid price and ask price on a stock or ETF, then, on average, trading costs 1 cent per share.  For large trades, spreads effectively become wider due to the market impact of these big transactions.  The definition of a “large trade” depends on the liquidity of the ETFs you own.

For investors with sub-million-dollar portfolios who stick to popular broad-market ETFs, spread costs can be quite low.  So, if you plug in zero for the commission cost in my formulas, rebalancing thresholds will be narrow, leading to lots of rebalancing trading.

To decide whether this is a good idea, imagine that your spreadsheet tells you to rebalance three times a day.  Right away it’s clear that your time has value.  You might find rebalancing exciting for a little while, but it would feel like a job quickly.  It’s clear that you need to place some value on your time.  Once you get good at rebalancing, perhaps $5 or $10 per trade makes sense.

Another concern with frequent trading is uncertainty in the prices you’re getting.  Markets today are very efficient, but with some markets selling trade data to high-frequency traders or selling the right to make the market for the trade, it’s hard for individual investors to know if they’re getting good prices down to the penny.  If you trade infrequently, this isn’t much of a concern, but these imperceptibly small losses to market sharks add up if you trade too often.  For this reason it makes sense to be conservative in choosing a value for the typical spread on your favourite ETFs to plug into my formulas.

When I did my original rebalancing analysis, I included a factor f, which we might as well call a fudge factor.  I decided that I didn’t want to rebalance unless the expected profit from rebalancing was at least 20 times the trading costs (commissions plus spreads).  In part this is to make sure that I get to keep most of the profits instead of losing them all to costs.  But other reasons to make this factor as high as 20 are to place some value on your time, and to handle some uncertainty in the trading prices you’re getting.

So, in my formulas, you could replace the commission c with c+v, where v is the value of your time for each of the required trades.  You could also choose spread values on the high side for safety.  Then you could reduce the profit factor f to, say, 10.  This wouldn’t make much difference in the original case I envisioned where trading commissions are about $10, but these changes give better threshold levels when commissions are zero.

Something else to keep in mind is that your thresholds are most likely to get triggered in volatile markets, such as the ones we had earlier this year.  During this volatility markets remained orderly, so I went ahead and rebalanced a few times.  But if bid-ask spreads ever get very large, it’s a sign that markets aren’t orderly, and you should be cautious about trading for any reason.

It might seem like a lot of work to understand and implement threshold rebalancing, but it has a positive side effect for me beyond capturing profits during market volatility.  I mechanically follow my spreadsheet’s orders when it tells me to rebalance.  This means buying stocks after they’ve crashed or selling stocks after they’ve been on a tear.  Many investors can’t bring themselves to rebalance at these times, but my spreadsheet’s daily reminders to rebalance are hard to ignore.

Thursday, September 24, 2020

Short Takes: Foreign Withholding Taxes, Financial Happiness, and more

I wrote one post in the past two weeks:

Fortress Fiasco

Here are some short takes and some weekend reading:

Justin Bender brings us his ultimate guide to foreign withholding taxes on ETFs.  Unlike other so-called “ultimate guides” I’ve seen from other financial writers, this one really is comprehensive and useful.

Morgan Housel says being happy financially requires managing your expectations as much as making more money.

Alexandra Macqueen explains what goes into calculating official inflation figures and the controversies surrounding what is and is not included.

Jason Heath
is a Certified Financial Planner who refers to his practice as “advice-only” to try to distinguish his services from those paid by commissions or percentage of assets.

The Blunt Bean Counter explains how large gifts to grandchildren can have some unpleasant tax implications if you’re not careful.

Fortress Fiasco

A great many investors have lost money on Fortress syndicated mortgages.  The fact that investors sometimes lose money isn’t news.  But I have a more personal story concerning how these syndicated mortgages were sold.

