By Liam Pleven
This has been a good year for big online brokerages. That could
be a bad sign for many investors.
TD Ameritrade Holding says customers are trading more
frequently, and placing more trades using options. E*Trade
Financial also reports that trading activity is up. Both firms say
customers are borrowing more money to buy securities--as does rival
Charles Schwab.
This kind of activity makes money for brokerages, and it is
among many reasons the firms have been doing well nearly six years
into a bull market for stocks. (The firms report their net revenue
and net income are up year over year in the most-recent
quarter.)
Yet buying and selling stocks too often, investing borrowed
money and trading complex options can increase the risk that you
will underperform the market or suffer sudden, outsize losses.
Investors should think hard about whether such moves are beneficial
for them.
Most investors would be better off buying and holding
diversified mutual funds that charge low fees, many financial
advisers and analysts say. If you deviate from that path, be aware
of potential consequences, and do it sparingly.
Take trading. TD Ameritrade says its per-share earnings go up
one cent when clients place an additional 3,000 trades on an
average day over the course of a year. Clients averaged nearly
427,000 trades a day in TD's fiscal year ended Sept. 30, up from
nearly 374,000 in the prior year, according to the company--a 14%
increase.
The cost of trading has come down, and commissions are often
less than $10 for an online trade, much lower than a few decades
ago. That's a good thing for investors when they do trade. The risk
is that investors will trade more often.
"When you make something easier, sometimes people just do it
more," says Terrance Odean, a finance professor at the University
of California, Berkeley.
Instead, consider the cost of trading as one more hurdle to
making money. If you pay a $10 commission to buy 20 shares of a
stock that costs $50 a share, the stock needs to rise 1% for you to
break even. You pay when you sell stock, too.
Keep in mind that research by Mr. Odean indicates that, on
average, the stocks that individual investors buy tend to
underperform the stocks they sell.
The bottom line: If you take the risk of buying individual
stocks, find stocks you are able and willing to hold on to.
Lending money to investors to buy securities--a so-called margin
loan--also can be profitable for brokerages, which charge interest
on the borrowed money.
As of Sept. 30, E*Trade had $8.1 billion in outstanding margin
loans to clients, up 31% from the prior year. Schwab had $14.4
billion in outstanding loans, up 20%.
Investors can use margin to amplify their bets. For example, an
investor who buys $5,000 worth of stock in a given company could
borrow up to another $5,000 to buy more, says Randy Frederick,
managing director of trading and derivatives at the Schwab Center
for Financial Research.
That can pay off if the stock rises. But using margin also can
magnify any losses, cutting into your original investment and
leaving you on the hook for any difference between what you
borrowed and what the shares you purchased are now worth.
"Margin is a two-edged sword," Mr. Frederick says.
If stock prices decline significantly, you also could have to
put up more cash as collateral, in what is known as a "margin
call." If you can't, your position could be sold from under you,
locking in the losses.
Brokerages must determine whether using margin is suitable for
an investor before approving them to borrow. But do your own gut
check. Don't take out a margin loan if you can't afford to lose
both the money you put up and the money you borrow. Remember that
interest on the loan--which currently ranges from 6% to 8.5% at
Schwab, for example--is another hurdle to making money.
Options--which, among other things, can give investors the right
to buy or sell a stock at a specified price by a given date--also
can be hazardous to your portfolio and should be handled with
extreme care.
Brokerages generally require that investors be specifically
approved to trade options. Steven Quirk, senior vice president of
trading at TD Ameritrade, says roughly 70,000 of the firm's more
than six million accounts use options for the first time in any
given 12-month period. The company approved 29% more applications
to use options in the three months ended Sept. 30 than in the same
period a year prior.
Limit yourself to strategies that could curb volatility, not
ratchet it up. Investors, for example, can limit potential losses
by "collaring" a position they already hold in a certain stock by
selling an option that lets another investor buy the shares at a
higher price while also buying an option to sell the shares at a
lower price.
But it is a rare investor who needs that kind of protection,
says Larry Swedroe, director of research at BAM Alliance, a network
of investment advisers based in St. Louis. He offers the
hypothetical example of a 95-year-old investor who doesn't want to
sell long-held shares that have risen significantly because that
would trigger a big capital-gains tax bill. Heirs, by contrast,
will typically owe taxes when they sell based on the share price at
the investor's death.
Rather than engage in potentially risky activities, consider
what it means that other investors may be doing exactly that in the
current bull market.
"Good news makes people forget that there's risk," Mr. Swedroe
says. "It always ends badly. Always. It's just a question of
when."
Email:
liam.pleven@wsj.com
Access Investor Kit for E*TRADE Financial Corp.
Visit
http://www.companyspotlight.com/partner?cp_code=P479&isin=US2692464017
Access Investor Kit for The Charles Schwab Corp.
Visit
http://www.companyspotlight.com/partner?cp_code=P479&isin=US8085131055
Access Investor Kit for TD Ameritrade Holding Corp.
Visit
http://www.companyspotlight.com/partner?cp_code=P479&isin=US87236Y1082
Subscribe to WSJ: http://online.wsj.com?mod=djnwires