Which broker is the cheapest?

If our intent in investing is to generate a profit, then it is prudent to reduce our expenses as much as possible. One of those expenses is the commission on our trades and any monthly or annual fees.

Depending on your chosen strategy and account type, one broker might be better than another. I’ll be looking at this from the point of view of implementing the No Lose Stocks (NLS) strategy in a Traditional IRA account. The NLS strategy requires buying 100 shares of stock and 1 Put option contract on the same stock.

Broker summaries

Here is a summary of the pertinent data for each of the 4 brokers I considered:

Zecco (http://www.zecco.com):
– Stocks 10 free trades per month
– Options $4.50 + $0.50 per contract
– $30 account fee for IRAs (each account!)
– 0.1% interest on balances

TradeKing (http://www.tradeking.com):
– Stocks $4.95
– Options $4.95 + $0.65 per contract
– No IRA fee
– 0.9% interest in sweep money market account

Fidelity (http://www.fidelity.com):
– Stocks $10.95
– Options $10.95 + $0.75 per contract
– No IRA fee
– 2.45% interest on balances

InteractiveBrokers (http://www.interactivebrokers.com):
– Stocks $.005 per share which is about $0.50 per 100 shares, with a $1 minimum
– Options $0 + $0.70 per contract for > .10, .5 to .10 is .25 to .50 per contract. $1 minimum.
– $10 fee per month ($120 per year per each account), less transaction fees.
– 1.5% interest on balances greater than 10k

Fidelity vs. Trade King

Trade King beats Fidelity if you are only making one NLS trade per year. Trade King costs $10.55, while Fidelity costs $22.65.

Unless you are planning to keep a large amount of cash in a money market Fidelity seems to be a bad choice for the NLS strategy. Their higher money market interest rate is their only saving grace. But since my positions are completely protected by the Puts, I will be keeping as much of my money invested as possible to expose my portfolio to as much positive luck as possible. So I won’t be generating interest income.

Trade King vs. Zecco

Trade King beats Zecco for less than 6 trades per year. At 6 trades per year, Trade King would cost $63.30 and Zecco would cost $60. The average trade using NLS requires about $6500 and lasts for 4 months. With 6 trades per year, that’s about 2 trades per 4 months, which would require a maximum of $13000 in capital. So if you’re planning to invest more than $13000 using NLS then Zecco is better than TradeKing.

Zecco vs. Interactive Brokers

Interactive Brokers (IB) charges $2 per NLS trade with a minimum of $10 per month. So if you only do 1 trade in a month, then you pay $2 in commissions plus $8 in remaining fees. If you do 6 trades per month, then you just pay the $12 in commissions. So with 6 trades per year and 2 trades every 4 months that means you’re paying the minimum $10 each month. So that’s a total of $120 per year for IB. At that number of trades Zecco is still the better choice.

Zecco hits $120 at 18 trades per year. Assuming you split the trades up between months to be no more than 5 in a given month (or at least evenly split if more than 5), then at 18 trades or more per year, Interactive Brokers would be the cheaper alternative.

If you staggered the purchases to be 3 NLS trades every 2 months for a total of 18 trades in the year, and the average capital needed to fund a trade was $6500, you could do this with $39000.

Conclusion

So if you’re going to be investing in the NLS strategy with $39000 or more, Interactive Brokers seems to be the best choice.

Their software is a little complex, but once you figure out how it works, things move quickly.

If you need help, the NLS strategy is a specialized form of a “Synthetic Call” and falls under their “Combination” trades. So you can actually enter the stock and the Put you want and the total limit price you want to pay for both combined, then let IB go put the deal together.

Example Trade

I’m going to run through an NLS trade that I placed on this past Friday. I’m not recommending this stock. In fact, I’m not making any judgments about this stock at all. The whole point of NLS is that I am admitting that I don’t know what is going to happen, so I place multiple bets that have little to no downside and wait for one or more of them to hit. This is what I mean when I refer to fishing for luck.

The trade as reported in the NLS output on Thursday night was:

Stock: HNZ
Close: $51.38
Expected Dividend: $0.42 in December

Option: HNZML
Ask: $9.00
Strike: $60.00
Expiration: 1/16/2009

So I put in a limit order for ($51.38 + $9.00) $60.38. With 100 shares that requires an investment of $6038.00. Assuming the company does not cut their dividend, I expect to get a $0.42 dividend in December. So the minimum that I expect to get when I sell this stock is $60 plus the $0.42 dividend. That’s a ($60.42 – $60.38) $0.04 profit per share. At 100 shares, I should get $4.00.

