Will No-Cost Trading Improve Your Investment Returns?

Will No-Cost Trading Improve Your Investment Returns?

Earlier this week Charles Schwab & Co. announced that they would eliminate online transaction fees for ETFs, stocks, and options. Two days later TD Ameritrade followed suit, causing brokerage stocks to suffer their worst weekly drop in well over a decade as investors digested the earnings losses brokerage firms are likely to experience. Is this really a big deal, and which investors are most likely to benefit?

It is always beneficial to reduce the cost of making investments. And it’s fair to say every little bit helps. But in reality transaction fees typically represent only a tiny fraction of the cost of investing, except for those with very small portfolios. Let’s take an example. Jane Smith has an investment portfolio at Schwab comprising twenty ETFs and individual stocks worth $1 million, while John Jones has a $100,000 portfolio with ten holdings. Let’s also assume that they each rebalance their portfolios twice a year. Before the change, Jane’s annual transaction fees would have been at most 20 x $4.95 x 2 = $198, while John’s would have been no more than 10 x $4.95 x 2 = $99. Those fees would have reduced Jane’s overall annual portfolio return by $198/$1,000,000 or less than 0.02%, an amount that is virtually immaterial. In John’s case the impact would have been $99/$100,000 or 0.1%. A bigger hit than Jane’s losses to be sure, but still pretty small. It is only with portfolios worth less than $10,000 that transaction costs can actually begin to make a difference in returns.

One fact not highlighted by the media is that mutual fund transaction fees have not been eliminated. And across the discount brokerage world they can run anywhere from $0 to as much as $75. Coupled with the fact that the majority of individual investors as well as those working with advisors hold more mutual funds than ETFs, the benefit from this highly publicized cost-saving action by Schwab is likely to be even smaller for most investors.

Consider also that the annual expense of owning a mutual fund or ETF is likely to dwarf any transaction fees associated with trading it. Just a single mutual fund with an annual expense ratio of 0.50% and with a balance of $10,000 in your portfolio will cost you $500 each year, significantly more than even the maximum $75 it would cost to buy or sell it.

One class of investor that Schwab’s move would definitely help is the so-called day trader. And that’s unfortunate, because I think Schwab would be doing them a disservice by encouraging them. There is no evidence that day trading, which relies on market timing and/or individual stock picking, has ever been a consistently successful strategy. Quite the contrary. Most studies reveal that the more people trade, the lower their returns. And not so much because of the transaction costs (which are certainly a factor) but rather because of the unpredictability of future price movements, especially in the short term. Day trader successes and failures are largely a matter of luck.

Brokerage firm stock prices are likely to be quite volatile over the next several weeks as the market sorts out who will be the winners and who the losers as a result of this new round of cost cutting. While I’m glad that some investment costs are coming down, don’t expect to be able to celebrate with anything more out of your savings than perhaps one nice dinner.

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