YOU Are the Product
The retail brokerage industry began in New York City in 1792 with the signing of the Buttonwood Agreement. It established the organization now known as the New York Stock Exchange and fixed commissions for customers at one quarter of one percent. One hundred eighty-three years later, the discount brokerage industry began with the deregulation of stock commissions through the Securities Acts Amendments of 1975.
I’m offering this history lesson to make the point that just because you can’t see the costs associated with a purchase, it doesn’t mean they’re not there. As Robert Heinlein famously said in his 1966 science fiction novel The Moon is a Harsh Mistress: “there ain’t no such thing as a free lunch,” noting that bars which serve a free lunch also charge more for drinks.
The New Scientist recently reported on Purdue student Abhinav Pathak’s research into the battery usage of free games for mobile phones. He found that the popular game Angry Birds uses about 20% of the total power it consumes on the game itself and the remainder on determining where the user is, downloading location-appropriate ads and keeping the wireless connection open. In a somewhat more candid approach, take a look at Avery. I recently downloaded free software to create custom note cards. It makes the design process much easier and it’s obvious what Avery gets out of providing the software - increased sales of their extensive line of blank card stock.
“Rollover your 401(k) and get a year of free trades.” Does this advertisement sound familiar? Variations on that theme are legal because of the deregulation of commissions but, from a business perspective, how is it possible? How can the brokerage firm give away something that has had cost associated with it for well over two hundred years?
Since brokerage firms are retail businesses, it’s possible that we’re seeing an example of a loss leader, a deeply discounted deal advertised in hopes of bringing you into a business. Once there, the retailer anticipates that you’ll spend money on more appropriately priced items. In this case, perhaps if you accept their offer, you’ll also transfer your non-retirement account and the brokerage firm will be able to charge its normal commissions. After a year, the free trade period is up but the firm hopes the friction which is part of any transfer process will keep the account with them instead of the customer chasing after another offer.
In addition to commissions, there are less obvious ways that a brokerage firm can make money. During the housing bubble, new mortgages were replacing old ones at a previously unheard of rate and Merrill-Lynch stockbrokers were paid for referring their customers to another M-L division for new mortgages. Even in more normal times, brokerage firms have additional sources of income. It’s easy to enter an order to purchase a stock on-line and see that the commission was added as expected but do you pay attention to the firm’s role in the transaction? Did they act as your agent, buying in the open market or as principal, selling shares from the brokerage firm’s own inventory? If principal, do you have any idea what the firm might have paid for the security you bought? It was almost certainly sold at a profit. Likewise, buried in the contract you signed when you opened the account is language describing what’s called “payment for order flow,” a concept originated by the investor’s good friend Bernie Madoff. These are fees paid to brokerage firms by market makers for routing orders through them instead of the NYSE.
Both of these factors make it difficult to determine whether you really got a good deal or not. Although “best execution” is broadly required on the aggregate of all trades made for all customers, it’s pretty hard to tell how a small investor who is unable to demand the best prices did on any particular transaction.
Of course, financial planning services are also offered on the web and a recent Bing search for “free financial planning” returned 410,000,000 links. WWA Planning & Investments provides personalized planning which at least some people find worth paying for. As I’ve discussed, the “free” alternatives are certainly making money somewhere. It’s up to each consumer to decide if free services are worth their true cost.