There has been a lot in the news recently about major investment brokerage firms eliminating trading fees. In the past, buying and selling stocks could be expensive – as much as $50 in commission fees to trade. Now, most of the major brokerage firms are advertising commission-free online trading for U.S stocks, exchange-traded funds (ETFs), and options. The trend started a few years ago when an investment app started offering free trades. Now brokerages are lowering or eliminating fees to remain competitive.
The benefits of lower trading costs
Trading fees are subtracted directly from your investment portfolio, so every prudent investor should be aware of the trading and fund fees they are paying. Making sure these fees are reasonable, selling high and buying low, and investing for the long-term are key tools for the successful investor. Lower fees are especially appealing in terms of reducing the financial and psychological barriers for the new investor.
The pitfalls of lower trading costs
On the flip side, free trades may not always be good for the investor. Brokerage firms are for-profit businesses, and this may encourage them to recoup lost revenue in less transparent ways.
Spreads: One way is to increase the spreads. This means the difference between the price you see and the price you pay. The spreads compensate Market Makers for maintaining stock market volume and liquidity. This has narrowed to a penny or two a trade in recent years, but they could go in the other direction as brokerages look for new revenue. Most investors are not aware at this level how the market works — so what you don’t know can hurt you.
Cash: Brokerage firms also make money on investor cash accounts. Some pundits are starting to say brokers are more like bankers. Many firms sweep idle investor cash into their own bank. You could likely get better returns elsewhere.
Margin: Margin accounts are another source of brokerage firm revenue. Buying on margin is when an investor borrows money from a broker without selling their investments. Think of it as using your investments as short-term collateral for a loan. The brokerage charges interest on that loan, and they could choose to raise these rates.
Fund Fees: Brokerages charge mutual funds a fee to be on their trading platform. They already charge more for commission-free funds. These rates could go up too.
Free does not mean you should trade
Probably the biggest danger to the elimination of trading fees is bad investor behavior. Just because trading is free does not mean you should trade more often. A big benefit to investing is the compounding of interest over time. Selling low during a market downturn or buying high when stocks are at a peak could prevent you from achieving long-term investment goals. A study of speculative trading by the Haas School of Business (trades not driven by income needs, rebalancing, or tax concerns) has shown that investors who traded frequently bought stocks that consistently underperformed what they sold.
Don’t forget taxes
When you think about selling investments, you need to consider tax implications. If you make money (capital gain) on a sale from a taxable account, you may pay a capital gains tax. Frequent trading will cause these gains to be short-term and likely taxed at a higher rate. This may make sense if you are trading for the right reasons. However, you should consider all of the ramifications before making a move despite how enticing free trading appears to be.
While access to the stock market has never been easier or cheaper, you still need to make sure any stock trading is in line with your overall investment goals. Creating a long-term investment plan provides the guidelines for making trading decisions. You may want to work with a financial planner to create the best approach for you.