The Impact of No Brokerage Fees on Retail Investors
Unless you work in finance, you may not be aware of a fundamental shift that’s underway at the moment in the industry. On Tuesday, October 1st, 2019, Charles Schwab rocked brokerage firms around the globe with their announcement to drop all commissions for stocks, ETFs, and options on U.S. and Canadian exchanges – permanently. Within a day, Ameritrade and E*Trade announced no brokerage fees as well. Ameritrade’s stock tanked in response, as 32% of their revenues came from commissions. Not long afterwards, Charles Schwab moved to acquire TD Ameritrade for $26 billion. (Unlike Ameritrade, only 5% of Schwab’s revenues come from commissions with the bulk of revenues coming from interest-earning assets.) The brokerage landscape seems to be forever changed.
The biggest beneficiary of no brokerage fees happens to be retail investors – mom and pop accounts – most of whom aren’t playing in the markets with a whole lot of money. Brokerage fees are now pretty much nonexistent. All those ads we used to run here on Nanalyze touting “cheap trades” over at firms like TD Ameritrade for $4.95 have now gone to zero. For all practical purposes, you can now trade domestic stocks for free at all major brokerage firms. The impetus for this change is said to be a fintech firm called Robinhood that built their entire business around free trading and fractional share ownership. Today, we want to talk about the implications of this change for retail investors, starting with first-time investors.
We’re in a unique position to address first-time investors. Many of our readers will discover some exciting investment themes – cannabis stocks for example – and will immediately want to invest in cannabis stocks. Emails we’ll receive along these lines are typically something like, “I have $100/$500/$1000 to invest in cannabis stocks – which one do I buy?” Our initial response is always to point these would-be investors to a more conservative strategy – robo advisors, for example. Once that’s in place, then it’s okay to dabble in stock picking or preferably, make more diversified investments in risky themes using vehicles like ETFs. In the absence of brokerage fees, it’s now possible for a first-time investor to purchase fractional amounts of shares with no fees, something that encourages diversification.
The final barrier to entry has been removed, and it’s easier than ever now to “trade stocks.” It’s a blessing and a curse. Most first-time investors we see come to the table wanting to invest in a stock or theme before they’ve even deposited their money into a brokerage account. (The inverse situation is when someone goes to a financial adviser – many of whom are complete rubbish – with their money asking for investment advice. At least then, they can be introduced to critical investing concepts.) This means most new investors will know nothing about how to invest competently. Volatility, diversification, and dollar cost averaging are concepts investors must constantly be reminded about, especially during bull markets, where the benefits of adhering to these best practices may not be so apparent.
Dollar Cost Averaging
Simply put, dollar cost averaging (DCA) suggests that instead of pulling the trigger and purchasing an asset all in one go, you buy a fixed amount, at fixed intervals over time. In the world of finance, this is seen as a way of reducing “market timing risk” (i.e. you buy 100 shares of a stock and it drops 50% a few months later – just like most cannabis stocks have).
If a stock falls 50% after you purchase it, you question your decision, but more importantly, you could have bought much more of that stock if you would have only waited. Here’s how the psychology of dollar cost averaging might look like when an investor purchases a stock on the first day of every month:
- Month Zero – Buys some shares
- Month One – Shares have risen by 15%. Investor is pleased that the shares they hold already have risen, but less pleased they’re paying more for shares now.
- Month Two – Shares fall by 25%. Investors is bummed that the shares they hold have fallen in value, but happy they’re buying shares today at a discounted price.
The psychology is what’s important here. Either way the market moves, the investor will experience some positive and negative emotion. First time investors have no idea how fraught with emotion investing is, a topic that’s well covered in the book “Reminiscences of a Stock Operator.” When the markets crash, many investors panic and sell their assets at the bottom. “Be greedy when others are fearful,” says Warren Buffet. Much easier said than done.
The jury is out in the academic world as to whether or not dollar cost averaging outperforms in the long run, but we do know that it provides psychological comfort for retail investors. In the absence of brokerage fees, it’s hard to argue that it results in lower returns. If 80% of active money managers can’t beat a broad market benchmark, why do you think you’ll fare any better? Up until now, transaction fees were a limiting factor in whether or not you could engage in dollar cost averaging. Today, they aren’t.
30 Stocks for Diversification
At a broad level, we refer to types of investments as “asset classes.” Stocks, bonds, real estate, and even art are considered to be asset classes. (Cryptocurrencies are not asset classes.) When you’re investing for the future, you want to be diversified across multiple asset classes that are loosely correlated. That is, when some are going up, others are going down. (Again, we see psychology coming into play here.) When talking about stocks as an asset class, there’s an often-cited rule – some say a myth – that says you should hold no less than 30 stocks for diversification purposes.
