Brokerage firms leveraging the “compelling power of free”…

I oft preached in class about the “compelling power of free”.

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Consumers just can’t resist free stuff … whether they need it or not.

So, “free” is consistently reported to be the most powerful word in advertising. It draws attention … and provokes action.

And, in terms of market response, there’s a big difference between “free” and “almost free”…

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Several years ago, Amazon reportedly  tested the likely impact of offering free shipping.

Besides demonstrating that free shipping would demonstrably increase sales, the test revealed a more subtle effect.

The study was a “matched market test”.

In the U.S., shipping was free for orders over $25.

Sales skyrocketed.

In the UK, Amazon tried “nominal shipping fees” (think, 99 cents) for orders totaling the equivalent of $25.

Sales increased in the U.K. … but only by a fraction of the U.S. sales gain.

Proof-positive of the “power of free” … and evidence of an equally important dynamic:…

When you slip a price on something – even a small one, people are far less responsive.

OK, now fast forward to last week’s announcement by Charles Schwab that would start offering commission-free trading on most online transactions.

See the WSJ for details.

With deregulation, technology efficiencies and stiff competition …  brokerage commissions have dwindled over the years from hundreds of dollars to transaction to under $5.

That is, stock trades have been”almost free”.

Reflecting the Amazon effect, Schwab went from almost free to free … and rivals Ameritrade and E*Trade immediately followed suit.

Sure, they can increase trading volume by taking share from less efficient rivals … but how can they make money off the increased volume?

Simple.

They act more like banks, lending out the cash that investors keep in there “sweep accounts” at a rate higher than they pay in interest on those cash accounts.

That’s sets up another competitive dynamic.

Fidelity didn’t immediate follow Schwab’s move to free.

But last night during sporting events, Fidelity started running ads highlighting that they pay substantially (?) higher interest rates on sweep accounts’ cash than Schwab and the other freebie offerers,

Key point: the brokerages are going to make money some way … either through transactions fees or interest rate spreads (between what’s paid on cash balances and what’s received when the cash balances are invested).

So, before you switch to a free-trader,  it’s worth checking the interest rate differences between brokerage firms … especially if you don’t trade much (lessening the incremental benefit of free trades) or keep high cash balances (increasing the incremental benefits of higher interest rates).

Stay tuned on this one.

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Follow on Twitter @KenHoma

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