recent decision to reduce brokerage commissions to zero has generated a lot of sound and fury that signify nothing.
Literally. That’s because brokerage commissions already were so low that they amounted to nothing more than a “drop in the bucket” of total transaction costs, according to Aswath Damodaran, a professor of finance at the Stern School of Business at New York University. Therefore, he said in an interview, the move to zero commissions will not lead to significant cost savings for almost all investors.
There’s more to this story, however.
That’s because zero commissions may very well encourage retirees to trade more often than they would otherwise. And that would be a big mistake.
That’s because the average stock transaction loses money. It doesn’t take a rocket scientist to therefore conclude that we should undertake such transactions as infrequently as possible.
This is for two reasons.
• As mentioned above, the lion’s share of transaction costs come from sources than brokerage commissions. Bid-asked spreads are the major culprit, and they are unaffected by the move to zero brokerage commissions. Nor are they insignificant. According to Professor Damodaran, spreads on the least liquid stocks (the 20% with the lowest trading volume) average 2.06%, while spreads on the most-liquid-stock quintile are still quite high—0.62%.
• The average stock trade loses money, even before taking bid-asked spreads into account. On average, according to considerable academic research, the stocks we buy perform worse than those that we have just sold—over the subsequent three months, year, and two-year periods. In other words, we tend to sell what we should instead be holding on to, and then replace those stocks with others that we should instead be avoiding. No wonder we have such trouble keeping up with the stock market averages
This counterproductive behavior is evident in the track records of the investment newsletter portfolios monitored by my Hulbert Financial Digest. As a general rule, those who undertake the fewest transactions have the best long-term performance—as illustrated in the accompanying chart. It plots 20-year trailing annualized return versus average holding period of portfolio positions. Each dot represents a different model portfolio of monitored newsletters.
Notice from the best-fit trend line on the chart that its slope is strongly upward. Specifically, that slope indicates that, on average, increasing your average holding period by one year increases your 20-year annualized return by 0.43 percentage points. That may not seem like a lot, but compounding that increase over 20 years adds up.
To be sure, some of the dots on the chart fall relatively far away from the trend line. Some of the newsletters with relatively short holding periods, for example, still perform quite well. But, from a statistical point of view, we can be confident that this upwardly sloping line represents the genuine trend.
The bottom line: The odds are strongly against us when we think our short-term trading can add value. And those odds remain just as overwhelming even after brokerage commissions are reduced to zero.
And though it’s human nature for us to believe we can beat these odds, of course, we should resist that temptation.
This is especially good advice for retirees. That’s because, on average, their scores on a financial literacy test decline by more than half between ages 60 and 90, according to one study. Even worse, while their literacy is declining, their overconfidence is rising, according to the same study. So retirees are prone to become more confident in their trading ability just as they are becoming less skilled at doing so.
That’s a dangerous combination.
So the best advice, as it often is, is to sit on your hands.