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Here’s Why Free Trades Might Not Be A Good Deal After All

D-I-Y? How about D-I-No. Here’s why those free trades might not be such a good deal after all.

Articles by Dan Egan
By Dan Egan VP of Behavioral Finance & Investing, Betterment Published Jun. 09, 2020
Published Jun. 09, 2020
4 min read

What could be better than free? Free speech, free beer, free trades!

While we aren’t aware of any brokerage companies offering free beer, there are some that offer free trades. These companies aren’t charities, however, and the fact that they offer free trades isn’t a coincidence. They likely make money through other ways than just through you directly. Since their ‘end customer’ isn’t always you, their services aren’t designed to optimize your investment performance—they’re designed to optimize their profit from others.

In contrast, some advisors—like us—earn revenue as a percentage of the balance you let us manage. We have an incentive to grow your money responsibly, because any reduction in your wealth is a reduction in our revenue. Besides, because we are a fiduciary by choice, our main goal is to help you be successful.

Here are the actual consequences of your free trades.

Brokerages that offer free trades are often designed to encourage actions that reduce your success without you even knowing it. They aren’t evil, they just want to make more profit for themselves, and they don’t care if your portfolio is collateral damage.

Brokerages usually make money by:

  • Charging you directly for transaction fees.
  • Making interest for themselves on your cash balances.
  • Accepting payment from fund managers in exchange for various advantages.
  • Charging for upgrades instead of providing you with those services by default.
  • Charging interest for margin lending or leverage loans.
  • Payment for order flow from high frequency trading firms.

Which means they generally have an incentive to:

  • Nudge you to trade more—which could lead to more turnover, more transaction costs, more taxes, and more stress.
  • Nudge you to hold more low-yielding cash—which usually isn’t good for you, because that cash could be growing more elsewhere.
  • Nudge you to hold or trade securities they profit on—which could increase your fund expenses and hurt your overall portfolio.

This is how your brain reacts to “free.”

Let’s start with a study on something most of us think is pretty good: chocolate.

In the study, one group was offered a choice between buying delicious Lindt truffles at 15 cents per piece, or, less appealing Hershey’s Kisses at 1 cent per piece. 73% of the group chose the decadent Lindt truffles.

In the next phase of the experiment, things went off the rails of logic. When the price of the Lindt truffles was reduced to 14 cents and the Hershey’s Kisses were offered up for free, 69% chose the Hershey’s Kisses. Keep in mind that the price difference between the two chocolates is 14 cents in both phases of the experiment.

Nothing against Hershey’s, but I prefer to indulge in chocolate that’s rich and dark. So, what exactly is going on in this study?

Free just hits our brains a little bit different.

Our brains hate it when we make them work hard, and love it when decisions are easy. We’re attracted to easier decisions, even if they’re bad for us. For example, you’ll prefer a font that is easier to read, but you’ll actually retain and understand more if the font is hard to read.

Our brains treat “free” differently because we believe we don’t have to do anything. We aren’t parting with any money, so we don’t have to go through an entire “is this worth it?” thought process.

When something is free, we don’t consider the non-monetary costs. As a result, things that are free are generally over-consumed. Think about how much more you eat at a buffet than you would otherwise.

Think your brain can outsmart this effect? Think again.

Once we take price out of the equation, we’re actually not very good at discriminating between the quality of goods or services. Imagine that you’re at the store, standing in front of a shelf of red wine—but there are no price tags. Only those of us who happen to be expertly trained would maybe be able to figure out the actual quality of each bottle.

If this example doesn’t apply to you—um, can you help us pick out a bottle next time?—we’ve got plenty of other general examples that might sound more familiar to you.

  • People are more likely to spend over $40 to get free shipping, rather than under $40 and pay the cost of shipping.
  • We tend to fill our homes up with free useless nicknacks. Remember that free t-shirt you took home from a conference, but it was actually a few sizes too big?
  • People will wait much longer for things that are free, even when it actually ends up wasting more of their time.
  • We are willing to watch ads to get free access to online videos.

When things are free, we’re left to differentiate the quality, which we’re not so great at. If you are in the market to buy pure expertise, such as financial advice, you might be doing so because you appreciate that quality second opinion from an expert.

It’s unwise to pay too much, but it’s worse to pay too little.

There are good free things: fresh air, sunshine, and time with friends come to mind.

But, over the years, I’ve learned that I need to be wary of those who are offering free things. They usually end up costing me more in time, stress, and mistakes, than if I had paid a little bit for something of better quality.

As John Ruskin said:

It’s unwise to pay too much, but it’s worse to pay too little. When you pay too much, you lose a little money—that’s all. When you pay too little, you sometimes lose everything, because the thing you bought was incapable of doing the thing it was bought to do.
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Original content by Betterment

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