Since I placed this trade with Interactive Brokers, the cost was $2, so I should net ($4-$2) $2 even if the stock goes down. That’s assuming they don’t cut their dividend. If they for some reason decide to cancel their dividend or pay it much later, then my maximum loss on the trade is $0.38 per share plus the $2 transaction fee, or $40. In percentage terms that’s 0.66% of the invested capital, so less than 1% of the capital is at risk.

And if the stock goes up more than 17% over the next 4 months, then I could make even more profit on this trade.

Where does the bail out path lead?

Inflation has been the topic of a few of the previous articles on this site. One article talked about how inflation is a manufactured phenomenon, and that deflation is the reality. Another article talked about ways we can deal with inflation, like by trying to out run it. And still another article mentioned Buffett’s comments on inflation in his 1983 Chairman’s Letter, but didn’t go in to the idea too far.

Buffett’s ideas on inflation

Let’s remedy that last one. Buffett’s idea is that he assumes that inflation will continue, so he’s looking to make investments in companies that will benefit from inflation.

Consider two different investments [1].

One company, a candy maker, needs $8 million in machinery to produce its goods and earns $2 million a year in profits. That’s a 25% return on invested capital.

Another company, a screw maker, needs $20 million in machinery to produce its goods and earns $2 million a year in profits. That’s a 10% return on invested capital.

Now consider what these companies would sell for. For a buyer, the first company looks more attractive if the buyer can just buy the machinery. If the buyer pays $8 million, the buyer can make a 25% return on the invested money. Even if the owner of the candy company raises the price to $15 million, the candy company is still a better deal. Only when the candy company costs $20 million does the return on the new buyer’s invested capital become the same for the two businesses. In this case that return is 10% in both cases.

However, now consider that we believe inflation will continue and that the costs to these companies will also increase. Let’s say that costs double.

For the screw maker, that means that the $20 million in machinery is now $40 million. But they are also able to sell the screws for twice as much, so they make $4 million a year in profits. The return on invested capital is still 10%.

For the candy maker, that means that the $8 million is now $16 million. And they too are also able to sell their candy for twice as much, so they make $4 million a year. So the original purchase price of $20 million, plus the new $8 million in inflated costs means that the total invested capital is $28 million. With a profit of $4 million, that means that the return on invested capital is ($4 / $28) about 14%. That’s much better than the 10% of the screw maker.

If the buyer now decides to sell the candy maker, the buyer should expect to get $40 million for it, since that’s how much someone would pay for the screw maker. But the candy maker buyer only paid $28 million total as opposed to the screw maker buyer who paid $40 million total. The screw maker buyer can break even. The candy maker buyer gets a ($40 – $28) $12 million profit.

So in an inflationary environment, a business that can make a higher return on its assets is worth more than a business that cannot.

Why bring up inflation now?

The solution being proposed by Congress is to buy our way out of the current problems in the financial sector. The proposal is to buy the bad loans from the banks that have them with $700 billion. That money is basically going to come from nowhere. It will be printed up and given to the banks in exchange for something that is not worth $700 billion. The way we know it’s not worth $700 billion is because there isn’t anyone else willing to buy these things at that price right now.

This is basically the engine of inflation at work. If you add $700 billion dollars to the money sloshing around in the economy, then the prices of everything rise to account for the extra money that people can now use to bid on stuff.

Unintended consequences

There’s a further problem caused by this bail out though. The government has now tipped their hand. Now an investor believes that any scenario that results in a blow up of the financial sector can count on a bail out from the government. So the investors have an incentive to risk more because they benefit from all the gains, but don’t have to suffer all the pains.

The more investors believe this, the more they are going to rely on it. The more they rely on it, the more real risk they ignore because they expect the government to bail them out. Until finally the real problems are so big that the government won’t be able to paper over them with printed money and the full force of the pain will fall on the investors, and probably everyone else as well.

This problem comes from the government trying to subvert natural laws. These would be things that go against the laws of physics. For example, the law of conservation of matter and energy says that you can’t create matter out of thin air. It has to come from somewhere. So if you try to create money or value out of thin air, eventually that’s going to come back to bite you.

Natural consequences

When I was a kid my brother and I would horse around sometimes. Eventually we’d knock heads or something and go crying to mom. She’d give us hugs of course, but then ask us if we were horsing around like we knew we shouldn’t be. We’d guiltily acknowledge and she’d sagely intone “Natural consequences”.

