Zero brokerage commissions are the latest Siren Song to tempt retirees into dangerous behavior.
Like Ulysses of Greek myth, retirees need to tie themselves to the masts of their ships to avoid these Sirens.
I’m referring to J.P. Morgan’s JPM, -0.25% recent decision to give clients at least 100 free stock trades and, in some cases, unlimited free trading. This follows closely on the heels of Vanguard’s decision to allow online customers to trade nearly 1,800 exchange-traded funds commission free. Other leading discount brokerages are expected to follow suit in what many believe will be a race to the bottom.
On the surface it hardly seems like a bad thing that brokerage firms will charge their clients less when they trade. And it wouldn’t be a bad thing—if zero commissions had no effect on trading frequency. But that seems unlikely; J.P. Morgan and Vanguard made their decisions precisely because they believe it will attract and retain more clients.
And therein lies the rub: More trading on average leads to lower returns.
Retirees aren’t the only group of investors who are tempted to trade more than they should. But they are particularly vulnerable, because of a toxic pairing of two developments in retirement: Reduced cognitive ability and increased confidence.
In fact, as you can see from the accompanying chart, the trends are quite pronounced. The chart is based on a study entitled “Old Age and the Decline in Financial Literacy,” by Michael Finke of the American College of Financial Services; John Howe of the University of Missouri at Columbia, and Sandra Huston of Texas Tech University. They found that retirees’ score on a financial literacy test dropped by more than half between age 60 and age 90, even as their score on a confidence survey rose. Even more dramatic was the extent of the increase in a measure of their overconfidence, which increased more than four fold.
The pairing of these toxic behavior patterns in retirement means that retirees are especially susceptible to overtrading. So they need to be particularly on their guard against heeding the lure of zero trading commissions into excessive trading.
You might object that excessive trading wouldn’t be such a bad idea if brokerage commissions were zero. But you’d be wrong.
We know because of a groundbreaking study from two decades ago in the prestigious American Economic Review, entitled “Do Investors Trade Too Much?” The author of the study, Terrance Odean, a professor of finance at the University of California Berkeley, meticulously analyzed the trading histories of 10,000 traders at a leading discount brokerage firm. He found that, on average, traders sell stocks that are about to go up, and replace their sold issues with other stocks that are about to go down.
One of the most telling results that Odean reached came when he analyzed each sale that was made by a trader in his sample. If that trader bought another stock within 30 days of that sale, Odean assumed that the new stock was intended as a replacement—and compared the returns of both the sold stock and its replacement.
The results are devastating, as you can see from the accompanying chart. Over the four months subsequent to the transactions, the stock that was bought produced a return that was 1.5 percentage points less than the stock that had been sold. Over the one-year and two-year periods following the transaction, the differences were even bigger—3.2 and 3.6 percentage points, respectively.
And note carefully that these returns were based on the performances of the stocks themselves and nothing else. The returns did not include brokerage commissions, taxes, or any other transaction costs for that matter.
In fact, Odean found that the major behavioral factor leading to these results is overconfidence, which is precisely what retirees are so susceptible to.
The bottom line? On average, each trade you undertake causes your portfolio to do worse than it would have without that trade. And that remains true even if brokerage commissions are zero.
Even retirees with lower financial literacy can conclude that they therefore should trade as little as possible.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.
