Financial Investments: When Free Isn't Free
April 22, 2021 Author: Tess Downing, MBA, CFP®, Complete View Financial
An unexpected consequence of the pandemic has been to alter the face of the brokerage business.
After companies sent people home to work, many had more spare time to get involved in self-directed investing. In parallel, a good deal of portfolio shifting resulted from the markets' volatility. In fact, in the second quarter of 2020, one firm reported clients making an average of 3.4 million trades per day, which was four times the volume of the same period in 2019. [Source]
This activity coincided with the industry consolidating its move to zero commissions – or 'free trades' – as online brokerages vied for existing and new clients. As if 'free' wasn't enough, they sweetened the deal with several attractive incentives. Here are a few that have been marketed:
- Sign-up bonuses – You can have transfer fees reimbursed, bonuses paid for referring a friend, a free share of stock or cash for a new account with a significant balance.
- Cutting-edge platforms – If you want to invest on the go, mobile apps can access research, trade stocks, pay bills and move money. Others interact through Alexa or messages via Twitter, Facebook or iPhones.
- Credit card rewards and free ATMs – cash-back earnings can be deposited in your brokerage account, and ATM or foreign transaction fees can be waived.
- Free mutual funds – You can access some (in-house) mutual funds with no minimum investment and 0% expense ratios.
- Partial-share trades – You can buy 'parts' of high-priced shares that are beyond your budget.
Today virtually all brokerage firms offer free trades of stocks and exchange-traded funds (ETFs). They also provide research and tools to help you make educated financial decisions.
But, as we discovered about social media platforms like Facebook and Google, 'free' isn't free. Brokerage houses are businesses, and they have to make money somewhere.
Full-service brokers are still available, in which case the commission may run $40 or $50 a trade. The online brokerage aspect of companies has to find ways to make money using the electronic marketplace.
The Price of Zero-Cost Trades
When companies charged $50 a trade in the 1990s, it seemed clear how they made their money. But it was not clear that some of them earned – and continue to earn – a sizeable portion of their revenues by acting as a bank. They earn a net interest margin by paying you an interest rate on idle cash deposits lower than what the company might make lending or investing that cash. That helps explain why bonuses are paid for significant deposits: they hope part of the cash will remain idle.
While trades of stocks and ETFs might be free, others are not. Margin trading, for example, costs you an interest fee on that margin. Bond trading typically involves fees. A brokerage house can also be paid depending on how it decides to execute your order, and that payment has to come from somewhere. Indirectly, it could come from you. And the more you trade, the more they make.
Some firms might propose investments in mutual funds that belong to the brokerage firm itself. So, while no brokerage-associated charges appear for buying shares in the funds (that is, it's commission-free), management fees are deducted from the fund's return to you. Companies will always find a way to be paid for managing funds.
None of this activity is illegal. As a self-directed investor, you choose your investments. And, if you choose to churn your account by trading frequently, the cost will be yours to bear. (Another cost of frequent trading – specifically when not holding a stock for 12 months – would be the short-term capital gains taxes owed.)
The Psychology Behind Free Trades
'Free' is powerful when it comes to decision-making. It's the easiest decision to make, and – by nature – we tend to look for ease. Deciding between two free options could be more difficult, though. That explains why brokerage firms sweeten your decision with added benefits: they're differentiating their free service.
If you have to pay anything at all, no matter how small the sum, your brain has to start making comparisons of one cost against another, and a more complex analysis takes place.
The goal of the 'free trade' firms is to avoid that analysis. If trades are perceived to have no cost, you have no incentive to limit the number of trades made. Since online brokerage is a volume business (both in terms of customers and the number of trades per customer), the more trades you make, the more the brokerage firm makes.
The Cost of Not Paying a Financial Advisor
There are some other subtle downsides to not working with a financial advisor who you compensate directly and who knows you personally:
- Education – Do you have the time, or choose to spend the time, to reach and maintain a level of knowledge needed to invest carefully?
- Lack of knowledge – Do you have a way to 'know what you don't know?'
- Mistakes – While you may learn from your mistakes, can you afford the cost of those mistakes if they are serious?
- Unintended consequences – Are you aware of how different aspects of your financial planning are interrelated, and can you factor the possible related consequences into your investment decisions?
- Temperament – Is your temperament one that deals well with emergencies or disasters, so you are prepared to handle urgent action (or non-action) to protect your investment portfolio?
We looked earlier at some of the costs of being self-directed in your investment decisions, especially the risks that come with free trades. Those can include poor diversification, bad tax choices, high-cost products and churning your own account.
One step up from that might be using technology to work with robo-advisors or subscription-model investing services, where algorithms and occasional human tweaks by strangers determine your investment allocation. They do have one advantage: convenience. You operate from your computer or phone, and you never have to leave your home. All you need to do is pay the bill each month for the service if there is one.
But you won't have a person in your corner when you need one. When you are investing to achieve your life goals – whether you plan to retire or not – it's not a time to do it alone.
The Value of Paying a Financial Advisor
Not all financial advisors charge fees. Those who do not are typically compensated by financial companies through commissions. That raises concerns about conflicts of interest: are the investments being proposed the best for you or the best for them, thanks to the commissions generated?
But, when you work with an advisor with fiduciary responsibility, you will be supported by a professional transparent about costs and working in your best interest. That person will focus on the long-term view, asset allocations, tax implications in retirement and, most importantly, understanding who you are so that the investment strategies can be personalized, targeting your unique needs and wants.
Part of that strategy may be to set aside some discretionary funds for you to invest on your own. If successful, you will add to your available funds at retirement. But if not, your plans will not be materially impacted.
For the record, advisor fees are usually lower than most people expect. So, when you realize that you have more to gain than what the advisor will charge you, it will be the right time to ask for advice.
You'll be better off if the advice isn't free.
As financial planners, Complete View Financial believes everyone benefits when issues have been thought through and when plans are put in place to ensure that wishes are fulfilled. If you think we could help you with that process, do call us for an initial consultation.