On October 1, 2019, Charles Schwab announced commission-free trading in stocks, ETFs and options trades. Other online broker rivals followed suit shortly afterward. Did the introduction of commission-free trading affect investor behaviour? William Johnson, Surendranath Rakesh Jory, Tanakorn Likitapiwat and Thanh Ngo, authors of the study The Liquidity Impact of Commission-Free Trading on Stocks with Lottery Features, published in the January 2024 issue of , hypothesised that because of the well-documented retail investor demand for “lottery-like” stocks, eliminating the broker’scommission would lead to their increased trading.
The academic research, including the 2023 studies, Lottery Preference and Anomalies and Do the Rich Gamble in the Stock Market? Low Risk Anomalies and Wealthy Households, the 2022 study, Lottery Demand and the Asset Growth Anomaly, and the 2014 study, Do Investors Overpay for Stocks with Lottery-like Payoffs? An Examination of the Returns on OTC Stocks, has found that there are investors who have a “taste,” or preference, for lottery-like investments. Stocks with lottery features tend to exhibit low prices, positive skewness and excess kurtosis (fat tails), and greater idiosyncratic volatility, all while generating poor returns. The poor returns are the result of irrational demand (from a traditional finance perspective), which drives prices higher. The behavioural finance explanation for this irrational behaviour is that investors place a high value on these trades. Thus, they are willing to buy them (perhaps because they enjoy the excitement) even though they offer low average returns.
If providing commission-free trades increased retail trading of these lottery-like stocks, the losers would be the naive retail investors who overinvested in stocks with historically well-below market returns. And because outperforming the market is a negative sum game (once costs are considered), any increase in trading would likely lead to lower returns for investors engaging in that behaviour. The winners would of course be the brokerage firms – while sacrificing commissions, they would earn far more on revenue gains from increased payments for order flow, the ability to match more buyers and sellers internally, and the enhanced ability to gauge supply and demand in the market and influence their proprietary trading.
Johnson, Jory, Likitapiwat and Ngo’s sample included all stocks (4,520) with available data in both the Center for Research in Security Prices (CRSP) and Compustat databases in the (-252, +252) days around the event date (October 1, 2019). They classified stocks into three groups: 1) lottery-type stocks, 2) non-lottery-type stocks and 3) other stocks based upon three stock characteristics, namely, idiosyncratic volatility (IDIOVOL), idiosyncratic skewness (IDIOSKEW) and stock price (PRC). They defined lottery-type stocks as the stocks in the highest 50th percentiles of IDIOVOL and IDIOSKEW and in the lowest 50th percentile of PRC. Stocks with lottery features were defined as being cheap to buy, generating abnormally extreme positive returns on occasion and exhibiting high volatility such that the extreme positive returns are likely to recur. The non-lottery-type stocks were those in the lowest 50th percentiles of IDIOVOL and IDIOSKEW and in the highest 50th percentile of PRC. “Other stocks” were defined as those remaining.
Their event study compared firm liquidity prior to and after the start of commission-free trading. The liquidity measures included TURNOVER, ZERODAYS, SPREAD, Amihud’s liquidity measure and PRICEIMPACT. The authors explained: “TURNOVER measures how easily a stock can be bought or sold by comparing the number of shares traded daily to the total number of shares available. A higher turnover means the stock is more liquid, making it easier to trade. ZERODAYS, as a measure of transaction costs, represent the number of days with no change in the stock price. A higher number of ZERODAYS indicates higher transaction costs and lower liquidity. SPREAD measures the difference between the highest price paid for a stock (bid price) and the lowest price received from selling it (ask price). A larger spread indicates higher transaction costs and lower liquidity. Amihud’s liquidity measure considers how much a stock’s price moves in response to trading volume. A higher value means the stock is less liquid, and its price is more affected by trading activity. PRICEIMPACT is similar to Amihud’s measure but also considers the differences in trading frequencies across stocks. It measures the stock’s price movement in relation to its turnover. Like Amihud’s measure, a higher PRICEIMPACT value indicates lower liquidity.” Following is a summary of their key findings:
17% of stocks had lottery features.
The healthcare, business equipment and finance industries dominated the sample of stocks with lottery features, composing 29%, 17% and 12%, respectively, of the stocks at the announcement of commission-free trades.
The advent of commission-free trading led to an increase in the trades of stocks with lottery features.
Stocks with lottery features tended to be smaller, with lower prices, lower book-to-market ratios (they tended to be growth, not value, stocks) and greater idiosyncratic volatility and skewness.
The average price of stocks with lottery features was $6.80, while that of stocks without lottery features was $70.68.
Using mean figures, the idiosyncratic volatility (IDIOVOL) of stocks with lottery features was 0.68, while that of stocks without lottery features was 0.22.
The mean figure for idiosyncratic skewness (IDIOSKEW) of stocks with lottery features was 0.11, and for stocks without lottery features, the corresponding figure was -0.01.
On average, firms with stocks exhibiting lottery characteristics were smaller in asset size ($9,085 million vs. $36,216 million) and market capitalization ($689 million vs. $18,356 million) than stocks without lottery features.
Commission-free trades appealed to a particular group of investors whose response to free trade significantly affected the liquidity of lottery-type stocks but did not affect the liquidity of other stocks – stocks with lottery features experienced significantly larger increases in TURNOVER and decreases in ZERODAYS, SPREAD, Amihud’s measure and PRICEIMPACT compared to non-lottery stocks, suggesting a significant liquidity boost for these stocks following the advent of commission-free trading.
The observed liquidity effects were driven by the lottery features rather than other firm characteristics such as market capitalization, book-to-market ratio, and the ratios of cash and total debt-to assets.
The authors findings led them to conclude: “The appeal to trade stocks with lottery features remains prevalent despite the evidence that this strategy does not yield an accumulation of wealth. A sizeable number of investors continue to share the attributes of investors seeking to maximise wealth by assuming the more significant risks of stocks with lottery features.” Their findings are consistent with those of Jie Hu, author of the 2021 study Impacts of Zero-Commission Trading on Stock Market Liquidity who also found that “the implementation of zero-commission trading significantly improves market liquidity.”
Investor takeaways
The findings reviewed demonstrate that investors, enticed by the prospect of “commission-free trading” (perhaps ignoring other costs such as bid-offer spreads and market impact costs), increased their trading of lottery-like stocks but not others. Given the risks associated with lottery-type stocks and the limits to arbitrage (including the high cost of shorting), overpricing persists.
The literature demonstrates that excessive trading and risk-taking are attributes of naive retail investors attracted to lottery-like stocks. On the other hand, the more sophisticated institutional investors have less than 0.1% of their portfolios in lottery-like stocks.
The empirical evidence demonstrates that investors are best served by avoiding both the enticement of commission-free trading and the “siren song” of lottery stocks. If you find yourself tempted by their allure, take a lesson from Greek mythology – Odysseus, having been warned about the Siren’s perilous nature, famously tied himself to the mast of his ship and ordered his men to plug their ears with beeswax to resist the allure of the Sirens' captivating voices.
ABOUT THE AUTHOR
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
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