Mom was basically telling us that it was our own fault we got hurt and that the way of the world was that if you knew something was wrong, and you kept doing it, eventually you were going to get hurt.

Summing up

We’ve got the fact that deflation is the natural way of things, and that inflation is a manufactured phenomenon. We’ve got a way to profit from inflation by buying companies that make a higher return on their invested capital. We’ve got a government that is determined to use inflation as a problem solver until it no longer works. And we’ve got a reality that likes to knock our heads around to a harsher and harsher degree the longer we try to subvert it.

All that leads me to think that at some point the government is going to push inflation one step too far and prices are going to collapse and bring deflation back with a vengeance. I don’t have any insight into when that might happen. But if I follow my No Lose Stocks strategy then I should be able to benefit from the rise in prices due to inflation, and maybe even bet on the companies more likely to benefit from inflation (capital efficient companies). And if the prices do fall due to deflation, the Puts in the strategy will help me to keep my gains while other investors are scrambling to sell their investments.

[1] This example is basically the same example in Buffet’s 1983 Chairman’s Letter from the section called “Goodwill and its Amortization: The Rules and The Realities”, but you may find his version better, so consider taking a look at it. Do a search on the page for that title to find it. It’s in the appendix of the letter at the bottom.

How many histories are there?

In Taleb’s book, Fooled By Randomness, there is an interesting take on analyzing history. He calls it summing across histories. His point is that regardless of the actual outcome, it’s the many possible outcomes that we should consider when determining after the fact if the right choice was made.

For example, let’s say a janitor buys a lottery ticket every day of his life and wins one of those times, thus making him rich. That outcome of him winning, even with buying a ticket every day, is highly unlikely to happen. If he repeated his life a million times, he would probably never win the lottery in all those other life paths.

On the flipside, let’s say a dentist drills teeth every day for a 30-year career and then retires with a large nest egg. If the dentist repeated his life a million times, it is highly likely that he would end with a large nest egg in the majority of life paths.

The point here is that when we analyze history, we shouldn’t let the actual outcome affect whether we consider a decision a good one or not. Rather we should consider all the paths equally and not give undue weight to a good result that wasn’t also highly likely to happen.

Hindsight bias

We aren’t too bad at acknowledging that there are possibilities in the future, but we are terrible at seeing the possibilities that existed in the past. In behavioral finance, this blind spot for the possible past paths is called the Hindsight Bias. A more common name for it is Monday morning quarterbacking.

Once we know the outcome we generally think that things could only have turned out the way that they did. For the lottery winner above, even though it is highly unlikely that he would win the lottery, and is a waste of $365 a year to play, if he wins, no one will tell him that he was stupid for playing. Instead, they will likely congratulate him and tell him he was smart for playing.

This is very similar to the way that mutual fund managers are treated. We see the returns they have generated in the past and assume that they must know something. They must have learned some skill or intuition that allows them to pick the right stocks at the right times. And we believe that this same skill will allow them to pick the right stocks at the right times in the future after we give them our money to invest. And we think this no matter how many times we hear the words “Past performance is no indicator of future results.”

Ignore the best-case

Summing over histories implies that we should pay more attention to the worst-case scenario (since we usually ignore it), and for the most part ignore the best-case scenario (since we usually over emphasize it, meaning we get greedy). It also implies that we should be looking to reduce the range of the possible paths to a range that includes only possible results that we are comfortable with.

So let’s look at two examples of what we might expect as possible histories from our investing. Since we have difficulty seeing the possible past histories, I’ll use two examples of real stocks, one that has gone well up to now, and one that has not. By using two examples with different outcomes, maybe we can make it clearer to our brains what we are missing when we only look at the actual outcome and not the possible outcomes.

Johnson & Johnson

One possible good path a stock could take in the coming 20 years is the path that Johnson & Johnson has taken over the last 20 years.

We want to believe that of course we knew 20 years ago that JNJ would still be around today and still be a strong brand with a high stock price. But at the time 20 years ago we couldn’t have known that. We may have believed we knew it, but there are many possible paths where JNJ could have taken a turn for the worse, and not ended up where it is today.

It might help if we briefly list off a few things that could have happened to derail the stock’s upward climb, but did not.

One possibility is that their products could have been the targets of multiple terrorist attacks. A few randomly poisoned bottles of baby oil could lead to massive recalls and a drop in sales as people prudently switched to a safer brand.

