Commission-Free Trading to Encourage Foolishness

Trading

Critics of trading used to rely on the argument that commissions make trying to trade too difficult or even futile. Now that this is gone, detractors are down to hurling insults.

Jack Bogle, the founder of Vanguard and a staunch believer in the buy and hold strategy, did not quite live to see commission-free online trading, but we know what he would think about it, because he’s already made his staunch opposition to investors trading quite clear over the years.

According to Bogle, “trading is the investor’s enemy, by definition.” While it never has been made all that clear why trading in itself would be an investor’s enemy, by Bogle or anyone else in this camp, this one statement seems to be all telling, as they have simply defined trading as bad and therefore it is so.

The battle cry from those who think trading is a bad idea used to be that the cost of commissions to time your investments would be prohibitive, and you’d be better off just standing pat. Whether this was actually the case or not was left unexamined by them, as they just assumed this to be the case. They essentially took themselves at their word, as did many.

Commissions were very high indeed back when Jack Bogle launched the world’s first index fund in 1976, as a way to allow investors lower transaction costs. Low costs were near and dear to Bogle’s heart, and a fund that didn’t trade offered lower ones. People were told to buy and hold and now the fund was doing that as well.

Index funds have continued to grow in popularity over all these years, and they do beat most actively managed funds in terms of returns, the ones that don’t stand pat but seek to trade their portfolios.

Some might therefore want to argue that the buy and hold approach of index funds, taking all of the decisions out of the matter and just buying all the stocks or other assets in an index and doing nothing else, is simply better than a fund that instead trades, switching assets around to seek to be in the right assets at the right time.

Mutual Funds Have Huge Trading Costs, But We Don’t

The numbers actually support this view, as index funds beat managed funds 80% of the time, and the 20% that beat them don’t do so consistently, and each year there is a different 20% that does it. It’s not that this cannot be done, but this is at least pretty difficult to do and we’re told that we should just hedge our bets and go with the 80% winning side.

We aren’t just entitled to assume that the disadvantage of transaction costs with trading active funds would be too difficult to manage, but it’s obvious that this is not such an easy task or more people would be beating index funds with their managed funds. Skill does play a big role in this, and you need the benefits of your skill to exceed the additional trading costs involved. The most skilled manage this, but most do not.

Everyone can trade more cheaply these days, because trading has become more efficient over the years. Back when Bogle started out, trading was done the old-fashioned way, with pen and paper. Computers have allowed trading to be conducted much more efficiently, which is reflected in both the speed of transactions and their much lower cost than in yesteryear.

Transaction costs themselves have evolved into comprising a very small part of trades overall. If this were all there was to it, this should present a big advantage to active funds, but transaction costs are only a small part of the overall trading costs that funds pay, costs that are simply a product of the large sizes that these funds must trade in.

Almost all of these costs come from what we call slippage, which is the difference between the price that something is trading at when you want to get in and out and the actual price that you pay or get.

Large investors cannot just unwind their positions at current trading prices like individuals can, and they face two big problems that individuals do not, which is the need to take on increased slippage and increased risk. If something is falling in price and it takes you weeks to get out, this exposes you to the potential of greater losses, in other words, greater risk.

If you’re looking to buy something, this can also take weeks to enter, and this also subjects you to a lot of slippage. The first thing to go when bound by such restrictions is that you can’t really trade like you would want to, with the trends, buying and holding things while they are going up and selling them when they start going the other way.

While this would normally be the only sensible way to trade, this strategy will simply involve way too much slippage, as you’ll be punished on both ends with this, paying too much and getting too little back. Even with an abundance of skill, all this slippage would be too much to overcome, so mutual fund managers are forced to take a more contrarian approach, buying weakness and selling into strength.

This in itself causes a different form of slippage, the difference between what an optimal strategy would be without the concerns of slippage, and what you actually do. No matter how they do it, these funds are at a big disadvantage due to their trade sizes and it’s actually not surprising that so few beat index funds under these big challenges.

Slippage plays a negligible role with the trading that individual investors do, because they can trade single orders. There is still the spread to contend with, but nowadays spreads are tight and your investment only has to tick up a bit to get even on this, and investors aren’t in it for a few minutes and the returns that they are seeking simply dwarf these very small spreads, so this isn’t even meaningful to them.

If you had to pay a couple percent in commissions for a round turn trade, like you did back when Jack Bogle started out, this can be pretty significant indeed and certainly did serve as a reason to be more selective when you traded. If you bought and sold 1000 shares of a stock trading at $50, this would cost you $1000 in commissions.

The first 2% of your returns would therefore be eaten up by commissions, and while this would not mean that you would want to refrain from trading, you are going to have to pick your spots more and make sure that the risk that your exit and subsequent re-entry is looking to avoid is significant enough.

Investors don’t mess around with risks of just a couple of percent though or they would not even be investing, as this is the stuff traders play around with, those who may be out at this risk level or often well before. Sidestepping the bigger stuff, like the crash of 2008, where you could lose half or more of your investment can make this 2% look like a pittance though in comparison.