As you can see in the above chart, the optimal number – where portfolio risk approaches market risk – is actually less than 30 stocks. The more stocks you hold, the less your return will deviate from the overall market returns. In other words, the more stocks you hold, the less risk you are taking. Another way to think about this is the total amount of money you might lose if one of your stocks pulls an Enron. If you’re holding 30 stocks, the maximum drawdown in case of an Enron would be 3.33%. Of course, you also need to consider diversification across multiple factors such as industry, size, growth, value, and country. (For example, investing in multinational corporations can help address your over-reliance on U.S. stocks.)
One problem retail investors face is that they’ll be living much longer thanks to improved healthcare around disruptive technologies like machine learning and genomics. This means diversification becomes increasingly important. Aging Analytics Agency is a think tank dedicated to the emerging longevity space, and they produced an 83-page report talking about how this will affect investors. In that report, asset management firms are being called upon to allow smaller investments across more stocks which makes it easier for retail investors to diversify their investments, something that will help them weather difficult times.
Looks like asset management firms are listening.
Tech Stocks and Volatility
Trying to find the next Microsoft or thinking that shares in Google provide exposure to every technology under the sun are fallacies that investors need to watch out for. In bull markets, it’s easy to think that every tech stock is a winner. The life cycle of technologies is getting shorter, and emerging technologies are disrupting at a quicker pace than ever. All of this translates into volatility – in other words, risk. Someone with $1000 to invest in tech stocks used to be discouraged from spreading that money out among multiple stocks when each purchase cost $4.95, or when a single share in Google costs over $1,400. Today, brokerage firms are moving to “fractional share ownership” where you can commit any dollar amount to any stock. This encourages diversification. If you have $1,000 to invest in gene editing stocks, buy a small amount in all eight of them. Then use dollar cost averaging to do this over a fixed period of time.
Dividend Growth Investing
We largely cover tech stocks here on Nanalyze with a small number of articles dedicated to large companies that are using technology to disrupt their businesses (think Stryker (SYK) and medical devices, Walmart (WMT) and robotics, or Next Era Energy (NEE) and wind energy.) Even though our content is tech-heavy, the lion’s share of our own portfolio is in a mature dividend growth investing (DGI) strategy that’s been developed in-house by experienced finance professionals over the past decade. Our 30-stock portfolio is distributed across all ten industries, and has been not only paying a dividend, but increasing it for an average of 41 years. Over the past ten years, the average increase of each of these 30 income streams is just over 9%. Given an inflation rate of 3%, this means our income – in other words, quality of life – has been increasing meaningfully every single year.
Using dollar cost averaging, we’ve been buying 30 stocks every single month (you can buy many stocks with zero brokerage fees through DSPPs, something most people don’t know about) to build this portfolio over a period of about eight years. The rate at which an income stream grows every year at 9% is remarkable. If you started out at “year zero” with a $2,000 a month income stream, by “year ten” you’d be making $4,734 a month. By “year twenty,” you’d be making $11,208. By “year twenty five,” you’d be bringing in over $17,000 a month. Talk about living your golden years.
Of course, we need to consider that during the last ten years we’ve largely been in a bull market. What happens when there’s a recession? That’s where the historical track record comes into play. These increases have been happening on average for more than 41 years, every single year. These companies have weathered plenty of recessions and increased their dividends yearly using financial engineering, and there’s no reason to think that they won’t be able to do the same in the face of future recessions.
For tech investors, there’s a lesson to be had here about how quickly the tides of disruption can change. The day Charles Schwab broke that news, everything changed for Robinhood, a fintech startup that based their entire value proposition around free trading and fractional share ownership. As retail investors, we all stand to benefit by being able to invest with no fees. It’s now easier to engage in best practices like diversification or dollar cost averaging.
This zero-fee trend isn’t new. It’s something that large asset management firms like Vanguard have been doing for a while now to capture market share for their investment products – low fees or no fees. Today, anyone can buy 30 stocks a month for free. That’s why we’re now in the process of making our DGI strategy – along with our personal portfolio and insights – available in the form of a paid subscription to our lovely readers. Most importantly, we want to make it easier for first-time investors, or investors of all types, to develop their own DGI portfolios based on their own convictions, and enjoy an increased quality of life as they grow older. Sign up for our newsletter and we’ll let you know when this becomes available.
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