RIYADH, 28 February 2005 — The cost of investing is an important consideration that is frequently overlooked by many investors. Investing involves many expenses the most important are commission, fixed annual account fees, and interest on borrowed funds. An investor has to pay his brokerage firm a certain fee for each transaction. A complete trade cycle includes two transactions — buy and sell. These trading fees-commission, should be deducted from the initial (gross) profit or loss that investors make. Transaction fees vary with respect the number of shares bought or sold, and the total value of the transaction. More significant is the big difference in fees charged by various firms for identical transactions.
Full-service brokerage firms charge more than twenty times what the online discount brokerage firms charge for the same buy or sell transaction. In numeric terms the fee per a buy or sell transaction varies from a low of $8 which is charged by online brokers, and it reaches upto several hundred dollars charged by full-service brokers. Ofcourse the full service brokers provide professional advice to the investor, however only a small part turns out to be useful.
Although the difference in the transaction charges for the identical deals is huge however it becomes more significant when calculated as a percentage of the transaction value. Professional investors calculate their net return as a percent of the transaction amount. A transaction cost in excess of 4 percent, i.e. 2 percent to buy and 2 percent to sell, makes it unjustified to trade for a gross profit below 15 percent, otherwise the broker who takes no risk ends up with most of the profit. In addition to the above charges, many investors pay for advice regarding what equities to buy or sell and when to do so.
Human beings like action by nature, and for an investor this is translated into frequent yet mostly unwarranted buy or sell transactions. Many investors buy because they have idle cash in their account, or because they don’t want to miss on a rumor. Some sell because the shares they own did not move during the past month, or maybe to generate cash to buy the latest “hot stock”. The above boils down into a large number of unjustified transactions which cost investors a fortune in fees. These huge fees support the existence of an influential and wealthy brokerage industry.
In total, the charges that paid by investors to their brokers is a big amount that lubricates the engine of a powerful financial services industry. In the United States alone, traders spend close to $150 billion annually to buy and sell shares, funds, and to buy advice on what to buy or sell. These charges represent a substantial portion, around 40 percent of the total earnings of the traded companies, which otherwise should have been retained by the shareholders.
An investor who trades frequently using full-service brokers might pay in excess of several thousand dollars in commissions per year. If with good planning he is able to cut down his commission expenses by around $2000 per year, this will represent a saving of $20,000 over a period of ten years. If this amount is invested in a portfolio with an average annual return of 12 percent, the $20,000 will become $195,000 after twenty years. Yes it only needs a small effort but the rewards are huge.
In addition to the commission per transaction, many brokerage firms charge an annual service fee per account. Others also charge a custody account to hold the equities on behalf of their clients. Investors with margin accounts pay interest to the brokers on the funds that they borrow. Unfortunately most investors overlook the above expenses and focus on the potential gross profit that they hope to make.
A prudent investor can contain his trading expenses and improve his profitability by applying the following strategy — (a) trade through online or discount brokers in order to reduce the transaction cost, (b) increase the value of each transaction which in-turn reduces the percentage transaction costs and (c) avoid unwarranted trades/trade less frequent i.e. hold on to the stock for a longer duration.
Additional consideration is needed while selecting a mutual fund. Further to the above transaction costs, the fund shareholder pays the cost of operating a fund, plus any transaction costs associated with the fund’s buying and selling securities. These costs can erode a substantial portion of the gross income or capital appreciation that a fund tries to achieve. Even small differences in expenses can overtime have a dramatic effect on a fund’s real performance.
(Salim J. Ghalayini, [email protected], is the author of “Stocks for the Practical Investor”. He manages several investment accounts.)