You have undoubtedly seen the ads and commercials reflecting how the costs of buying stocks has declined rapidly over the past decade. From $10 commissions (paid every time you purchased a stock) to $5 commissions to $0 commissions to stock slices and fractal shares (“buy a tiny portion of Amazon for $1!”), it has become far easier, and far less expensive, to trade individual stocks in a “free” online brokerage account.

But is free actually free? And is free actually better? Is a do-it-yourself (DIY), low-cost world of individual traders a better one? Such questions are impossible to answer unless we first examine the potential pitfalls and dangers that can arise from this new world of “free” investing.

Free isn’t actually free, just invisible

When an individual puts in an online order for a stock, the broker fulfilling that order has costs—and this isn’t necessarily a bad thing! The broker fulfills an important purpose, matching buyers and sellers, and that has a cost.

The existence of $0 trading commissions, however, does not mean that this cost has somehow suddenly disappeared, or that brokers have magnanimously decided to give away all their profit to their customers. It simply means that the trading costs are either being captured from other customers (margin accounts, etc.), in other ways (securities lending), or are embedded in that other feature of buying stocks: the bid-ask spread.

The bid-ask spread can be explained in a simple way. Say the price of ABC stock is $10 per share. When you go to purchase ABC stock in the market, however, you will not be able to buy ABC at $10. The ask price (what the seller quotes) may be a tick higher, perhaps $10.05. If you turn around and go to sell ABC stock, the bid price (what the buyer offers you) will be a tick lower, perhaps $9.95.

This gap between $9.95 and $10.05 is the bid-ask spread, and it captures many costs. As a Quartz article from 2019 details, many brokers are now paid for order flow, meaning brokers are paid by large trading firms to send your orders for stock (either to buy or sell) to send your orders their way, presumably so they can fulfill their own trading desires without going to the exchanges (think the New York Stock Exchange), which is cheaper for them. But the broker is not required to share the payment they receive from the trading firm with the customers.

As the article at Quartz states, this does not mean you are getting a bad trade or price! There are many benefits to order flow and trading firms. But it does mean that the full cost of trading is no longer easily calculable. You can’t just compare the commissions of two brokers and figure out which one is giving you better terms, because both are at $0. It’s hard to be fishing through bid-ask spreads of numerous stocks to compare “best execution” among brokers. And, of course, if we’re talking fractal shares or a $1 slice of a $2600 Amazon stock, it’s even harder to find the bid-ask spread or the full-share price in the first place.

This lack of transparency means there is little way to tell if customers are being charged a higher price or wider bid-ask spread when making these transactions than they should be offered. As former SEC Mary Jo White stated while giving a speech in 2014, “When fees and payments are not passed through from brokers to customers, they can create conflicts of interest and raise serious questions about whether such conflicts can be effectively managed.”

Then there is the temptation…

Extremely low-cost trading for individual stocks also opens up another pitfall: the temptation to trade more frequently. It is human nature that when something appears to us to cost less, we do it more. Consider a restaurant where every order of steak and French fries costs another $20. Now consider a buffet where you pay $25 to enter and everything inside is “free.” In which restaurant are you more likely to eat more steak and French fries?

The same can apply to trading. It is well known that long-term investing is about buying and holding. Trading frequently, trading multiple times in one day, trying to “time the market” or pick between winners and losers can often be dangerous strategies.

If it costs $15 to trade a stock, an individual will think twice before trading it twice in one week. But what if the cost appears to be $0?

If the price of one share of Amazon stock is $2600, an individual is going to really think hard before adding that stock to their portfolio, especially if their portfolio is small and they want to be diversified and not have all their eggs in one basket. But what if the “price” of owning Amazon appears to be only $10?

How is it that we see so many studies about a “coin flip” outperforming investors in the stock market? Are people really less intelligent than a lifeless nickel? Of course not—but people make what we often call behavioral errors.

Individuals are tempted to “chase returns,” meaning they look to see which fund or manager did best last year and then put their money there. Then that fund does poorly so they look to see who did better this year and put their money there, and so on. They keep investing in a stock or fund after it has had its day.

As individuals, we are also often tempted to make other mistakes, like selling stocks that are performing well too early instead of holding onto them for the long-term, or failing to sell stocks that are underperforming because it is so difficult to admit that we have made a mistake.

Individuals often have difficulty not panicking during tough times, especially if investing and economics are not fields that come naturally to them. The same goes for any profession: an economist may be able to do a fine job running a physics lab when everyone around him is doing their jobs, but if something goes wrong and everyone runs to him for advice, then a lot can go wrong! The 2008-2009 recession was rife with stories of people who sold everything at the bottom of the stock market crash and then missed out on the recovery from 2010-present. 

Managing the risk of a portfolio is a difficult task. It takes discipline to invest in a diversified portfolio of stocks and bonds and to embrace a long-term strategy. Extremely low-cost trading introduces the temptation to overtrade and to fail to diversify.

As a CNBC article on fractional investing points out, while there may be benefits to these low-cost ways to buy individual stocks, they cannot and should not be the core of your retirement portfolio. Long-term, diversified investing remains key, and this is done not by putting your first $100 into one fractal share of a stock, but by saving in well-diversified funds and ETFs that invest across a wide variety of stocks, bonds, and other asset classes.

Furthermore, as with any serious life decision, it helps to have a voice of expertise to help us stay calm and not panic when the storm comes. The DIY, cheapest-cost approach leaves no room for that kind of advice.

Does this mean you might pay that visible $5 commission? It certainly does. But in the end, that $5 might be a small price to pay to avoid the pitfalls of the DIY investing world.

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Alex Urpi, CFA

Sources:
https://www.mauldineconomics.com/the-10th-man/american-chop-suey#
https://www.mauldineconomics.com/the-10th-man/not-enough-dots-on-your-dice
https://qz.com/1719659/charles-schwabs-zero-fee-commissions-still-have-costs/
https://www.cnbc.com/2014/06/05/sec-chair-wants-to-see-changes-in-trading.html
https://www.cnbc.com/2020/05/07/schwab-to-offer-fractal-trades-of-sp-500-companies-like-amazon-apple.html