Do Zero-Cost Trades Actually Benefit Investors?


Last week in Sagacious, we commented on the recent move by Charles Schwab and TD Ameritrade to cut trading commissions to zero on stocks listed in North America. Our initial thoughts and comments were on the potential for negative externalities, regarding how market structure may be impacted by brokers selling order flow. This week, we would like to explore how zero commission trades may affect behavioral biases of individual investors, and whether retail investors may be worse off despite saving on trading fees.

Business Insider published a piece a few weeks ago that referenced a study conducted by (ironically) Charles Schwab and Cerulli Associates, which looked at the top behavioural biases for clients of advisers. Though different behavioural biases are more impactful for certain generations, the most significant behavioural bias found in the study was the “recency bias,” or a cognitive phenomenon which convinces individuals that new information has greater value and importance than older information. This can lead to investors overreacting to the latest news headlines, causing trading decisions that are not rational and are based solely on noise.

In the book "A Man for All Markets" by Edward Thorp, the author talks about how it is the media’s job to explain what caused price action in financial markets, because humans find comfort in clinging to narratives. Often prices gyrate within a probabilistically normal band for no apparent reason and what caused price action is just noise. This is not to say that price action in financial markets represents a normal distribution from a statistical perspective, but the point is that there is a lot of randomness in financial markets and the essence of a narrative is how humans are able to process this noise.

The challenge for investors is deciphering what is noise, and what is the integral information needed to make asset allocation decisions. When you combine noisy markets, individuals suffering from recency bias, and then throw-free trading commissions into the mix, the probability of investment underperformance is likely to increase. This article from the Globe and Mail references a study done in 2000, which found that investors who traded frequently ended up lagging broad equity indices by approximately three percentage points annually.

While it is beyond the scope of this piece to dive into how investors can go about processing and weighing new information in order to guard against recency bias, for a refresher, Phil Tetlock’s book “Superforecasting” posits how important it is to establish a base case grounded in historical data before updating those views when new information is received. So, the question we wanted to highlight today is this: Will reducing commissions from between $5-$10 per trade to $0 actually benefit investors in the long run? For those investors focusing on asset allocation who make a few trades a year, the difference in cost savings will end up being immaterial. However, if zero-cost trading commissions make it easier for retail investors to “day-trade” and it has the potential to amplify behavioural biases, is it ultimately a good thing?