The True Cost of Free Trades

Free trade brokers are great training wheels for new investors, but more experienced traders might want to stick with traditional brokers.

That’s our conclusion after reviewing the increasingly crowded and competitive trading marketplace.

Average Order Size

Orders from incumbent discount and traditional brokers are 1400% and 750% larger than orders from free trade brokers.

We categorize brokers as “traditional,” “discount,” or “free trade.” Traditional online brokers, such as Charles Schwab, focus on the personal touch of retail investing by offering their clients access to a human stockbroker. While they have made recent advances with robo-advisory services, they continue to provide a more old-fashioned (and often more expensive) investing experience for their clients.

Discount brokers have cut costs by stripping away the infrastructure of traditional brokerages. OptionsHouse, for example, offers trades at a $4.95 commission, compared to Schwab’s $8.95. Discount brokers target a younger, more tech-savvy customer who is willing to do more independent research to save on advisory fees.

Jennifer Van GroveIn the last few years, new brokers have begun to offer commission-free trading, breaking the traditional broker’s profit model. In response, well-established brokers fought back by promoting their premium educational and research tools, which free-trade brokers rarely provide. For example, Fidelity ran this ad in Fortune and Wired in 2015, after free-trade brokers started gaining popularity among millennial investors.

Whether or not free-trade brokers can build a profitable business model is still up for debate. More importantly, however, it remains to be seen if free trades are truly beneficial to investors in the long run.

greed buy fear sellAs inconvenient as they are, trade commissions help some anxious investors make better decisions to build long-term wealth. Since individual stocks and ETFs are highly volatile in the short-term, many investors suffer from market anxieties and make rash trade decisions. For these types of investors, trade commissions act as a financial disincentive to participate in the “Greed/Buy” and “Fear/Sell” cycle that causes so many investors to lose money.

Other investors see it differently: stubborn investors who don’t want to pay trade commissions often adopt a “hold & hope” policy when their investments start to decline in value. For stubborn investors, free trades allow them to use their proper judgment and sell poorly chosen investments before they decline in value.

That being said, traditional and discount broker clients trade in much larger quantities, which diminishes the impact of trade commissions. Orders placed through traditional and discount brokers are 1,400% and 750% larger, on average, than orders placed through free trade brokers. For investors who trade in small quantities, a few dollars in trade commissions will eat up a larger percentage of returns, making free-trade brokers more attractive.

Which type of broker is best for you? That depends on your goals. For amateur investors with small portfolios looking to learn the art of trading, a free trade broker could be a smart pick. But for investors who suffer market anxiety or seek to build wealth over the long-term, guidance and education is crucial, and the cost of free trades could be higher than the cost of trade commissions.

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