Psychology & The Cost of “Free” Trading
During class a few of my students discussed their portfolios. With the market volatility, there were many opinions being thrown around as to where and how to place trades.
This led to an impromptu survey of what trading platforms they use and why.
Most had accounts with Robinhood, with several others having accounts at Schwab, Fidelity and Vanguard.
As we discussed this, Pablo said he liked that Robinhood was “free,” as in no commissions.
To promote conversation, I asked, “Do you think Robinhood, Schwab, Fidelity or Vanguard operate as non-profits?”
The class knew it was impossible to stay in business if not generating profits. As such, if these platforms aren’t charging overt commissions, how are they generating revenue and profits?
I explained that all brokerage platforms are essentially high-speed toll booths. However, the brokers get to route buy or sell orders through different “market makers” like Citadel Securities or Susquehanna International Group.
Given the mega-size of these brokers, they bundle trade orders with millions of other trades sending them to market makers, instead of directly to the New York Stock Exchange.
By doing so, the market makers sit in the middle of all trades. Enrique asked for an example.
Let’s assume Pablo wants to sell Microsoft stock and simultaneously, Enrique wants to buy Microsoft. At the time, it was trading for $405 per share.
Pablo won’t get the full $405. Instead, he nets $404.99 while Enrique pays $405.01 to buy the same shares at the same moment. The two-penny difference is the “bid-ask” spread.
The spread goes to Citadel or Susquehanna, but not before sharing some of the spread with the initial broker (like Robinhood). As such, there may not be commissions—but there is definitely a trading cost. Since most investors don’t see it on their statement, they incorrectly assume it doesn’t exist.
A fractional penny may not seem like much, but consider that Robinhood places more than four million stock and option trades per day. This got my students’ attention.
This is not the only profit lever brokers have. If you analyze their income statements, you learn that a sizable chunk of their revenue doesn’t come from trading. Instead, it comes from Net Interest Revenue. Essentially, Robinhood takes a bite from an investors’ money market yield keeping it for themselves.
As we discussed this, my students acknowledged the conflict of interest but concluded this probably didn’t cost the average investor too much.
However, there is another aspect of Robinhood that does concern me relative to the average investor. The class was curious.
I asked, “What attracted you to Robinhood, specifically?”
Albert said his friends used Robinhood while his parents’ generation uses Schwab. Jimmy said he liked the lottery-style awards in which new users receive a “free stock” worth $5 to $200. The “free stock” was revealed through a digital scratch-off interface mimicking a lottery ticket.
Veronica felt motivated to trade more as she received dynamic visual “milestones” tracking her progress.
Enrique jumped in saying Robinhood was easy to use as it had one-tap trading. He said the simplified “Candy Crush-like” interface made complex transactions feel more like casual mobile gaming.
Pablo said there are fun notifications with emojis and real-time price alerts providing awards.
As we discussed these features that got their attention and encouraged them to trade, I asked if any of these things made a given business worth more? Did any of these motivations increase the earnings of a given business?
Diving into each of these motivations, my students started to understand that these actions encouraged trading and other addictive behaviors. However, it did not necessarily improve investing returns.
As class finished, we summarized a few key points.
There is no such thing as “free” trading. There are conflicts of interest between your assets and your broker. Trading is not investing.
Beware of psychological nudges that encourage trading or get you to engage in addictive behaviors. Don’t fall victim to the gamification of trading or other casino-type manipulations.
If you are truly investing, it should be a long-term, patient process.
When placing trades, know what a fair price for a given security is. Use limit orders to execute trades. Successful investors will often place limit orders after hours or on weekends to remove the current emotions of the market.
Dave Sather is a Certified Financial Planner and the CEO of the Sather Financial Group, a fee-only and fiduciary investment management and strategic planning firm.
