Commission-Free Trades: A Bad Deal for Investors

Four of the biggest online brokers just cut their commissions to $0 per transaction. Be careful, or you could be a big loser.

Young bearded man trader at office sitting at table holding head exhausted top view hard-working
(Image credit: Pandora Studio (Pandora Studio (Photographer) - [None])

Commissions on stocks and exchange-traded funds (ETFs) now come to a big fat zero if you use one of the four biggest online brokerages.

On Oct. 1, Charles Schwab (SCHW) announced commission-free trading on stocks, ETFs and options trades. Online-broker rivals E*Trade (ETFC) and TD Ameritrade (AMTD) followed suit within 24 hours, and Fidelity fell in line within a week.

Online trades were already incredibly cheap: Schwab and Fidelity charged $4.95 for each trade. It was only a little more expensive ($6.95) at E*Trade and TD Ameritrade. Still, money is money. So isn’t a zero-dollar trade a clear win for individual investors?

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I don’t think so.

In fact, I think many investors are going to end up paying through the nose for these “free trades” in a way they didn’t expect.

The Cost of No-Commission Trading

Over the years, I’ve heard from several clients who have had trouble disciplining themselves from trading too frequently. That was in a low-cost world.

Now that trades are no-cost, it’s going to get a lot worse.

It’s difficult enough to match, much less beat, stock indexes without the drag of frequent trading. Frequent traders, from my experience, rarely do well in the stock market.

Terrance Odean – the Rudd Family Foundation Professor and Chair of the Finance Group at the Haas School of Business, University of California, Berkeley – performed several studies earlier this decade using trading data from a discount brokerage.

In one study, he found that trading costs did indeed weigh on the performance of investors who traded more frequently – a problem that no-commission accounts will render obsolete.

But no-commission trades won’t do anything about the results garnered from another study. Odean found that, “on average, the stocks that these investors bought went on to underperform the stocks they sold.”

Speculative trading (trades that didn’t seem driven by, say, tax purposes or rebalancing concerns) was even worse. Across all trades, stocks that investors bought underperformed those they sold by three percentage points – but that disparity widened to five percentage points when considering only speculative trades.

The zero-commission trade is bound to amplify the low-cost proposition of exchange-traded funds, accelerating the huge migration of investor dollars away from actively managed mutual funds. At TD Ameritrade, for instance, it still costs $49.99 to buy or sell some no-load mutual funds. And that doesn’t include the funds’ annual expense ratios. Who’s going to want to buy them when many ETFs’ management expenses are cheaper and are free to enter?

Now, if investors simply stuck to buying broad-based index ETFs and holding them, that actually would be a good thing.

But what’s far more likely is that a big swath of these investors will trade more – and try to pick ETFs and stocks that will beat the market over short time periods. After all, the trade is free – why not make it?

“Free trading doesn’t help investors. It only encourages bad behavior,” says Daniel Wiener, editor of The Independent Adviser for Vanguard Investors newsletter. “As someone who’s been managing client assets for more than 25 years, we talk about ‘time in the market, not market timing’ because long-term investing works.”

I couldn’t agree more.

Pressure Mounts on Brokerages

Then there’s the question of how these brokerages are going to make a buck. That’s not my problem or yours – yet. But it will be if it leads brokerages to increase their profits through hidden charges on investments, which it could well do.

In recent years, bid/ask spreads – the difference in price between what you can buy and a sell a stock for – have narrowed substantially to a penny or two on most trades. What some investors don’t realize is that those spreads represent the compensation that market makers take for facilitating the trades. Those spreads could widen as brokerages seek to fly in new revenue-generating methods under the radar.

Brokerages also make meaningful profits on idle cash in investor accounts. They pay too little on money market funds and they make it cumbersome to move your cash into and out of them. Fidelity, however, plans to automatically sweep idle investor cash into a government money market fund, thus forgoing much of the profit on money markets.

Margin accounts – where traders borrow against their existing holdings to invest more – are another big source of brokerage profits. And brokerages might need to lean on them more, potentially raising rates, to fill this new gap.

Brokerages also squeeze money out of mutual funds. They charge the funds an ongoing fee for offering funds on their platform, including much higher fees for offering them commission-free. Pay close attention to these fees; over time, they can cost you big money. Often, you are better off paying the small upfront commission when buying a fund.

The stocks of all three publicly traded brokerages that cut their commissions to zero cratered after the announcements. TD Ameritrade suffered the most because it’s seen as more dependent on trading income than the others. While their stocks have recovered somewhat since then, there’s no question that their businesses will take a hit. They’ll try to recover what revenues they can.

The trick for individual investors: Instead of trading more, use this sea change in the industry as an opportunity to trade even less.

If you continue to find yourself trading too much, it’s probably time to hire an investment advisor. Having the knowledge to be a good investor doesn’t make you one. The emotional side of investing is every bit as important.

Steve Goldberg is an investment adviser in the Washington, D.C., area.

Steven Goldberg
Contributing Columnist, Kiplinger.com
Steve has been writing for Kiplinger's for more than 25 years. As an associate editor and then senior associate editor, he covered mutual funds for Kiplinger's Personal Finance magazine from 1994-2006. He also authored a book, But Which Mutual Funds? In 2006 he joined with Jerry Tweddell, one of his best sources on investing, to form Tweddell Goldberg Investment Management to manage money for individual investors. Steve continues to write a regular column for Kiplinger.com and enjoys hearing investing questions from readers. You can contact Steve at 301.650.6567 or sgoldberg@kiplinger.com.