Become an Investor (Part 9): Trade Life Cycle, Placing Orders and Rebalacing

Once you defined your investment strategy, you’re almost ready to go on your own. You may have learned more on the side or even entertained the idea of placing an order to test the grounds. Before letting you go, I’d like to explain how to actually make the buy orders and also what happens when you do. Also, we will cover how to maintain both your portfolio and your asset allocation when it’s likely to change.

Trade Life Cycle

The trade life cycle is what happens when you place an order and buy (or sell) shares. This is not something that you’re required to know in order to start investing, so I’ll keep it short and simple, just so you can get a general idea of what is actually going on in the background.

The place (or marketplace) where people can buy and sell shares (or other financial instruments) is called an exchange. The main responsibilities of the exchanges are to enable trading – to match the buy and sell orders, and to provide sufficient information about the securities traded on it.

But not everyone can simply go in an exchange and start making trades. As an investor, you need an intermediary in order to make trades on an exchange. This middleman is a brokerage, with the main purpose to connect buyers and sellers and facilitate transactions. As an investor, your only point of contact is your broker (or online broker account), which is responsible to supply the buyers’ and sellers’ orders to an exchange. The brokerages have to comply with strict requirements (for capital, qualifications, etc.) and are continuously monitored by the exchanges. After the orders are passed to an exchange, it will then match your buy order with an adequate sell order and we continue to the next phase of the trade life cycle.

The clearing phase comes after the trading phase and it starts after two parties are matched. The main role in this phase is the one of the clearinghouse – an independent entity that acts as a counterparty to all trades of the exchange. Namely, it identifies which securities (and which quantity) are owed to the buyer and which payment is owed to the seller.

Based on the data from the exchanges, the funds from the buyers, and the securities from the sellers, the clearinghouse makes two contracts: one with the buyer and one with the seller. It is responsible for the delivery of the securities and payments, so it acts as the central trusted entity that ensures that the buyer sent the payment and that the seller delivered the securities.

Lastly, after the trade is cleared, there is the settlement phase. This is the actual exchange where everyone receives what they are owed. This is called fulfilling the obligations and the transaction is settled.

Please don’t forget that this is a really high-level overview and there are plenty of details we didn’t cover. The main takeaway is that this whole life cycle is set in place so people like us can trust the process and buy assets without knowing who the seller is and not be concerned about whether the assets will be delivered.

Although the details are not required for maintaining a passive portfolio, you have all the keywords you need if you want to explore the clearing process in more depth. Until then, you just need to login to your investing account and place the orders of your choice. The whole process will make sure that you receive what you paid for.

Placing Orders

Although we, the investors, are not exposed to the actual clearing and settlement processes, we still need to do the heavy lifting up-front. This include researching your ideal allocation, deciding which strategy to use, compare the fees of various funds, etc. Then you just click a button and see the shares in your account.

In order to do that though, you need to find either a fund or a broker where you will place your orders. The factors that help you decide which broker to use are similar to those used to pick the right funds. It boils down to minimizing expenses. Since the reader base of MonkWealth is not localized, I couldn’t recommend a single solution that will work for everyone and everywhere. But nowadays, a simple search can answer that question and if you end up with multiple candidates available in your country, proceed to compare the benefits of using one over the others (such as availability of products, more adequate fee structure & minimum investment amounts, etc.).

If you choose a broker, you might want to learn about the different types of buy orders you can place:

• A Market Order is an order to be executed immediately at the current best available market price.
• A Limit Order is an order to be executed at a price lower or equal than the one specified by the investor.
• A Stop Order is an order to trigger a market order at a price higher than the one specified by the investor.

This is by no means a complete list, but just the simplest of the buy-order types. You can read more about various types of orders and their analogous sell order counterparts here. For the purposes of a long-term passive portfolio, market and limit orders are all you need.

And most probably the broker you’ll use will also ask you about your order’s time-in-force. It represents a time period in which the order will remain active (i.e. can be executed) after which the order expires. Again, three examples:

• Good-for-day (GFD, or sometimes a Day Order) is an order valid throughout the current day’s trading hours.
• Good-til-cancelled (GTC) is an order that theoretically will remain active indefinitely.
• Immediate-or-cancel (IOC) is an order that is immediately executed or cancelled.

And similar to what we said about the order types – this is not a full list and for the purposes of passive investing and maintaining a lazy portfolio, a day order is all you need.

Basically, long-term investing helps us to keep it simple and put our focus in things that are more meaningful to us. Except for that one day per year…

Rebalancing

Before explaining the what, let’s consider the why.

For simplicity, let’s say that you decided to use a stock allocation of 80/20 between developed and emerging markets. In dollar amounts, let’s say that you put 8000$ and 2000$ respectively. Perfect.

A year passes by and you get a negative 5% return on the developed world, but a 40% return from your EM allocation. Pardon the unrealistic numbers, it’s all in the name of simplicity. I’ll assume that the dividends are reinvested for the same reason. Now, you can just congratulate yourself and go on with your life, but you’re exposed to a higher risk than when you first started. The reason is because your allocation shifted.

Actually, your developed world allocation is now at 7600$ and your EM allocation is at 2800$. In other words, your developed/emerging markets allocation is now at 73%/27%. And don’t forget that the asset allocation is the most important factor on how your investment experience will be.

So, what you should do now is rebalance. You need to shift the wealth distribution back to your original amounts in order to remain consistent with your investment strategy. You do this by selling some of the winners and/or buying some of the losers. In this example, you’ll need to either buy more developed world ETFs, sell EM ETFs, or sell some EM ETFs in order to buy developed world ETFs.

In my opinion, it’s best to just buy more of what’s lagging with your next deposit(s) instead of combining multiple trades. Whichever way you choose to do it, the goal is to achieve the original proportion (80/20 in the example).

And how often should you do this? For a lazy portfolio, once per year or semi-annually is more than enough. And it doesn’t necessarily have to be towards the end of the year. Just pick a day and do your rebalancing on the same date every year – maybe the day of your first order. This is the most effort you will put into maintaining your portfolio… Unless you are diversified enough using a single ETF portfolio, in which case you don’t have to do anything.

So, enjoy your newly acquired knowledge and see you in Part 10.

 

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