Free Stock Trades, Expensive Car Loans, and the Price of Bad Timing

"Take care of the pence, and the pounds will take care of themselves," or so the old saying goes. But whatever currency you're using, the point is valid -- if you pay proper attention to the small sums, you'll find it's much easier to accumulate large ones. Well, in this "What's Up, Bro?" segment from the Motley Fool Answers podcast, co-hosts Robert Brokamp and Alison Southwick start off by digging into the details of a trend that's excellent news for anyone trying to turn their pennies into dollars over the long term: the recent moves by some of the biggest retail brokerage houses to make stock trades free.

Then, Brokamp offers up a few insights into two personal finance stories that prove the truth of another well-worn saying: Time is money. In one case, it's the money Americans are overspending thanks to ever-longer car loans. In the other, it's the wildly different returns being accrued by long-term investors depending on which decades they happened to be in the market.

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This video was recorded on Oct. 8, 2019.

Alison Southwick: So, Bro, what's up?

Robert Brokamp: Well, guess what? Three things for you today.

Southwick: Yes!

Brokamp: No. 1. You get a free trade -- and you get a free trade -- and you get a trade. Hats off to Oprah on that, off course.

Southwick: Everybody gets free trades.

Brokamp: Everybody gets free trades. Almost everybody, at least. Last week discount broker Charles Schwab made headlines by eliminating commissions on equity and ETF trades. Not to be outdone, within a day TD Ameritrade cut their commissions to zero and then E*Trade joined in. Even before the Schwab announcement, Interactive Brokers announced a new service, IBKR Lite.

Southwick: Catchy.

Brokamp: They eliminated trades on stocks. Of course, Robinhood's been doing that for years and every brokerage has been offering free trades, at least on a select number of ETFs. So this is all generally good news. It's sort of like the Latte Factor for investors. You're not spending that $4-8. Over the course of the year it leaves more to be invested and compounded over decades. It's nice.

But brokerages are not charities, so they have to be making money somehow. How do they do it?

Several ways, but here are probably three of the biggest. No. 1, "order flow". Essentially brokerages have to go to someone else to complete the trade. They can go to the exchange and pay the exchange or they can go to market makers, and the market makers are willing to pay a little bit to handle that trade. In a blog post at the end of last year, Robinhood's co-CEO said that they make about $2.6 for every hundred dollars that are traded. It's not a lot of money, but it's one way that they do it.

No. 2 is "upselling other products". If could be that these free trades are basically loss leaders in the hope that once you open the account you do other things. Maybe you buy some of their mutual funds. Maybe you use some of their financial planning services. Maybe you do some trades that have higher commissions, like options. Some of these people are still charging for options trades. Or using margin.

And then No. 3 -- and this is the biggest -- is basically making money on "lending out your cash". According to an excellent article by Josh Barro in New York Magazine, in 2018 Schwab paid 0.27% on cash that you just had in your account. What would they do with that? Well, they would lend it out and make 2.57% and they actually derived 57% of their revenue just on that 2.5% differential. It's basically like being a bank. That's how they're doing this: by offering the free trades, getting more assets, and that way they can lend out more.

And also, of course, you may use some of their robo-advisors with many of these brokers. Many of these brokers have cash in the allocation, so that's another way that they can accumulate some of that cash. The lesson here is, dear Fool, to enjoy those free trades, but don't end up paying for it in a roundabout way by letting a lot of your cash sit there in these very low-yielding cash accounts. If you don't have a lot cash at your brokerage -- or if you do -- go seek out some of the higher-yielding options like a money market fund.

No. 2 is driving your finances into the ground. Here's a recent headline from The Wall Street Journal: The Seven-Year Auto Loan: America's Middle Class Can't Afford Its Cars. The average length of a new car loan, these days, is 69 months. It's almost six years and it's an all-time record. One-third of new loans are longer than six years, according to Experian, and that's up from just 10% a decade ago. People are taking out longer loans for their cars.

What are the consequences of this? Well, first of all, generally, the longer your loan the higher the interest rates. You're going to end up paying more for the car. But also a car is a depreciating asset and at some point it has to be replaced. According to car-shopping site Edmunds, one-third of buyers replace their old vehicle before they've paid off the loan. And they roll the old loan into the new loan.

