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Will Free Trading Help Individuals Become Smarter Investors?

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Recently, Charles Schwab introduced zero commission (free) trading on individual stocks and Exchange Traded Funds (ETF’s).

Others, including TD Ameritrade, quickly followed suit. While this has certain strategic implication for brokers, it likely won’t help individuals become smarter investors.

Removing friction in the form of trading costs will encourage many DIY investors to trade more. Several research studies on individual investor behavior, including a landmark study (using data from over 60,000 Schwab retail customers), authored by Terrance Odean at UC, Berkeley and Brad Barber at UC, Davis conclude that trading is bad for your wealth. In general, the more you trade, the lower your overall returns will likely be over time.

Behavioral biases or preferences, already the most substantive problem for investors, will now be free to roam. Overconfidence can now operate without bounds.

Don’t Fall for Loss Leaders

Lost in all of the fervor over free trading are the real economics and “loss leader” intentions by the brokerage firms. Retail trading commissions account for only about 7% of gross revenues at Schwab. They have clearly made a strategic decision to focus on selling investors other Schwab products in lieu of making money on trading commissions. There is a recent precedent for this very outcome.

Last year Fidelity cut the internal fund management cost to zero for four Fidelity index mutual funds. If industry reporting is to be believed, Fidelity has experienced a substantial increase in business from investors outside of the zero expense ratio funds. This is akin to going into a store and heading into the rear of the store to look at the sale items. Along the way you pass all of the new stuff and inevitably walk out with some of those items as well as the sale items you ostensibly were interested in at first. Watch our brief video on this topic above.

The Overconfident DIY Investor

The path toward becoming a smart investor starts with having your eyes wide open to human emotions and built-in biases. DIY investors tend to be confident, if not over confident. Managing these preference is close to impossible for most investors. Perhaps outranking overconfidence on the scale of behavioral biases is herding. This is a catchall preference that describes how investors make decisions as a group or herd. It’s difficult for investors to recognize because it feels so natural.

Investing costs matter but pale in comparison to behavioral costs. Being a smart investor requires that you recognize both. Start there.

Related: The Sworn Enemy of Preparing for a Successful Financial Future: Status Quo

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