Another possibility is that their management team could have been embezzling funds like Enron or Tyco.

Another possibility is that some other company could have merely out competed JNJ and stolen market share from them.

So the path that JNJ has taken so far is really only one of many, and is actually an example of one of the better paths the company could have taken. Many other unsavory ones were just as likely 20 years ago (and even today).

The chart below shows the value of one dollar invested in JNJ over the last 20 years. One line represents the buy and hold strategy, and the other line represents the no lose strategy. With the no lose strategy the losses are completely removed , while the gains are only dampened. In this case we’re assuming a 15% lag in the profits for the no lose strategy. So if JNJ goes up 20% in a year, the no lose strategy only gains (20% – 15%) 5%.

With the buy and hold strategy we could have made 22 times our money over the last 20 years. So we start out with $100k, and we end up with $2 million. Seems pretty simple. Nice and easy. We know how great of a company JNJ is so we just drop the money down and wait 20 years. (But of course as pointed out above, we don’t know that JNJ is going to be a great company, we only think we do.)

With the no lose strategy we could have only made 5 times our money over the last 20 years. So we start out with $100k, and we end up with $500k. That’s not bad. It’s a return of about 8.2% a year over the 20 years. But it’s a far cry from the $2 million for buy and hold.

If we stopped our considerations here our biases would convince us that buy and hold is the better strategy. Buy and hold had a higher return over the long-term, but we’d be ignoring the possibility of a loss on the downside.

Fannie Mae

Now consider a possible bad path that a stock could take like the path that Fannie Mae has taken over the last 20 years.

There are probably a great many pundits saying that they knew that FNM would collapse one day, and another great many that said FNM could never fail because of it’s implicit government guarantee. But again, 20 years ago, we had no way of knowing what path FNM would take. The changes in interest rates, the wars or lack of wars, the changes in different countries’ governments and economies are all things that were unknowable. We couldn’t know these things and so we couldn’t accurately predict how they would affect FNM in the future (whether or not we now believe we could have).

The chart below shows the value of one dollar invested in FNM over the last 20 years. One line represents the buy and hold strategy, and the other line represents the no lose strategy. With the no lose strategy the losses are completely removed, while the gains are only dampened. In this case we’re assuming a 15% lag in the profits for the no lose strategy. So if FNM goes up 20% in a year, the no lose strategy only gains (20% – 15%) 5%.

With the buy and hold strategy we could have made about 20 times our money over the last 20 years, with a peak of as much as 45 times our money. However, the chart only shows FNM through January of 2008. If we pushed it forward to today, where the last FNM closing price is $0.74 per share, we would have a 26% loss from our original money. So over 20 years, if we started with a $100k investment, we would have at one point had $4.5 million, but eventually only $74k left of our original investment.

With the no lose strategy we could have made about 23 times our money over the last 20 years. So we start with $100k and end up with $2.3 million. That’s actually quite good, better even than the JNJ buy and hold above. That’s the equivalent of a return of about 16% per year.

Summary

The thing to realize here is that both JNJ and FNM, and all stocks, are highly affected by randomness, and are vulnerable to situations and circumstances that we can’t know about beforehand. Even something that looks really good today (like JNJ now, or FNM about 6 years ago), could eventually turn sour, and do so very quickly. And it is nearly impossible to tell when a stock is turning permanently sour, or just “correcting” before moving higher.

The idea then is to choose the strategy where the possible paths lead to a comfortable outcome the most often, even if that outcome is not the highest success conceivable. So we give up a shot at the best-case result, in exchange for avoiding the worst-case result, and getting a high likelihood of hitting a comfortable-case result.

What about IRA penalties?

Putting money in a traditional 401k or IRA is a good idea if only for the tax benefits. In the last article on how to invest a 401k I noted that someone in the 25% tax bracket gets an instant 33% gain on their money just by depositing that money in the 401k or IRA.

But 401ks and IRAs have restrictions on when we can make withdrawals. Namely, if we withdraw the money before age 59 ½, then we are required to pay a 10% penalty fee.

This seemingly puts a cramp in the plans of someone who is planning to retire early and wants to take advantage of the tax advantages of IRAs and 401ks. If a person started working at 22 and saved 50% of their income in order to retire in 20 years at 44, then it would seem they’ve still got 15 ½ years left before the money will be penalty free.

