No free lunch

When 24 brokers gathered under a buttonwood tree outside 68 Wall Street in 1792 to set up the precursor of today’s New York Stock Exchange, one of the two conditions they all agreed upon was related to the amount of minimum brokerage commission they would charge their customers. Fast-forward to 2013. Go to any Pakistani website that is likely to attract viewers with some understanding of stock investments, and you’ll come across online advertisements of brokerage houses offering their services at extremely low or no brokerage commission at all. We know there’s no such thing as a free lunch. Somebody, somewhere is always paying for everything that is on offer, apparently, for free, including brokerage services. But still a large number of retail investors fall prey to such advertising tactics and open trading accounts with brokers doing retail business ostensibly at zero per cent commission.

Such unsuspecting retail investors base their decision on one premise. No matter which brokerage house they trade through, there is little chance they’ll get customised investment advice, unless they happen to be high net worth individuals (which means an initial investment ticket size of at least Rs5 million). So, why pay a brokerage fee at all if retail investors are supposed to trade on their own in any case.

But most retail investors seem to miss the point that the quality of research is what differentiates a good brokerage house from an ordinary one. A brokerage business that lures investors on the pretext of zero per cent commission is more likely to produce second-rate research compared with one that charges a minimum fee for its services.

The analyses of stocks constitute a highly complex, data-oriented exercise that involves statistical models and risk management tools. I was once shown a financial model for OGDC, a KSE-100 Index heavyweight, which spanned at least two dozen Excel spreadsheets. This kind of research requires heavy data gathering, sophisticated software and highly skilled personnel with a solid grounding in finance.

In the absence of the availability of quality research, retail investors end up buying cheap stocks offering a huge upside in the unlikely case of an uninterrupted, long bull run. In many cases, such stocks are low-priced precisely because institutional investors have little interest in them. So, when the overall market undergoes a routine correction, the prices of relatively inexpensive stocks fall disproportionately, hurting retail investors the most. Ultimately, going to a cheap brokerage house deprives retail investors of a major chunk of their investments. In brokerage parlance, ‘free’ means expensive.

Published in The Express Tribune, October 20^th, 2013.