Around the same time that Bogle was looking to reduce transaction costs by creating the world’s first index fund, Charles Schwab rolled out the world’s first discount brokerage, and this industry evolved to dramatically reduce trading costs for individual investors.

As these costs dropped lower and lower, the criticism that commission costs made looking to time your positions unwise remained. Even with a round trip commission dropping to less than $10, this persisted, even though in our example this would drive the cost from 2% to 0.02%, from somewhat significant to investors to virtually meaningless.

Instead of needing our trade to move from $50 a share to $51 to break even under the 2% round turn model, we now only have to see it rise a penny, as 1000 shares times a penny equals $10. The fact that people will tell us that this penny is important enough to not want us trying to sidestep double digit moves or even single digit ones is simply absurd.

If you don’t have anything else to criticize with though, you may be down to the absurd, and all sorts of people who are actually being paid by someone to give out advice would continue to harp on the effect of commissions on the viability of investor trading.

Just Because Some Trade Foolishly Doesn’t Mean it’s a Foolish Practice

Now that the commissions are gone, it seems that these people are left with nothing but just hurling insults at the practice, and we’re seeing this come out now that Schwab and their major competitors have chosen to offer commission-free online trading.

“The bottom line is that trading is still a fool’s errand,” quips Advisor Investments chairman Daniel Wiener. Advisor Jim Lowell adds that “trading is a gambit, not a discipline,” and sees a zero-commission environment as a means for more fools to run more foolish errands.

We are left to speculate on why they think that traders are fools though, as it can’t be because they are paying commissions now, but if we only just take their word for it, it will be settled.

We do need to be clear on the fact that one may invest wisely or foolishly depending on how the investing is done, but if we’re going to claim that timing positions is foolish, we’re going to need to provide convincing reasons to support it. When we take on the practice itself, we’re going to have to demonstrate that this is a foolish practice in itself rather than a practice that may be engaged in foolishly, and there is a big difference here.

There is no doubt that some investors trade very foolishly, and the classic example is riding a big move down, getting out near the bottom, and when watching it go back up while still being out. People do such things, and make mistakes of a lesser nature as well, but does this mean that the practice itself is foolish?

Would it be foolish, in our example, to get out earlier and get back in when the war is over at a much lower price, and pocket the difference? Would it be wiser here to stay in your position and bear the entire loss because you have been told that managing risk is foolish?

It seems that the world is full of such fools because these brokers do a lot of business indeed, and this is far from a niche thing. Some of the criticisms against investors trading do have some validity though, which boil down to investors lacking the proper discipline to trade well and resorting to greed and fear to drive them away from more sensible approaches.

We could go even further and point out that many investors are clueless and trade without a real plan, let alone a good one, and become stuck like deer in headlights often times when it becomes time to act. Without a plan, they are not sure at all what to do and often will do the wrong thing.

Even so, we do not want to toss out the baby with the bathwater here and say that trading itself is bad. The intermittent trading style that an investor would use is not a difficult task to learn to be proficient enough at to be able to help yourself manage risk significantly better over just ignoring it like the buy and hold proponents want you to do.

This really is primarily about managing risk better, which critics miss. They encourage our holding less money in stocks by putting a certain amount in bonds or some other asset but somehow managing risk is foolish when you look to step aside more when risk rises too much. You can also get better returns if you do this well, something a bond hedge won’t provide as this hedge always lowers returns overall.

However, this isn’t primarily about beating the market at all, it’s about reducing your risk exposure, and in bear markets, this can be a pretty helpful strategy indeed, where you can now sit back and watch how much money other people are losing.

Instead of calling them fools, we should be telling them that trading involves the risk of acting foolishly, and can both harm and help. If we choose to trade, we need to realize that this does take some skill to pull off properly and the more skill we have and the better judgements we can fashion, the more we may help ourselves.

Gambit is actually a good word to use here because this involves making a sacrifice to obtain a bigger gain, which is what trading actually is supposed to be. Whether or gambits are wise or foolish depends on how well we play the game. With commissions now gone, the cost of the gambit is down to just the spread, which is a small price to pay to obtain much bigger advantages provided that we know what we are doing.

Those who are disposed to trade aren’t going to be too put off by these people essentially telling us that they don’t believe in trading and think that it is foolish, and given that we’ve shown that investors can really help themselves with well-timed trades even with commissions in place, taking on the practice itself is an argument that they cannot win and will only really convince their own following who have accepted their truths to be self-evident as they are claimed to be.

However, if they wish to make a meaningful contribution to the discussion and not just express their disagreement, they should be pointing out how this might be a mistake, even foolish, in certain cases, to at least give people more of a head start on what to watch out for.

However, the buy and hold strategy is more like a creed, and if you believe this, even entertaining another approach is seen as sacrilege, so don’t expect anything either true or helpful from this group other than commands to obey them without question. Many still do, but many now are bold enough to question this view and give this a try.

If zero commissions have us wanting to trade more as investors, we need to realize that commissions haven’t been meaningful to investors for a long time and this just doesn’t change things much. We do need to be well aware though that these things require a certain amount of skill and discipline to do well, and if we are ignoring this or not striving for it, we may indeed be the fools at the party like they claim.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.