Commission-Free Trading: Is There a Dark Side to It?
Commission-free trading has skyrocketed in popularity in the US.
Pioneered by fintech startup, Robinhood, commission-free trades has revolutionised the world of investing there.
It removes the frictional cost of investing in stocks and ETFs, making investing accessible to anyone and everyone.
For long-term investors, commission-free trading is great.
Zero trading fees mean higher returns.
It also “democratises” trading such that anyone, even those with a few hundred dollars to spare, can start investing in a diversified portfolio.
But What’s the Catch?
Although is it hard to argue with the obvious benefits of commission-free trading, there’s a catch: It creates short-term trading behaviour.
In stock markets, there’s data to show that long-term investors tend to do better than those who move in and out of the market.
Investors are traditionally bad market timers and tend to buy during a market peak and sell at a market bottom.
This short-term trading mindset has caused retail investors to often lag the overall market, far under-performing investors who simply bought to hold.
Encourages Poor Trading Behaviour
Just because something is free, does not mean we should be doing more of it. This is the case for trading.
Unfortunately, the rise of commission-free trading platforms has created more short-term trading mindsets.
People trade frequently just because it doesn’t cost them anything.
So, while investors save money on trading fees, their investment returns suffer due to poor investing behaviour.
In the book Heads I Win, Tails I Win: Why Smart Investors Fail and How to Tilt the Odds in Your Favor, financial journalist Spencer Jakab discussed how poor investor behaviour led to poor returns, even though the underlying asset performed well.
An interesting example he gave was the case of the Fidelity Magellan Fund managed by legendary investor Peter Lynch.
Even though the fund earned around 29% per year during Lynch’s tenure as manager of the fund from 1977 to 1990, Lynch himself estimated that the average investor in his fund made only 7% per year.
This was because when the average investor had a setback, money flowed out, and when there was a recovery, money flowed in, causing the investor to miss the recovery.
Discipline Is Important to Improve Long-Term Returns
Commission-free trading is undoubtedly a good thing for investors who are able to stick to the long-term principle of investing.
However, for those who are tempted to trade more often due to the zero trading fees, commission-free trading may end up doing more harm than good.
This article first appeared on The Good Investors and is part of a content syndication agreement between The Good Investors and Seedly.
The Good Investors is the personal investing blog of two simple guys, Chong Ser Jing and Jeremy Chia, who are passionate about educating Singaporeans about stock market investing.
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