Terrance Odean issues a warning to his students at the Haas School of Business at the University of California at Berkeley.
So when discount broker Charles Schwab scrapped the $4.95 commission on all online trades, as a buy-and-hold investor, I immediately thought, “Bad idea.”
Why?
Because anything that encourages more trading could induce nonprofessionals like myself to buy and sell more stocks. That’s a loser’s game. I can’t compete with the professional investors who work for institutions such as mutual funds, foundations, companies and universities. Those really smart professionals, known as institutional investors, pound away all day on their computer screens, trying to make a profit on massive trades.
And even those people aren’t successful all the time. That stacks high odds against nonprofessionals like myself being able to pick stock market winners.
“You will lose more money trading than you will save by not paying any transaction costs,” said Daniel P. Wiener, chairman of Adviser Investments, based in Newton, Mass. “Most investors trade poorly. They tend to buy high and sell low. The best investors and the names that everyone knows in the investment markets are people who do their research, make their purchases and stick with them.”
That said, even Warren Buffett, Ken Langone, Carl Icahn, George Soros and others go through rough patches and lose money on investments.
No one I spoke to thought Schwab’s move was a bad thing. It’s one of the discount brokers like TD Ameritrade, E-Trade and Interactive Brokers who have helped drive down brokerage fees and democratize the stock market for all.
“The vast majority of investors are going to benefit from lower commissions,” Odean said. “I am not coming out against lower commissions. But there will be a minority that will likely trade more than they would otherwise.”
Schwab is part of a trend adopted by Vanguard Group, Fidelity Investments and the discount stock brokerage houses as they drive commissions and fees toward zero to compete for market share.
“I see this more as a change in the business model for online brokers than I do as a change in investor habits,” said Fritz Gilbert, who writes a blog called the Retirement Manifesto.
Schwab’s revenue from commissions on securities trading represents only 6.7 percent of its $10 billion-plus in revenue. The brokerage is also a bank, and it makes most of its money — around 57 percent — from interest on the uninvested cash that people leave in their accounts. Schwab invests that money at a higher return than it pays out to its clients.
“Schwab is making money,” said Kenny Polcari of SlateStone Wealth. “Trading feels free to you, but you are generating plenty of money to Schwab.”
Schwab also makes money on selling advice to investors and on proprietary fees it charges on its in-house exchange traded funds and mutual funds. The company is betting that eliminating commissions will attract more customers who will become clients of its services.
“This is a classic, ‘Put up a poster in the window saying you have a gallon of milk you are selling in the back of the store for $2.99,’ ” said Ben Johnson, director of global ETF research at Morningstar. “The owner is betting you buy a bag of Cheetos, some bread and bubble gum on the way to getting the milk and coming back up front.”
Johnson said reducing the trade commissions is not going to change investor behavior.
“Those previously inclined to trade are not going to trade any less,” Johnson said. “Those who did not trade are not going to wake up the next morning and start being day traders.”
I am somewhere in between. First of all, I do not have an issue with Schwab or its brethren in the money management business earning a profit. I do not want to go back to the cumbersome days when you bought stocks through a stockbroker.
But I also hope people don’t think that because trading is free, they should jump on the computer and punch in a trade on a whiff of emotion or a tip from their Uber driver.
Odean doesn’t have a problem with people trading when they need to convert an asset into cash, such as selling stock shares to pay for a child’s college tuition. But his studies in the past cast doubt on the ability of individual traders like me to distinguish between future winners and losers.
If the study were run today, Odean said, “the market might be a little more efficient, creating a little less of an opportunity to shoot yourself in the foot. That said . . . there is still an opportunity for people to win and lose, and on average the institutional investors win more often than individuals.”
My own experience at picking winners and losers is not great. I bought a dozen stocks including General Electric, Alcoa and McDonald’s decades ago. I took a bath on GE and Alcoa, and I sold McDonald’s more than 10 years ago. McDonald’s has been on a rocket in the last few years, causing me much regret over selling the fast-food giant.
My other stocks have done fine, mostly thanks to my wife’s suggestions. If you are dying to own individual stocks, most professional advice is to own a diverse group of established companies in different industries. That would include financials, energy, technology, health care, utilities and consumer staples. Then hold those stocks and reinvest the dividends.
Schwab doesn’t disagree.
“We’ve long advocated a ‘core and explore’ approach,” said Alison Wertheim, Schwab’s vice president for public relations. “But investing for the long-term, by establishing a low-cost, diversified portfolio that takes on less risk, should be the foundation for everyone.”
“Most people, if they do some research, should assemble a portfolio of a dozen stocks, with an average holding period of at least a year and, ideally, a number of years,” said Whitney Tilson, a former hedge fund manager who writes an investment newsletter.
That’s what I did about 25 years ago. It isn’t perfect, but it can work for you.
But there is also no shame in simply owning an index fund and letting it do the work.
Or as Odean advises, just sit tight.
“E-Trade use to run an ad that said, ‘It’s two o’clock in the morning and you want to place a trade for a fast-moving stock without waking your baby or your broker. It’s time for E-Trade.’ ” Odean recalled. “And I said, ‘It’s time to go back to sleep.’ ”
