Cheap calories and commissions, redux
- March 21st, 2012
It’s funny how ideas percolate through time. A couple of years ago I wrote a piece entitled “The true cost of cheap calories and commissions.” From that article:
The parallels between commission and calories are striking. Unfortunately both lead to adverse outcomes. In the first case overtrading and the second obesity. Lower trading costs, both explicit and implicit, and a removal of an strictures against trading have cleared the way to higher portfolio turnover. One could argue that this has lead to a short term focus and overtrading.
Just as there is a brief high when we open that bag of french fries or can of soda there is a similar buzz from trading. Unfortunately for the investor there is a cost to that fleeting feeling on the part of the portfolio manager: underperformance. The highest costs funds tend to be those that trade the most, and subsequently those funds with the highest expense ratios had the lowest returns. (See John Bogle on the hidden costs of high portfolio turnover.)
In this day and age it takes some degree of discipline to keep from overindulging or overtrading. A focus on the longer term can help alleviate the lure of that short term high. There are real benefits to cheaper calories and commissions, but their true costs may be much higher than advertised. In short, just because something is cheap does not mean it cannot have a high cost.
Cheap commissions, and in the case of many ETFs zero commissions, are in fact one of the reasons we cited for it being a great time to be an individual investor. However there is a downside to cheap commissions. Today we came across a post by Chris at SigFig coming at this very topic with some additional data. Research finds that individuals who use online, discount brokers tend to trade more and by extension have worse performance. He writes:
Online discount brokers often lure investors to their software with the promise of super low trading fees. Positioned as low-cost, fast, and easy to use – some buy-and-hold investors fall prey to day trading, a habit they may not have formed had they worked with a full-service broker…
Don’t get us wrong, we don’t think discount brokers are bad. In fact, they’ve shifted power away from full-service brick-and-mortar brokerage firms to individual investors (you and me). Discount brokers are great; their fees are low, they’re convenient, and they empower investors to take control of their financial future. The problem is that people who use discount brokers tend to trade too much – a practice we believe hurts your returns…
There is a good reason why some people tend to trade too much. Tim Richards at The Psy-Fi Blog looks at research showing that traders who trade too much are in search of a “dopamine rush.” He writes:
This leads to an interesting hypothesis – that when we see overtrading and excessive risk taking in markets we’re not seeing some kind of irrational bias at work, but the affect of dopamine craving traders desperate for some action. McClure and colleagues have shown that the gratification of instant rewards – such as those received by someone out shopping – are also linked to dopamine pathways through the nervous system…
As the researchers point out, the evidence isn’t conclusive because of the difficulty of getting access to traders. In addition, because success is defined by longevity this might be missing the most successful traders of all, who get rich quick and retire early. Still, it’s suggestive if nothing else.
A theme we note in our forthcoming book is the importance of having a well-researched and detailed trading plan. Trading therefore isn’t inherently bad. There are plenty of reasons why one might want to trade. The challenge is that for most people doing less actually means doing yourself a favor. Just like when it comes to fast food, when we overtrade we do not see the vast majority of the costs until much later. And then it is often too late to do anything about it.
Items mentioned above:
The true cost of cheap calories and commissions. (Abnormal Returns)
There has never been a better time to be an individual investor. (Abnormal Returns)
Are discount brokerages the fast food chains of investing? (SigFig)
Craving a high: trading on dopamine. (The Psy-Fi Blog)
Doing yourself a favor by doing less. (Abnormal Returns)
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