According to Neil Gross, “thousands of Fortress investors were badly stung or wiped out entirely – losing perhaps hundreds of millions of dollars in total,” but the Financial Services Regulatory Authority (FSRA) “announced that everything’s been settled by Fortress agreeing to pay an administrative penalty of $250,000 – an astonishingly low amount in comparison to the estimated $320-million that Fortress pocketed in fees and paid its agents.”

At question is whether Fortress misled investors.  Gross says “FSRA hasn’t provided a rationale for the low penalty, or an explanation about why Fortress was given such a settlement deal without first compensating its investors.”

My small contribution to this story started with a friend (let’s call him Jake) asking for advice.  Jake told me his friend and financial advisor wanted him to invest in some mortgages.  Jake showed me the sales materials promising a 12% annual return on investment.  The advisor was pushing it hard, and Jake knew little about investing.

I explained that the high guaranteed return was suspicious.  Why couldn’t Fortress get financing from more sophisticated lenders?  If these lenders passed, Jake probably should too.  The risk was a possible default on Jake’s entire investment.  Jake remained on the fence until I mentioned commissions.

Jake was surprised when I told him the advisor was likely getting a fat commission for selling these mortgages.  He wasn’t swayed by much else, but said “you had me at ‘commission.’”  Apparently, this is what got Jake to see this advisor as a salesperson rather than a friend.

So, if Jake’s case is at all representative of Fortress’ investors, they weren’t savvy.  They were regular people pushed hard by commissioned salespeople to buy a product.  Like Gross, I’d like to know more about FSRA’s decision to give Fortress a slap on the wrist.

Friday, September 11, 2020

Short Takes: Mortgage Deferrals, Financial Optimism, and more

I wrote one post in the past two weeks in the form of a quiz:

A Quiz on the 4% Rule

Here are some short takes and some weekend reading:

Rate Spy has some statistics about Canadian mortgage deferrers who are soon to have to start making payments again.  How much this will affect the housing market is anyone’s guess.

Morgan Housel explains why we should save like pessimists and invest like optimists.  I would add that we should avoid debt like pessimists as well.

Robb Engen at Boomer and Echo asks whether he has already achieved FIRE (Financial Independence Retire Early).  FIRE gets used to mean so many different things that it’s hard to say.  To me, financial independence means not needing income from work ever again.  So, Robb doesn’t pass this test.  I define retirement as being free from demands on my time that I can’t ignore because I need the money.  Robb doesn’t pass this test either.  However, to many people FIRE means quitting the job they don’t like to work at something they much prefer.  Robb does pass this test.

Thursday, September 3, 2020

A Quiz on the 4% Rule

Reporters and bloggers write endlessly about William Bengen’s 4% rule for retirement spending, but its details are widely misunderstood.  So, I’ve created a short quiz to test your knowledge of this rule.  I give answers below, but this isn’t multiple choice, so you’ll have to decide for yourself how closely your answers match reality.

  1. Jane retired a year ago with $500,000 saved.  She is using the 4% rule, so she initially withdrew $20,000 to spend during her first year of retirement.  Today it’s time for her next withdrawal, and her portfolio has grown from $480,000 to $505,000.  Inflation was 2%, and she’s now 66 years old.  To follow the 4% rule, how much should she withdraw today?

  2. Jane pays a hefty 2.5% MER on her mutual funds.  If she reduces her costs to only 0.5% per year, how does that change her withdrawals under the 4% rule?

  3. Tom saved aggressively during his working years and retired at 45.  How does the 4% rule apply in his case?

  4. Jim is a very conservative investor.  He invests only in GICs and bonds.  Does the 4% rule apply in his case?

  5. We can’t count on getting the same returns that U.S. investors got during the period of Bengen’s study.  How does this affect the 4% rule?

