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This is part 1 of a 2 part series.The new Consumer Financial Protection Bureau states on its website that its mission is to “Make markets…work for Americans” via “education…. and enforcement”. In the next few installments I’ll offer suggestions as to where the new Bureau should focus its early efforts.
The Bureau would do well to start by educating investors of the inherent conflict of interest between online brokers and their customers. Brokers make money with every client trade and so encourage their accounts to transact as frequently as possible, advertising lower commissions and increased ease of trading through their new high-tech trading mobile apps.
What online brokers don’t tell their clients is that each app that lets customers buy stocks from their iPhone while on a ski lift, or sell while in the checkout line at Duane Reade is actually costing the investor dearly. In fact, not only does the now standard $7/trade commission add up to a meaningful cost for a trader of any appreciable frequency, it isn’t even the largest cost to their trading.
Each time an investor executes a trade they must pay half the bid/ask spread in order to be filled. For the most liquid US stocks (the components of the S&P500, roughly 5% of listed U.S companies) that spread is currently roughly 0.1%. Half of one tenth of one per cent may not seem like a lot, but it adds up. Market makers, those that collect the bid/ask costs, have long been highly profitable. Specialist firms, which had a virtual monopoly on market making in the US until 10 years ago, were no exception. One such specialist firm, Spear, Leeds , Kellogg sold to Goldman Sachs for $6.3bbb in 2000.
In recent years hedge fund and investment bank’s high frequency trading desks, with their superior technology, have taken over the market making function from specialists. Profits to high frequency traders in the U.S. run to tens of billions of dollars a year. Each time a retail investor crosses the bid/ask spread they contribute to that kitty. To put it in actual numbers, assuming an investor trades in $25k unit size, his commissions at $7/trade are 0.03% of the value of the trade, which is 0.06% round trip (enter and exit).
Adding in the bid/ask spread .1% the total cost is .16% per round trip. Trading in an out of a stock once a month would mean fees of 1.9% a year. Trading once a week would cost 8% a year. Virtually no retail investor can make money in the long run paying away 2% a year let alone 8% a year yet the online brokers are unfettered in encouraging their clients to trade, trade, and trade some more. It should be noted that online brokerages funnel client orders to high frequency trading desks for a fee and are therefore collecting more than just the commissions on each order. They are in fact collecting a large percentage to the total cost to the client and thus have all the more reason to encourage heavy trading.
Another reason investors should trade less rather than more is the significantly greater tax burden to more frequent trading. For instance, given today’s short and long term capital gains tax rates of 33% and 15% respectively, If you pay $100 for a stock and it appreciates 20% each year and you sell it at the end of 5 years, you will have $226 after compounding gains and capital gains tax costs. If on the other hand you pay $100 for a stock, and once each year sell it and buy it back even at the same price you sold it, and do so until the end of 5 years, you will have $187 after compounding and taxes (not including commissions).
Why the difference? Because if you hold an investment rather than flip it not only do you benefit by ultimately paying the lower long term capital gains tax when you sell (assuming a profit) you get the benefit of your profits growing tax free until you sell—in other words your earnings compound on a pre- tax basis. However if you keep selling and buying back, you must pay taxes and thus your compounding each year is on an after-tax rather than pre-tax amount.
Even if long term and short term cap gains rates were both say 20%, pre-tax compounding would provide an additional $10 (10% of the original investment) more at the end of 5 years if you bought and held rather than traded in and out once a year. That’s 2% a year, which may not seem like a lot but if a money manager beat his benchmark by 2% a year over a 10-year period, he’d be ranked in the top 5% of all mutual fund managers.
Finally, there is ample evidence that the more frequently an investor trades the worse he does independent of trading fees and taxes. In 2000 Daniel Kahneman protégé Terry Odean and Brad Barber published a paper called ‘Trading is Hazardous to Your Wealth’ wherein they looked at 10,000 investor accounts and found that the average retail trading decision is usually ‘wrong’ (buys went lower, sells went higher) over the course of the following year. It follows then that they found that the most active investor had the worst results (even before costs).
The authors were not certain why frequent trading would cause worse trades, but our surveys show that the public base investment decisions almost solely on recent price performance (as opposed to quality of company’s products, valuation, etc..) and as such are momentum traders, expecting prices to do tomorrow what they did today. However market data shows that prices typically revert, and thus the more frequently a retail investor trades the more he loses—even before their higher transaction fees and taxes.
An investor stands the best chance of making money the less he trades. A consumer financial protection bureau worthy of its name would require brokerage advertisements to carry a warning that indeed frequent trading can be hazardous to your wealth.