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Carla Fried: No-commission trading is a threat to your investing success

Carla Fried, Rate.com on

Published in Home and Consumer News

In October, discount brokerage firms were falling all over each other trying to hand out what looks like an enticing treat: no commissions when you trade stocks, mutual funds or exchange-traded funds (ETFs).

Schwab started the free free-for-all and was quickly followed by E-Trade, TD Ameritrade and Fidelity. Not coincidentally, private online trading platform Robinhood -- where trades have always been free -- had made news in the summer when it was valued at more than $7.5 billion. Nothing like a little upstart competition to get the price wars revving.

What's not to like? Well, no-commission trading can in fact be an expensive trick that entices you into trading more.

It's not as if trading was expensive before the October commission surprise. Typical costs were around $5 to $7 per trade. But we're all human, and when we hear anything is free, we think we should take advantage of what looks like a great deal.

Trading more is typically a bad idea. A sweeping study published in the Journal of Finance in 2000 analyzed the trading habits of more than 65,000 households over a six-year period. The title of the paper, Trading Is Hazardous to Your Wealth, sums up its central finding: Households that traded more had net returns lower than households that took a more hands-off, buy-and-hold approach.

The main culprit: overconfidence, a central behavioral bias that makes us think we have market-timing superpowers that deliver a higher return than if we stick to more of a buy-and-hold approach. We don't have superpowers. (My other personal finance advice can be found here: https://www.rate.com/research/news/categories/personal-finance.)

An annual study by Morningstar compares asset-weighted returns for funds and ETFs with the average return for a specific fund category. The asset-weighted return takes into account money flowing into and out of a fund; it's a proxy for market-timing attempts. Overall, the average asset-weighted return is less than the category average; in 2018, the average gap was 0.45%.

Moreover, if you are investing in a regular taxable account, making a lot of free trades is likely going to trigger one ugly tax bill. Profits from an investment you owned for less than one year are considered "short-term" by the IRS, and you will owe income tax on the gain. That's going to be a lot more than the $5 to $7 commission you are no longer paying. (For the record, buy-and-hold investors who sell shares they owned for more than one year at a gain get to pay the lower long-term capital gains tax rate. For most investors the long-term capital gains tax rate is either 10% or 15%.)

The bigger risk is money you have invested in an individual retirement account at one of the no-commission brokerages. When you buy and sell shares inside of an IRA there is no tax bill. That raises the temptation to trade even more now that there is no commission cost either.

 

Curb your trading enthusiasm. By all means, periodically rebalance your portfolio to make sure your mix of stocks and bonds stays in sync with your long-term retirement planning. In a retirement portfolio there is no excuse for not rebalancing, given there is no tax bill for trades.

For regular accounts it gets a little trickier, as profitable sales will trigger a capital gains tax. If you are adding fresh cash to that account, consider shifting where the new money goes to change your mix. For instance, if you are a bit top heavy in stocks now, earmark your new cash into bonds or cash to bring your allocation back closer to your target. If that doesn't do the trick, don't let the tax dog wag your portfolio tail. It is smarter to rebalance even if there is a tax bill involved than leave your future over-exposed to stocks.

For instance, if in 2009, the beginning of this bull market, you had a 60-40 mix of stocks and bonds, that would now be closer to 90-10 if you haven't rebalanced, given the strong performance of stocks for more than a decade.

For a taxable account, paying the long-term gains rate of 10% to 15% to get your portfolio back to your target allocation is likely to be a worthwhile cost. The alternative is to let a bear market do the reallocation for you; the average bear market loss is more than 30%.

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