Every now and then, friction is good

May 18, 2018

There is good friction in the world. This includes effects like your car tires gripping asphalt at a stop sign or the pens not rolling off that desk with the uneven leg you bought on sale. And there is bad friction, which includes the pistons in your auto engine overheating because you ignored the oil change light or the paperwork involved in moving financial accounts.

Costs are a type of friction in the economy. In most cases we don't like economic friction. It prevents the easy flow of resources to their optimal point. Occasionally, though, costs add value. Here's why.

This week a Silicon Valley tech company named Robinhood rose to a dizzying valuation by reducing mobile phone-based stock trading to a cost of zero, targeting the service to millennials, and featuring the added "benefit" of trading cryptocurrencies.

Let's ignore the crypto trading feature for now - we'll give Buffett the benefit of the doubt when he described it as "rat poison squared." What about the free trading, isn't that great? Doesn't One Day In July like lower costs?

Generally, yes. But there are two problems in free trading. The first: when something is free, it's only free from one dimension. The business still has to make money. In the case of Robinhood, this blogger points out that they are routing trades to high-frequency trading hedge funds and being paid on the back end for the transaction flow. This is not illegal, as Michael Lewis dissects in his book Flash Boys, but it likely diminishes investor returns.

John Bogle, the founder of Vanguard, did not like the idea of ETFs, and when he was CEO, he kept the firm out of them. He believed they offered the temptation for investors to trade all day, while a mutual fund tracking an index only settles once a day. The lack of temptation has value.

Reducing a perceived cost to zero changes behavior. In economics, zero is often considered a "special price" because of its psychological effects. (See this MIT paper or this famous Hershey kiss experiment). Every April my kids want to spend hours in line for Ben & Jerry's free cone day. When I offered to pay them enough to clean our offices, buy the cones, and have time and money left over, they just looked at me like I was weird.

Sometimes, then, a cost can have value as a deterrent from other behaviors. Rat poison or its mathematical derivatives may be too strong a term, but frequently trading stocks on a phone is not a wise activity. This is not what we call investing. It's what we call gambling. But millions more people are now doing it.

I do like the name Robinhood though. I've got to give them credit for that.

Dan Cunningham