Trading Costs: The Dark Side of Investing
If you haven’t spent your life studying investing, you may not have a complete picture of all the costs associated with trading. In fact, these numbers are probably much higher than you think, with potential hidden costs of up to 5% of your portfolio every year. Between the explicit and implicit costs involved in every investment, it’s important to gain a complete understanding of these expenses. Ultimately, controlling your costs could make the difference between investment failure and success over the long term.
Costs do matter, and they can have a devastating effect on the overall performance of your portfolio. The following expert insights will give you a firmer grasp of what is really going on with these costs and what you can do to manage them more effectively.
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Explicit Trading Costs
In the breakdown of trading costs, the explicit ones are those you can easily observe and account for in your investment plan. They include:
This cost is fairly straightforward. In essence, it’s a service charge incurred by the licensed agent for arranging the purchase or sale of a security in your portfolio. Every time a stock is bought or sold, there may be a commission charge that goes directly to your broker.
On a trading screen, stock prices show two quotes: the “bid” price and the “ask” price. The “bid” price represents the highest price someone will pay for a stock at a particular point in time, and the “ask” price is the lowest price at which someone is willing to sell a stock. The difference between these two is referred to as the “bid/ask spread,” which is generally regarded as an indication of the cost of liquidity.
Investopedia explains the bid-ask spread as “a reflection of the supply and demand for a particular asset. The bids represent the demand, and the asks represent the supply for the asset. The depth of the bids and the asks can have a significant impact on the bid-ask spread, making it widen significantly if one outweighs the other or if both are not robust. Market makers and traders make money by exploiting the bid-ask spread and the depth of bids and asks to net the spread difference.”
This is the cost of selling one stock and buying another. Some people assume that when a stock is sold, the shares go directly from one investor to another, but that’s not the whole story. The original stockholder sells shares to the person on the floor of the exchange (who, in effect, works for the large brokerage firms). This person may take a profit off the top and then sells the shares to the next investor.
Every time a stock changes hands, the market maker may take a profit, which goes to the brokerage house or wirehouse that controls those markets. Whether you are an individual investor or a big mutual fund, you’re still paying the bid/ask spread costs. The bottom line is this: Active portfolio management that fosters excessive trading will increase your trading fees based on the round-trip costs of selling and buying.
Implicit Trading Costs
The implicit costs associated with trading are the ones that are more easily overlooked by unknowing investors and they can be far more impactful. These hidden costs include:
This is the effect on stock prices that is driven by supply and demand, and it affects the cost of trading based on the extent to which buying or selling moves the price against the buyer or seller. The basic concept here is that high costs effectively “steal” from an investor’s returns. Again, this is where active portfolio management has a tendency to hurt your bottom line. The market can be quite volatile, and if you’re constantly reacting to its movements, you’re incurring greater trading costs with each sale and purchase.
When the placement of a large-volume trade is delayed for fear of driving up the price of the stock, you lose out on the interest that investment accrues for whatever amount of time the delay spans, which can significantly impact your net returns. The longer the investment is delayed, the higher your cost of opportunity may be.
These are trades that go unexecuted based on instruction to buy or sell stock when the share price meets a trigger point. For purchases, this is an opportunity cost as price moves up. For sales, it is a true loss in principal as price moves down.
Public Enemy #1
One of the most misunderstood truths about investing is that the greatest catalyst for high trading costs is high turnover within your portfolio. Portfolio turnover is a measure of how frequently assets within a fund are bought and sold by the managers. Active fund managers will have a hard time overcoming their trading costs with better performance.
As a recent MarketWatch article explains, “The majority of mutual-fund managers routinely lag behind their benchmark stock indexes and the corresponding index funds and index-tracking exchange-traded funds they are paid to beat. This performance gap, due largely to active management’s higher fees, is particularly evident over the multi-decade horizon that defines most individual investors’ experience.”
Active fund management is a short-sighted strategy. The best way to create sustainable wealth is to focus on the long term. . Some people believe that investing is a good way to make quick money, but that is a dangerous approach. The truth is that anyone who’s consistently made returns on the stock market has had to observe investing truths in action, including tenets like diversification and proper risk management. With something as important as your financial security, it’s vital to recognize the effects of active fund management and high asset turnover on the overall performance of your investment portfolio.
The latest trends or short-term gains can’t ever overrule your long-term goals. Investors are continually getting in and out of the market, each time chipping away at potential returns. Consider, for example, the case of those investors who attempted to ride the wave of technology stocks and lost between 20-70% of their wealth practically overnight. When this effect is compounded over a period of years, the potential for reaching financial goals is significantly decreased. These kinds of losses tend to foster even more frustration and fear about the future, which often leads to more short-sighted decision-making.
A strategic plan that aligns with what matters most to you is an absolute necessity because rumors, future predictions, stories, quick tips and sudden market expectations should never impact your strategy. Disciplined investing that follows your strategic plan maximizes the likelihood that you’ll achieve your goals.
At the end of the day, your total trading costs are an important aspect of your investment performance. Avoiding high costs and slick financial sales people posing as real investment advisors can prove hugely beneficial for your returns. Your investments are far too important to leave to chance. Understanding how your portfolio should be engineered and managed over the long term is critical to your success.
To learn more about the dark side of investing and gain clarity on how to achieve true peace of mind, get your free copy of the Investor Awareness Guide.
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About Greg Hammond, CFP®, CPA
Greg Hammond is the chief executive officer of Hammond Iles Wealth Advisors, and co-founder of Planned Giving Strategies®. Greg leads a team of professional financial advisors providing customized wealth management and investment solutions for high-net-worth individuals, families, companies, and charitable organizations across the U.S.