Cheap is good. Free might not be better.

Earlier this month, Charles Schwab reduced the cost of trading stocks and ETFs to the lowest possible level: $0.

Since their founding, Schwab has been disrupting the industry by taking advantage of the semiconductor to reduce the cost of investing for everyone. This is a good thing. Independently, Schwab and Vanguard changed the industry more than any other two companies, and average investors are better for it. 

No longer is it the norm for brokers to charge 1% (or more) of a transaction amount just to trade a stock. No longer is it standard for a mutual fund manager to charge in excess of 1% (or more) annually to attempt to beat the market, which they rarely do anyway.

Research and technology made things better, as did market competition. 

Check out the historical commission rates on the NYSE. The big drop came in 1975 after May Day, the first time in 180 years that brokers were allowed to charge varying commission rates not determined by regulators:

Source

And we’ve got Vanguard to thank for driving down the cost of investing in funds. Since 1997, mutual fund expense ratios for equity funds have been cut almost in half, from an average of 0.99 percent in 1997 to 0.55 percent in 2018.

Now, Vanguard’s average expense ratio (asset-weighted) is 0.10 percent, one-fifth of the industry average. 

So if cheap is good, free must be better, right?

After Schwab’s announcement, TDAmeritrade, E-Trade, and Fidelity quickly followed, knowing they’d be left-behind if they didn’t. And, last year, Fidelity announced a zero-fee index fund. 

But free isn’t always better.

Anytime something that should cost money is marketed as being free, you should wonder how they’re getting paid, because they are one way or another.

As it turns out, Schwab has essentially repositioned itself as a bank holding company, and most of the revenue they generate is now thanks to the spread they take on cash (net interest revenue). Trading revenue made up only 6.8% of their revenue.

Incidentally, Schwab had moved most of their clients’ cash holdings into Schwab Bank instead of (typically) higher-yielding money market funds. This was great for Schwab, less great for Schwab’s clients.

Fidelity, too, might be offering index funds for free, but they’re still making money off of them. They’ll raise prices elsewhere or offer similar cash management schemes to the one that Schwab uses.

Sometimes, free isn’t free. It just means less transparent fee structures.

Free trading! Use wisely

The data shows us that investors who trade more frequently end up underperforming the market than those that stick with their plan and trade less frequently. Trades should be made sparingly and wisely, and only with specific purposes in mind: to re-balance, reduce taxes, or some combination of the two. Free trading has the potential to encourage even more excessive trading than cheap trading did, and having worked with thousands of self-directed investors, and looked at the empirical data, I can safely say that free trades might end up costing investors in the end.

Investors should be careful to not allow free trades to encourage bad behavior, as the tool of cheaper trading is best wielded in experienced hands.