Zero-Commission Stock Trading

by The Compound Investor

When folks look back over the past sixty years I think two developments will stand out as being major benefits to ordinary investors. The first is the proliferation of tax-deferred and tax-exempt savings vehicles. It would need its own article, but taking advantage of the benefits of IRAs and a 401(k) plan is now the single best thing you can do in terms of your personal finances.

The second is the rise of low-fee index funds. One of the most eye-opening pieces of commentary you will ever read on the matter is contained in Warren Buffett’s 2018 annual letter to Berkshire Hathaway shareholders. You can find it as part of the preamble to the firm’s 2018 annual report. Anyway, over the course of his investing life – 77 years when he penned the letter – the US stock market compounded away at an 11.8% per annum clip on a ‘pre-fee’, pre-tax basis. Putting the $114.75 he invested in Cities Service preferred stock as an 11-year old into a fictional S&P 500 tracker fund would have returned just over $600,000 by the time he wrote that letter.

Buffett goes on to note that “a $1 million investment by a tax-free institution of that time – say, a pension fund or college endowment – would have grown to about $5.3 billion”. Obviously that is a pretty remarkable statistic in its own right. However the next bit is crazy. Applying just a 1% per annum fee reduced the return to $2.65 billion. Or put another way: pay 1%, lose half your potential gains. If you ever wondered why so much ink is spilled on fund expense ratios dropping by fractions of a percentage point, there you have it.

Zero-Commission Stock Trading

You’ll note that I failed to include one of the most recent innovations in the personal finance space: zero-commission stock trading. In the US it is now perfectly possible to buy domestic equities and ETFs free of charge. And we aren’t talking dodgy discount brokers that nobody has ever heard of. Charles Schwab announced it recently, as did E-Trade and TD Ameritrade.

Unfortunately too many people will never realize this as a tangible benefit. The reason I say this is because making stock ownership easier has already proved to be the ultimate expression of the law of unintended consequences. The average holding period for stocks has collapsed by an order of magnitude over the past few decades. On the whole, folks simply respond by trading more and more. (The evidence is pretty clear that this destroys compounding rates for investors). Zero-commission trading will put a booster under that.

Also, the person who will gain from zero-commission trading typically only racks up commission by buying. I’m talking old-school buy-and-hold folks like Paul Navone who very rarely sold assets. That said, and although not on par with tax-deferred and tax-attempt savings vehicles, the potential financial benefit accruing from zero-commission stock trading is still pretty significant.

To put a number to that statement, consider one of my ‘discount’ broker firms which comically charges around £12 (circa $15 at current exchange rates) commission per trade. Assuming one purchase per month, I’m looking at around $180 in one year. Over forty years that adds up to $7,200 before inflation. Then there is the big one: the opportunity cost of lost compounding. Over forty years that could be worth around $85,000 all together assuming 10% per annum returns.

Fractional Share Trading

Fractional share trading is where things get even more interesting. Not all of the big US broker shops are there yet, but some are. Until recently nobody could put, say, a spare $10 or $20 into Coca-Cola stock. Leave aside the commission issue, one share trades for almost $60 as I type. Now you can essentially buy a half-share (or any other fraction), at zero commission.

This combination could be seismic for lower-income investors. Imagining being able to put $10 here or $20 there into any domestic equity or ETF, as and when you can? That is now a reality. Imagine saving, say, $15 a week from your grocery bill. Instead you decide to put that cash into a vehicle compounding at 10% per annum. After a twenty-year period you could be looking at a $50,000 nest egg. The technical barriers that previously prevented that happening (outside of a thought experiment) are now disappearing. Unfortunately, I believe the vast majority of investors will not realize the full benefits of these innovations.

Note

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