  6. Is there anything we can do to increase our safe portfolio spending level, other than shortening our retirements?

Answers below:


  1. To follow the 4% rule, Jane should withdraw $20,400, which is her original $20,000 increased by 2% inflation; the rest of the figures in the question are irrelevant.  If you answered $20,200 (4% of the new portfolio value), you’re not alone; this is a common misconception.  The 4% rule ignores portfolio performance after retiring.  The percentage of your portfolio you spend each year after the first year will depend on how much it has grown or shrunk.  You just keep spending the same inflation-adjusted amount each year and hope your money doesn’t run out.  If instead you spend 4% of your updated portfolio value each year, you’re guaranteed to leave a sizable inheritance, and your odds of having your inflation-adjusted spending decline alarmingly over the years is quite high.  If you answered $20,000 because you thought spending stayed constant over the years, you’re close.  The idea is that spending after adjusting for inflation stays constant.  This inflexible approach is how then originator of the 4% rule, William Bengen, calculated his safe initial spending percentage, but he was clear that a real retiree may choose to increase or decrease spending in the face of a portfolio that is declining severely or growing wildly.

  2. William Bengen’s original study took no account of portfolio costs.  He used historical U.S. stock market returns to establish his 4% rule.  So, to follow the 4% rule strictly, Jane’s withdrawals wouldn’t change.  It’s tempting to say that because Jane is saving 2% each year, she can bump up her withdrawals to 6% of her original portfolio size (rising with inflation).  However, there are two problems with this.  The first problem is that as Jane’s portfolio shrinks (in a scenario where returns are weak), the 2% MER savings on a smaller portfolio don’t fully offset 2% higher withdrawals calculated on the starting portfolio value.  On average, saving 2% on costs makes safe withdrawals only about 1% higher.  The second problem is that Jane’s high-cost portfolio couldn’t really handle spending at 4% of the starting portfolio size.  In reality, repeating Bengen’s study to account for costs would have Jane using a little less than a 3% rule.  So, by reducing her costs, she is improving the chances that she won’t run out of money with the 4% rule, but she probably shouldn’t increase her planned withdrawals.

  3. The part of Bengen’s study that produced the 4% rule assumed 30-year retirements.  This would take Tom only to age 75.  So, the original 4% rule doesn’t apply well in his case.  He expects to have a long retirement, and has to reduce the spending amount from his portfolio somewhat to compensate.  Bengen was clear that the expected duration of retirement needs to be taken into account when choosing a starting withdrawal percentage.

  4. Bengen’s 4% rule came from portfolios 50-75% in U.S. stocks, and the rest in bonds.  This doesn’t apply to Jim’s case.  Suppose Jim expects the returns on his GICs and bonds to match inflation.  Then he can just divide the length of his retirement into 100%.  For example, to cover 40 years of retirement, Jim can spend 2.5% per year rising with inflation.

  5. The 4% rule is based on the worst-case starting year of retirement.  In U.S. data, the worst periods include the aftermath of the 1929 stock market crash and the poor inflation-adjusted stock returns from the late 1960s to the early 1980s.  So, the important question is how likely your returns are to be worse than these periods.  The eye-popping U.S. returns in other time periods isn’t relevant.  So, the fact that experts believe future returns won’t match historical U.S. returns isn’t a positive thing for your retirement, but it’s not as bad as it seems for the 4% rule.  Adjusting down to a 3.5% rule may be sufficiently safe.  Having to reduce the withdrawal percentage further by about half of portfolio costs is a bigger concern for many Canadians.

  6. Yes.  We can be more flexible with changes to the amount we spend each year.  This means being prepared to spend less if returns disappoint.  Bengen’s study assumed no flexibility at all.  At the other extreme of very high spending flexibility, we could use something like the table of RRIF withdrawal percentages that tell you how much of your current portfolio to withdraw each year.  These percentages are probably about right for someone paying about 1% each year in portfolio fees.  However, this plan could have your inflation-adjusted spending level change drastically over the course of a few years.  Not all of us can be this flexible.  There are intermediate levels of flexibility with plans that set spending floors and ceilings.  However, the less flexible your spending plan, the lower your starting spending level needs to be.