What is the bid-ask spread? Why should you pay attention to it? And, how exactly can you avoid paying this pesky fee? Those are the three questions we are going to answer in today’s blog post.
Robinhood, a newer investing platform with its own snazzy app, aims to revolutionize the investing industry by making free trades possible. It almost sounds too good to be true.
Are trades truly free with this platform? Does Robinhood really move wealth into the hands of the common man?
Unfortunately, the answer is “no.” The reality is, there’s no such thing as a free trade.[toc]
Here’s why: Trading and investing, in general, come with many costs. However, most people are only familiar with some of the costs of investing.
Investing fees people tend to know and understand include:
- The commission fee to trade a stock – such as $4.95 at Charles Schwab, or “free” at Robinhood
- Taxes on any increases in the value of your investments
- Perhaps an administrative or a setup fee that folks may get charged in a workplace-provided 401(k)
- The fee charged by your financial planner to manage your investments for you, and to invest on your behalf
- Investment fees which could be mutual fund fees, exchange-traded fund (ETF) expense ratios, or the hilariously-high fees of private equity and hedge funds
It’s easy to see why one may think that the fees listed above are the only ones you’ll ever pay. That’s because all of these fees are visible.
Usually, you’ll see these fees listed as a line item on your regular account statement. You see – in 12 point font – exactly what you are paying for.
It may look something like this:
8.8.17 – $4.95 – Trading Commission
10.1.17 – $1,128.43 – Asset Management Advisor Fee
12.31.17 – $10.00 – Account Administration Fee
The thing is, if you believe those are the only fees you’re paying to invest, you are wrong. There’s another very important fee that you will never, ever see you on your account statement.
Define Bid-Ask Spread
Unfortunately, free trades aren’t really free due to a concept called the bid-ask spread.
There’s simply no other way for me to explain how costs are hidden without bringing up the esoteric term called the bid-ask spread.
But, I must because the bid-ask spread is where massive investment costs can hide – costs which will eat away at your investment returns if you are not very, very, careful.
Let’s start with an example to help explain what a bid-ask spread is before we define the bid-ask spread.
Joe wants wants to buy a small value index fund. This is genius on Joe’s part.
Small value stocks have outperformed any other category of investment historically – and using an index fund means that Joe will not only keep his costs low, but reduce risk by diversifying across the entire asset class that is small cap value.
Good job, Joe!
Joe picks the SPDR S&P 600 Small Cap Value ETF (SLYV) and saunters over to Charles Schwab to place a trade.
Let’s take a look at the numbers. SLVY – an exchange-traded fund (ETF) – is trading at $119.91. But, in order for Joe to purchase one unit of SLYV, he must pay the ask of $119.99.
In short, as soon as he places his trade (market order for those who want to get technical), Joe loses eight cents, or 7 BPS (0.07%), of his investment.
While 0.07% isn’t huge, it can be twice the expense ratio of some ultra-low-cost mutual funds.
And while Joe isn’t paying a $4.95 trade fee, he certainly isn’t buying the investment for free. The trade is not free. It has a cost – one that is very well hidden.
The Psychology of Free Trading
Self-guided investors may give themselves a pause when they need to decide if trading warrants paying a trade fee. But, the absence of such a fee may remove that hesitation to act. As such, investors taking advantage of free trades may witness themselves trading more frequently – wherein the cost of the bid-ask spreads begin to add up.
While a 7 BPS expense for a one-time trade may not be detrimental to one’s investment returns, 7 BPS compounded over time will. That’s because fees add up – and the magic of compound interest means that a fee paid now means losing big money in the future.
Bid-Ask Spreads Gone Wild
I am being nice in the above example. Bid-ask spreads can be much higher which is why I highly suggest paying attention to this little-known investing fee.
Bid-ask spreads don’t just apply to exchange-traded funds (ETF’s) either. Individual stocks also have a bid-ask spread to monitor.
For a more extreme (but still common) example, let’s look at the San Diego-based company Tocagen (Ticker: TOCA).
As of this writing, the stock is trading at $11.54 per share. However, if you put in a market order to purchase the stock, you would have had to pay the ask of $11.76/share.
That’s a hidden cost of almost 2%! Factor in a small trading fee of $4.95 and you might have a pretty big hurdle to get over on day one.
Using Mutual Funds to Avoid Paying the Bid-Ask Spread Twice
At Define Financial, we almost exclusively use mutual funds. (A lot of the mutual funds we use trade for free.)
We use mostly mutual funds because trading ETFs requires greater due diligence. We also use them to minimize the impact (cost) of bid-ask spreads from stocks and ETFs.
Side note: The mutual funds we use are low-cost, index investments. Of course, there are low-cost index investments available in ETFs as well. Either mutual funds or ETFs can be used for low-cost investing. However, mutual funds have certain advantages (described in this blog post) over ETFs.
As mentioned already, when you buy a stock or an ETF, you’re paying a bid-ask spread. However, when you buy any fund (be it a mutual fund or ETF), the fund manager pays a bid-ask spread.
So, if you’re buying an ETF, you’re losing money because of the bid-ask spread twice: first, when you buy the ETF, and secondly when the ETF manager buys the securities comprising the ETF.
You can avoid paying the bid-ask spread twice on the same investment by either:
- Using mutual funds
- Buying your individual stock and/or bond picks directly
For most investors (ourselves included), the second option is a non-starter. This is because picking the few investments that will outperform is a loser’s game, and because buying enough investments to achieve an appropriate level of diversification is cumbersome.
Don’t Fall for Free Trading
If you see a company advertising free trades or promising to help you grow wealth for free, think twice before you pull the trigger.
Remember, you will be paying the bid-ask spread, even if a trade appears to be free. Also, free trading may tempt you to change your investments more frequently than necessary. Frequent trading can increase internal costs and reduce your long-term returns.