Sep 16, 2018

A Low Cost Investor

We hear repeatedly that the best returns are generally found with lower cost firms and financial instruments. Over twenty years ago, I accepted this mantra and opened an account with Charles Schwab. I was intrigued by their low cost indexed mutual funds, the vast amount of information they then would mail me, and their mostly zero account fees.

Fast forward and now there are multiple brokerage firms, including Schwab, that often charge nothing for maintaining an account, close to nothing for an exchange traded fund and often nothing for a trade. 
They charge me nothing for my bank account, nothing for my American Express Credit card (with a 1% cash refund) and nothing for new checks. All fees for cash withdrawals from any ATM world wide are refunded. They also charge nothing to trade and hold US Treasuries.

One day I realized that I could put all of my wife's and my money into a couple of low-cost stock and bond ETFs, and a basket of individual stocks and Treasuries, and it would incur very close to zero fees forever.

We now have most of our life's savings with Schwab, and I have wondered to myself, if they charge so little, how does a firm like Schwab make its money from me? So I walked through all of our Schwab accounts and their transactions from the past twelve months. Here is what I found. 

First, Schwab probably does not make much money from us. Much of our money is in very low cost ETFs, plus some international and bond funds that charge a little more. All of our funds in total have an annual fee of about .12%. I also made 6 trades during the year at $5 apiece.

Second, they do get some significant money from us through their bank. We averaged a bank cash balance of $6,000, which they loan out to others and pay us almost nothing in interest. We also have a home equity line of credit that incurs about $2,000 a year in interest.

Further, our overdraft account ran up $200 in interest. Although we get cash back on our credit card, Schwab has surely received something back from the tens of thousands of dollars we charge on it.

I reviewed Schwab's 10-K report and found that they make half of their money from their banking operations, which is consistent with where they make their money from us. The rest comes primarily from asset management and brokerage administrative fees, their next source of money from us. Finally, less than 10% of their revenue is from trading, where we provide them almost no revenue.

Being one of the lowest cost operators in the industry has made Schwab one of the largest brokerage firms and banks in the country. And they did it primarily by providing great products and services at a very low cost.

So, no, Schwab does not receive a lot of revenue from our investments, but at the same time, it doesn't cost them much to hold them. Low-cost, online investing is primarily a rich set of software that automates what was once a labor-intensive manual process. 

When I sign onto their website to either get information or to transfer money in or out of accounts, funds or financial instruments, this all happens electronically. The incremental costs for any of these actions are close to zero, regardless of how much money is transacted. Software doesn't operate differently whether transacting $100 or $100,000. Once software is running, your investments are reduced to bits on a disk that are either on or off.

What does it mean for my wife and me? It means that we retain nearly all of our investments and their gains, one of the most important figures to consider when investing. Compare this with many funds and services that normally charge 1-2% of your investments, regardless of how they perform, and hedge funds that normally charge 20% of gains.

Low-cost, online brokerage and banking services are one of the great wins available to all from the past couple of decades of technological advances, and make available to the lowliest investor amazing opportunities at close to zero cost. Yes, it's for real. And it works.