When I heard that Schwab, and then TD Ameritrade, is eliminating trading commissions, I was reminded of the chapter in Dan Ariely’s book Predictably Irrational: The Hidden Forces that Shape Our Decisions entitled “The Cost of Zero.”

Areily’s research shows that it is human nature that, when you get something for free (a freebee) you have an emotional high, even if this freebee is not something you actually need or want. The result is that the presence of the freebee leads you to decide to take a freebee you do not need over paying for something you do need, even if that price for what you need is steeply discounted. You do so because you intrinsically fear the loss, that is paying for something that you might find is not worth the money you spent. A freebee seems to be a "no loss" alternative, despite the fact that spending a relatively small amount now on something that is necessary will lead to much greater returns later than taking the free, but unnecessary, alternative. 

This “cost of zero” applies not only to the initial purchase, but also to "free exchanges" of an item you own for an item you do not own. Time is also affected by zero, such that people will spend more time waiting for an item to be delivered if it is "free" than they would if they had to pay for it. The result is that a business can draw a crowd by making something free and still profit because, once there, you will spend more money on other items than you would have done without the draw of the free item. To quote Milton Freidman “There is no such thing as a free lunch.”

It is estimated that, for Schwab, the cost of no trading commissions will be $90 million to $100 million per quarter or about 3% to 4% of annual revenues. Since commissions have no overhead attached to them, they are pure profit for the firm. So, how does Schwab see other sources of profit making up the difference? One source may be the announced subscription-based digital financial advisory service. This service seems to be a discount off of the prior advisory services, since it replaces the 0.28% of assets under management with a flat $30 per month fee. Seems like a deal doesn’t it? So, what’s not to love? The impact on the retail individual investor is what. 

The retail investor in the market who buys and sells stocks and bonds “on their own” is rare these days. Most individual investors rely, directly or indirectly, on financial advice from some third party. Sometimes this advice is through an actively traded mutual fund, sometimes this advice is from face-to-face advice from an individual financial advisor, and, increasingly, this advice is from a digital service, a so-called “robo-advisor.” Most of the individual investors rarely actively trade on a daily, weekly, or even monthly basis.   

So, for individual investors, I see little benefit from no trading commissions—perhaps a few dollars a year. The move to Schwab will include a “free exchange” of their existing financial advisor for Schwab’s new digital service, in the form of an Artificial Intelligence, at $30 a month. An individual investor would need to save $360 per year on trading commissions to equal the costs of replacing what you have today—or even higher if they hold Schwab’s mutual funds. 

So, the risk to individual investors is being lured in with the promise of a “free lunch” and end up paying more in the long run for unnecessary services they do not need, while missing out on the personalized advice that they do.      

Matthew F. Erskine is the managing partner of Erskine & Erskine LLC.