Large investment firms ditch commissions

The world of investments is having a sale! Now you can trade stocks for free. Zero commissions are now the headline-making trend. At several major brokerage firms, including Schwab, TD Ameritrade, E-Trade and Fidelity, it will cost you absolutely nothing to buy and sell stocks.

The shares of major publicly traded brokerage firms plunged immediately after the announcements. How would the firms make money? Plenty of ways, as it turns out, so don't feel sorry for them. Their profit motivation will be explained below, but first how should you — the “ordinary investor” — react to this opportunity?

Some see this as a chance to get rich quick. But it could be a chance to get poor quicker! After all, when you trade stocks you have to be correct three times: when to get in, when to get out and when to get back in again.

Even if the trading costs are free, the tuition can be expensive. In fast-moving markets, a zero-cost transaction can appeal to your most extreme emotions of fear and greed. And that doesn't typically lead to profits. Just consider these facts from a report on Tradeciety.com:

■ 80% of all day traders quit within the first two years.

■ Almost 40% of day traders day-trade for just a month. Within three years, the number plummets to 13%. After five years, only 7% of day traders continue.

■ The average individual investor annually underperforms a market index by 1.5%. Active traders underperform by 6.5% a year.

—Only about 1% of all day traders can predictably profit net of fees.

The bottom line is few day traders make money over the long run. Part of that is attributable to costs, which now have become zero. But an even more significant reason is the fact that it takes skill and discipline to consistently trade well. Whether that's a learned ability or an inherent trait is open to debate. But if you're willing to face reality, you'll find out quickly whether you have what it takes.

Brokerage profits

Meanwhile, the brokerage industry is not facing self-destruction, although some of the marginal players will certainly be forced to seek merger partners. Yes, commissions will disappear, but the larger firms have two significant ways to make money, even if they charge you zero commissions.

The first is “payment for order flow.” While you might think that your buy or sell order is being executed on the floor of the New York Stock Exchange, that's likely not the case. Most retail orders are routed to big marketmaking firms like Citadel Securities and Virtu Financial. The market-makers pay to “see” the orders and execute them. It's called “payment for order flow” — and it's perfectly legal because these firms guarantee the order will be executed at the very best price in the national market system. These market-makers make a tiny bit of money, called “the spread” between bid and ask price on each transaction.

There's a second way the big brokerage firms make money. They pay you a very low rate of return on the “free cash” in your account. And that can really add up. Schwab, for example, has over $3.5 trillion in customer accounts, with about $4 billion in cash at any given time.

Schwab has a banking subsidiary. Much of that customer cash is automatically swept into an account that earns about 0.5% in the Schwab bank. Then the bank lends it out very short term, earning about 2%. In fact, those interest earnings accounted for more than half of Schwab's net revenue last year!

Here's a tip: if you have excess cash at Schwab, you should request that it be moved into a higher yielding money market fund. Most clients don't bother — and that's a windfall for the firm.

Other major online brokerage firms have similar profit profiles, with half or more of their net revenue coming from earnings on customer cash. So even at zero commissions the major brokerage firms will continue to be profitable. The big question is: Can day traders say the same? Not likely. And that's The Savage Truth!