• Many brokers are slashing commissions down to zero to remain competitive with one another, but the question remains: How will they make money?
  • Today, Alexander Green explains the upside – and downside – of commission-free trading for wealth builders.

The cost of trading stocks has been coming down for decades.

It started in 1975, when regulators abolished fixed trading commissions. (Until then, you had to pay a minimum commission of $49, equal to $176 today.)

Charles Schwab responded by immediately slashing trading costs for its clients, becoming the first true “discount broker.”

Merrill Lynch – surprise, surprise – used deregulation as an opportunity to raise its commissions.

With the advent of online trading in the late 1990s, the cost of trading stocks came down further still.

That competition is now over, however.

Earlier this month, Interactive Brokers slashed brokerage commissions all the way to zero.

Schwab, TD Waterhouse and E-Trade – afraid of their most active traders making an exodus – quickly followed.

Now that brokerage commissions have gone the way of the ticker tape, it seems like an unalloyed good for traders and investors.

Yet you should be aware of a few potential drawbacks.

Let’s start by asking the obvious question: If discount brokers now charge you nothing to trade, how will they make money?

The short answer is the same way they always have, by milking clients’ cash. By that I mean these firms invest that money at higher rates – for themselves.

Most investors are not aware that Schwab, the nation’s largest discounter, derives the majority of its revenue not from fees or commissions but from net interest income.

It takes the billions that clients leave uninvested in their accounts and puts them to work in riskless assets – like short-term Treasurys – that yield substantially more.

Schwab’s standing policy is to automatically sweep idle cash not into money market funds that could yield 2% at today’s rates but into its own bank, which pays peanuts.

Schwab, in fact, estimates that its new policy of commission-free trading will reduce annual revenue by less than $400 million. That’s only about 3.8% of its $10.6 billion total.

(Now you know why the stock has held up reasonably well in the face of this month’s news.)

What should you do as an investor? Contact your broker and tell him or her to put your cash into a specific money market fund.

For example, I always instruct my broker – E-Trade – to put any idle cash into the Vanguard Municipal Money Market Fund (VMSXX). (This requires placing an actual buy order.)

The yield isn’t terribly exciting at 1.3%. But it’s exempt from federal taxes and beats the heck out of the 0.05% that the typical bank or brokerage pays.

And, not that it really matters much with such a microscopic yield, but that 0.05% is also taxable.

So the first order of business in the new era of zero commissions is to make sure your cash earns a real return. (Because if your money is earning five-hundredths of one percent, the return after inflation is definitely negative.)

Secondly, be alert that brokers – including discounters – have a new incentive to sell fee-laden financial products to make up for the loss of revenue.

I’ve written before about the fat commissions, hidden costs, high management fees, egregious surrender penalties, contractually limited upside potential, unnecessary complexity, and illiquidity of whole life insurance and variable annuities.

But there are dozens of other structured financial products out there. Do yourself a favor and give them a wide berth.

Another potential downside with zero commissions is that some investors may be tempted to trade too frequently. (After all, it’s free!)

History shows that day traders generally go back to their day jobs, since share price movements from hour to hour and day to day are almost totally random.

(Day trading is gambling, not trading or investing. If you haven’t learned this yet, you may have an expensive lesson ahead of you.)

Also, too frequent trading can generate an outsized tax bill, as short-term capital gains are taxed at the same level as earned income, which may be as high as 37%. And that figure doesn’t include state income taxes.

So try to restrain yourself. And when you do trade short term, do it in your qualified retirement account if possible, where your gains will compound tax-deferred.

You’ll thank me come April 15.