Southwick: That sounds awful!

Brokamp: Yes. The Wall Street Journal article profiled a 22-year-old guy. When he bought his new car, he pulled in the loans of two previous cars that he had already bought and he's only 22.

Southwick: 22 -year-olds are so dumb. Speaking as a former 22-year-old.

Brokamp: Exactly. So how are buyers able to get these loans? Well, to quote The Wall Street Journal article, "A lending machine has revved up in response, making it possible for more Americans to procure a vehicle by spreading the debt over longer periods. Wall Street investors snap up these loans, which are bundled into bonds." This I can't believe. "Dealers now make more money on the loans their customers take out than on the cars they sell."

The article provides some numbers from J.D. Power. When a dealership sells a car they make, on average, just $381, but they make $982 on the loan on the car, which is almost twice as much as a decade ago.

We previously mentioned on this show the 20/40/10 car buying rule of thumb. You put 20% down, you get a loan that's no longer than four years, and that multi payment should not be more than 10% of your gross income.

But this is where it gets challenging for middle income Americans. According to Bankrate, if you follow this rule using the median income of the American household, then folks should be buying a car that costs $18,390. Unfortunately, the average cost of a new car, nowadays, is $32,000.

Southwick: We paid $22,000 for our new car.

Brokamp: And I'm guessing you did not get a SUV or something like that.

Southwick: No, we got a very base model station wagon with a manual transmission.

Brokamp: Right. So part of the reason why the average cost of a new car is going up is because first of all, there's all the fancier things that just come with a car, now. The backup rear camera, the display, and all of that. Also, Americans have gone back to buying bigger cars. But you can see why Americans are taking out these longer loans. If the average new car price is $32,000 and you spread out that loan, it lowers the monthly payment and it gives you the illusion of it being more affordable.

The takeaway, here, is as far as I'm concerned, if your finances are at all stretched, and you cannot afford to pay for your new car either with cash or in a loan that is four years or less, buy used as I almost always have done, buy small, and aim to keep your car for at least a decade. How long did you keep your last car before you bought this one?

Southwick: I think we got it in 2002.

Brokamp: There you go. I think at least a decade if you can.

And No. 3 -- speaking of decades -- what a difference a decade makes. The Bespoke Investment Group, which has this active blog with all kinds of cool, little stats sent out an email that broke up the trailing returns of the S&P 500 for various time frames as of the end of this September.

How has the index fared over the last decade? Most listeners will know pretty well. In fact, over the last decade it's returned 13.2% a year on average. That's higher than the 10.4% since 1928 and when you place it among all past 10-year holding periods, it ranks in the 61%. In other words, it's better than 61% of all other 10-year periods. Pretty good.

But then they looked at the 20-year annual return for the S&P 500 as of the end of this past September. The average for all 20-year holding periods is actually 11% so even higher than 10%, but what about the most recent 20-year period? Only 6.3% a year, on average, and that places it in the 5%. The bottom 5% of all 20-year holding periods. The reason, of course, is when you stretch it out over 20 years -- you're starting in 1999 -- you get the .com crash and then the Great Recession. So what's the point besides me thinking this is just an interesting stat?

First of all, much of what will determine the value of your portfolio really comes down to luck, to a certain degree, and timing. Like you could take two people who earn the same amount of money -- adjusted for inflation -- contribute the same amount to their 401(k)s, put it in an S&P 500 index fund, and the person who started in 1999 is going to have a lot less than the person who started in 1980, which was the start of the best 20-year period for stocks when it earned 18% a year, on average.

The other point is you don't want your financial plan riding on a single asset category and hope that your timing works out. The S&P 500 is an index of U.S. large-cap stocks and from 1999 to 2009, they were the worst-performing asset class. If you also held mid-caps, small-caps, international stocks, real estate investment trusts, and even bonds, you did much better over that decade.

Now all those things have been a drag on your portfolio over this previous decade because once again, U.S. large-cap stocks have outperformed. The truth of the matter is when you have a diversified portfolio, you're never going to be beating everybody, but your portfolio is not going to be tanking at the absolute worst time. You're just going to have a smoother, even ride with a portfolio that's probably going to fare well in all kinds of future scenarios and for me that's a trade-off that I'm willing to take. And that, Alison, is what's up.