While there are a few well-known ways to make IRA withdrawals without the penalty like for buying a first house or for education expenses, there’s also one that’s not so well known called Substantially Equal Periodic Payments (SEPP).

SEPP says that if we agree to take money out of our IRA on a pre-defined schedule, then we can avoid the 10% penalty. This actually turns out to be kind of convenient. We’ll basically be replacing a regular paycheck from our job with a regular paycheck from our IRA.

This article on SEPP is a good primer on the subject.

SEPP can be a little complicated and situation specific, so you’ll want to research it more than just reading that article, but just knowing that the option for penalty-free withdrawal exists opens the way to using them in our financial planning.

No Lose Stocks addition

I added a small but interesting feature to No Lose Stocks this past weekend. I noticed in some cases that instead of buying the put and stock, it’s a better investment to take the money I would have invested in the put and stock, and instead to put that in a money market account, and then use the interest to buy a call option at the same strike price.

The new column shows an interest rate. This is the interest rate you would need to earn to make the call a better investment than the put and stock combo. That way you can decide for your own situation if the call option is better for you depending on where you park your cash.

Here’s a recent example to illustrate.

The data from Friday, September 5, 2008, says that JNJ could be purchased for $70.67 per share, and that a put option expiring on January 15, 2010 with a strike price of $80.00 could be purchased for $11.50. The total amount invested then to put on this trade would be ($70.67 + $11.50) $82.17 per share. Assuming you get the expected $2.30 in dividends by the expiration date, this trade can only go up. So you won’t lose money, but on the flip side you only profit if the price of JNJ goes over $80.00 before January 15, 2010.

Let’s say you consider buying 100 shares of this trade, which would be an investment of (100 * $82.17) $8,217.00. Then let’s say you look at your money market and notice that it’s paying 3.5% interest.

If you deposited that $8,217.00 in the money market for 496 days (the time to expiration), you would make roughly $390.00 in interest.

Another way to make money if the price of JNJ goes over $80.00 by January 15, 2010 is to buy the call option with that strike and expiration. That call option costs $2.60 per share. The $390 in interest divided by $2.60 means you could buy 150 shares of the call option and be in a similar situation to buying 100 shares of the put and stock combination. That means that if you get lucky and JNJ does go up, then you make more money owning the call option than you do owning the stock and put option.

Tracking results

It was suggested that I start showing some results for the Inflatable Dividends and No Lose Stocks Premium Services in order to market the services better. I have a bit of a moral dilemma on this though.

Here’s my dilemma. I don’t use the Inflatable Dividends service. I did initially, but that investing strategy doesn’t fit my goals any more. It exposes me to more risk than I’m willing to take and it doesn’t guarantee that I won’t suffer large negative changes in my account balances.

I’m only willing to be exposed to a very small fixed amount of risk (like the possibility of a dividend being cut). With Inflatable Dividends, since I first have to buy back the call option before I can sell the stock, it’s possible that the stock price could fall fairly far before I could sell the stock. So Inflatable Dividends doesn’t meet my requirements.

But I also recognize that I shouldn’t make decisions for other people because what I want may not be what they want. So I will continue to provide the Inflatable Dividends service as long as people want to subscribe to it.

However because of my behavioral finance research I’m also aware of people’s confirmation bias. This bias means that we look for information that agrees with our current opinion. The information doesn’t prove we are any more right, but we feel much more right. This is like the black swan problem. No matter how many white swans you see, you can’t prove there are no black swans. But the more white swans that you see, the more you will think that you are right that there are no black swans.

So if I posted trade results for the Inflatable Dividends service, it’s possible that they will be good for a long while, and would lull potential subscribers into a sense of safety and consistency. But it could be a false sense of security. If one bad trade can wipe out all the gains made on the previous good trades, then all those good trades are meaningless.

I have the opposite problem with No Lose Stocks.

I do use this service and it does fit my goals of a specifically limited amount of risk. But it suffers from the opposite problem that Inflatable Dividends has. The No Lose Stocks strategy can look wrong for a long time. It can look like you aren’t making any money because a lot of the time you are just breaking even. Then suddenly one of the stocks you own will pop up on good news and you’ll have a gain. The whole idea of the strategy is to make one-way bets and then wait for luck to strike.

A history of these trades looks like a lot of non-winning trades and then suddenly a win. So a history of the trades would scare off or discourage someone who didn’t understand the strategy because it doesn’t have the flash of lots of winning trades.

Either way I don’t think it would be a net gain to post a history for either service.