There are a number of brokers in the investment world that are offering free trading on the stock market. Why then would you pay anyone to manage your investments if you can get it all for free online? Added to this many investment houses offer automated trading platforms, so called robo-trading, that supposedly use algorithms and automated trading to optimize your portfolio and give you the best investment returns. Sounds appealing right? But what’s the catch?
There is no such thing as a free lunch; an often used cliche but quite appropriate in this case. These free stock trading platforms which include companies like Robinhood, Schwab, E-Trade, TD Ameritrade and others. So what’s in it for them? Here are some of the ways these businesses make money by giving something away for free:
- Premium services – in common with many “freemium” apps, Robinhood offers a free basic service and the option to upgrade for additional premium services that you pay for. These features include:
- Margin trading (see below);
- After hours trading;
- Instant access to deposits (if you deposit money with them you have to wait two days to be able to trade with it. Pay the premium and you get instant access)
- They make money off the money you give them. Margin trading is when a broker lends you money to buy additional securities often at attractive margin interest rates. This interest they charge you is income to them. But all lending comes with a risk; what if you cannot pay them back? In order to manage this exposure these brokers will carefully monitor the market price and even the types of the investments you buy with the borrowed money to ensure it is never more than an agreed percentage of the whole portfolio. At any time that the stock price drops to a level where they are no longer comfortable with the value of investments bought with borrowed money to the total value of your portfolio, they will make a margin call. This means they call on you to either chip in more cash to restore the percentage or they will sell shares, at the now reduced price, in order to reestablish the equilibrium. This is an extremely stressful process and usually results in investors losing money at a time when they should be buying stocks, not selling.
- Market makers pay them to place trades with them. Market makers are businesses that play both sides of a trade in order to create a market for particular investments. Both sides of the trade means that they will buy and sell securities in order to create liquidity in the marketplace. This is a very important and useful feature for all investors as liquidity in the marketplace is an important feature of our stock market. For example if you own land and property prices plummet, it may take you months or even years to offload that piece of land because real estate is a very illiquid market. In the meantime you bear the full brunt of whatever is causing the property prices to drop. In the stock market, because of great liquidity, you can often sell a share within seconds. This is what makes stocks a very important part of your investment portfolio. Market makers are to be thanked for facilitating this liquidity.
- They have their own investment offerings which charge you investment management fees. Offering free trades is essentially an old-fashioned loss leader marketing strategy. No different really than the grocery store selling you milk at below cost to get you to come in and buy a bunch of other things that they make good money on. Some online brokers also offer their own Exchange Traded Funds and Mutual Funds as investment choices and put out the message that these are ideal for the average investor who is not an expert in the stock market. There is a lot of truth in that many of these funds will have full-time professional investment managers running them. They are generally highly skilled professionals who are experienced at managing these funds. Unless you have a deep interest and can dedicate time and energy to researching stocks and the companies they represent, you will benefit from these investment managers. But you will pay for it via fees charged to the fund. Investment managers are paid handsomely from a fee that is levied on the fund and that, generally, most investors do not see or who are aware of. And then there are the infamous 12b-1 fees, or annual marketing fees, paid by Mutual Funds to broker dealers to have them direct their clients to invest in these funds.
This trend of offering free trades is a relatively new one, having started only a few years ago. The amount of money involved is huge so small percentages can make these companies a lot of money. Time will tell if that is enough.
Alluvial Wealth is a Registered Investment Adviser, a fee based advisor registered under the 1940 Investment Advisers Act. We are not a Broker Dealer and therefore are not permitted to accept commissions or 12b-1 fees and we have a fiduciary standard which means we must always act solely in our client’s best interests. We never have custody of any client funds and clients are free to terminate our services at any time. Our role is to manage your portfolio and advise you on what investments to make. We also offer financial planning services. Our fees are based on the value or your portfolio, so if you do well, we do well.
We typically invest in large cap US listed public companies with strong balance sheets. Our investment selection strategy is valuation based, meaning that we strive to identify opportunities where companies are undervalued relative to their current market price. For more information on our current recommendations please contact us.