As a follow-up to statements in recent blogs, here is my take on the discount brokerage (DB) model.
If lower trade costs result in better, more efficient portfolio’s then I am all for discount brokerage. There isn’t a large body of evidence aggregating results for investors in DB accounts since none of that data is released by the sponsoring companies. The data that does exist supports the position that investors should steer clear. In my opinion there is little incentive for DB firms to release data as it would be unflattering to their client base.
One notable exception was written by BRAD M. BARBER and TERRANCE ODEAN “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors”, in the Journal of Finance, April 2000. The article considered position statements and trading activity for 78,000 households at a large discount brokerage firm over a six-year period ending in January 1997. As the title implies the results were not encouraging. There was strong evidence of under performance when compared to the broad market return. In addition, this under performance was enhanced (synonymous with lower returns) in the group of accounts that traded most.
There are several implications.
Firstly, even though stock trading costs are lower in discount brokerage accounts somehow this advantage is not exploited for better client returns. The authors suggest over-confidence in trading strategies explains the drop in return. The correcting behavior recommended is lower cost transacting. When that doesn’t work, the individual usually feels the need to try harder. More effort is made on understanding the research. More time is spent staring at the screen to find meaning in the trading patterns. This can and often leads to more trading. A virtuous circle is created, from the point of view of the DB. A highly stressful and time consuming role is created for the investor-client (you).
Secondly, costs to DB clients are not lower for most asset classes, while the over-confidence factor presumably still operates. For example: the biggest DB wire house doesn’t currently rebate clients the fees for advice that are embedded into mutual funds. Instead the fees are collected as revenue though no advice is given. In addition, in my opinion, spreads or commission on fixed income securities such as CDs and GICs are collected by the firm though they are intended as compensation for professional advisers. The same can be said of bonds and syndication revenue, in which compensation for advice and distribution is simply absorbed into profits of DBs. As I said I’m for lower costs for investors. DB’s are simply not sharing the lower costs implied by their model with investors like you.
Thirdly, watch any ad for a discount brokerage firm and you will find that it exploits the view that lower transactions on stock trades equates to higher returns for investors. The clear parallel is drawn between superior trading strategies and their proprietary research resulting in confidence and better results. To me this is clearly a red herring. Most revenue streams, all of which are borne by their investors, are not disclosed. In addition, behaviors that reduce the likelihood of investor success are glamorized. Whereas behaviors that lead to better returns, like lower transaction counts and passive investment approaches are often discouraged through the introduction of additional fees. The overall result is that the incentives for DB and their clients are usually at odds.
Finally, DBs have institutional clients as well as retail clients (like you) who are often on the other side of aggregated small transactions. The research they provide is conflicted to the extent that DBs are efficient in terms of their institutional clients if they can provide liquidity. While no advice is provided to individual clients, advice is aggregated and released to many in the form of independent research. While no direct relationship exists, the overall effect is the same if it results in large numbers of small clients transferring one large position to a big institution.
My bias is clear. Advisors provide the best source of independent, professional advice specifically tailored to the best interest of the client. DBs may appear to present a cheaper option, but they are driven by profit motives and are generally profit centers for larger concerns. If your assets are important to you I advise you to choose a professional not a profit center, for your source of investment advice.
