The cost of trading may be higher than its ever been even though trading is free. In a bygone era, the cost of trading was mostly apparent. A commission was charged on every transaction.
Commissions acted like a speed bump or a governor on a car’s engine. It was tangible. It was obvious. It forced investors to slow down, realize a cost was involved, that had to be overcome to make a profit. It also didn’t take a genius to know how the broker made money.
Today that speed bump is gone.
There’s a second cost of trading that’s less obvious and easily overlooked. It’s self-imposed. It’s driven by human nature. It comes in the form of errors and mistakes. And, put simply, that behavior can be manipulated and extremely costly.
Warren Buffett once warned about the role brokers played in the markets (in relation to derivative securities), which seems especially relevant today.
The propensity to gamble is always increased by a large prize versus a small entry fee, no matter how poor the true odds may be. That’s why Las Vegas casinos advertise big jackpots and why state lotteries headline big prizes. In securities, the unintelligent are seduced by the same approach in various ways…
Brokers, of course, favor new trading vehicles. Their enthusiasm tends to be in direct proportion to the amount of activity they expect. And the more the activity, the greater the cost to the public. and the greater the amount of money that will be left behind by them to be spread among the brokerage industry… Since the casino gets paid a roll each time one of these transactions takes place, you can be sure that it will have a great interest in providing very large numbers of losers and winners…
You will have people wagering as to the short-term movements of the stock market and able to make fairly large wagers with fairly small sums. They will be encouraged to do so by brokers who will see rapid turnover of customers’ capital — the best thing that can happen to a broker in terms of his immediate income. A great deal of money will be left behind…as the casino takes its bite from each transaction…
Even though people participating in such gambling activity are not investors…they still feel that they have had a bad experience with the stock market. And after having been exposed to the worst face of capital markets, they understandably may, in the future, take a dim view of capital markets generally…
You might ask if the brokerage industry is not wise enough to look after its own long-term interests. History shows them to be myopic (witness the late 1960s); they often have been happiest when behavior was at its silliest. And many brokers are far more concerned with how much they gross this month than whether their clients — or, for that matter, the security industry — prosper in the long run.
What Buffett describes is nothing new. There will always be people that treat the market as a casino and brokers will continue to serve their best interests.
But commission-free trades removed an obstacle created by brokers themselves that limited their profitability. It also eliminated the last obstacle that deterred the urge to treat the stock market like a casino. There’s a non-zero chance that the casino mindset becomes more frequent and widespread compared to the past.
To defend yourself, here are a few suggestions.The cost of trading may be higher than its ever been even though trading is free.
First, barring the brokers bringing commissions back, set some ground rules for making trades. The urge to trade can be powerful when the market gets craziest. So any rule that forces you to stop, take a breath, and think through a decision is good for your portfolio in the long run.
Second, you have to understand how the brokers make money. If the broker is not charging you per trade, it’s getting paid another way. Things like payment for order flow and interest on margin loans become a broker’s primary source of revenue. When products become free, you cease being the customer and become the product.
There’s a thing in website/app design called user optimization. The site/app is built around the user experience to optimize conversion rates, engagement, and retention. The goal is to keep you on the site/app as long as possible and make whatever they want you to accomplish as easy as possible (Facebook has this mastered). The tactics used are pulled from psychology. The same tactics are used today by brokers to optimize for trading activity.
So it should not be a surprise if brokers persuade you to open margin accounts and/or trade more. Or they try to nudge you towards more complex investments like options with the enticement of bigger gains. Be aware of it. Anything that might influence your behavior in an effort to boost trading activity is good for the broker.
Third, realize that the game the brokers want you to play is optional. The brokers want to create as much trading volume as possible, so they can sell it, and profit. Nowhere in the small print when you signed up for an account did it say you must go along with their plans. You have a choice. You can use brokers just like you can use Mr. Market or you can fall prey to their whims.
Finally, it’s important to note that activity is not the way to wealth. The research is overwhelming. Increased activity in the stock market produces the same results as it does in a casino. It leads to a shorter time horizon, increased attempts to trade in and out of the market, and losses.
Instead, the opposite view is what pays off. More activity, more trading, leads to worse returns. Inactivity is the way to wealth.
Warren Buffett Letter to John Dingell
- Bored, Lonely, and Confused: Why It’s OK to Feel Lousy While Investing – J. Ptak
- The GameStop Story You Think You Know Is Wrong – D. Thompson
- The Price-Value Feedback Loop: A Look at GME and AMC! – Musings on Markets
- The Long History of Hating Short Sellers – J. Zweig
- Unfortunate Investing Traits – M. Housel
- The Biggest Risk Is Rising Interest Rates – H. Marks
- Myth-Busting: Low Rates Don’t Justify High Valuations – Factor Research
- The Lindy Effect – C. Mayer
- The Invention of the Ski Chairlift – Smithsonian