I had an interesting conversation with a friend recently. She was telling me about how some of her friends and peers had earned good dividends from their investments, and how they had made some good purchases to enable this to happen. I then casually asked about the level of commission they were paying to achieve this level of portfolio success, and the question stumped her so much that she was left speechless.
The angle I was coming from was this: If an investor has to constantly trade in and out in order to achieve a decent return, versus another investor who just buys and holds (and monitors his investments), all things being equal, the results from the two investors would be vastly different even if they had purchased the same companies. The reason for this – fees. So I shall illustrate the impact of fees and how they can reduce the performance of our investment portfolios.
Fees Are Charged On Every Transaction
Investors would do well to remember that brokers charge fees on every single transaction that we make. Even for “low-cost” brokers which are sprouting up like mushrooms, there is still usually a minimum fee per trade which is levied. This is because the brokerage firm needs to pay its employees. The broker himself also needs to make a living by assisting with the transaction and ensuring it is executed in an orderly, timely fashion.
Sandpapering Effect Of Fees
Let’s use a straightforward scenario to illustrate the pernicious effects of large amounts of fees.
Investor A makes a total of 20 trades for company X, while investor B only makes one purchase and sale of company X (i.e. 2 trades), and that they both purchase an equal amount of shares (say 1,000 shares). For ease of calculation, let’s assume each trade costs $10, and that company X’s share price was $1.00 at the time of purchase. The share price then rises from $1 to $2 over the period of a year, and investor A makes a buy and sell transaction each time the price rises by $0.10, for a total of 20 buy/sell transactions in total (i.e. he sells when the price has risen by $0.10 from $1 to $1.10, then buys back again because he feels there is further upside).
Investor A would have bought $1,000 worth of shares and sold them at $2,000 a year later, and investor B would have done the same. But the brokerage fees incurred by investor A would have amounted to $10 times 20 trades = $200, while investor B has only made two trades (once to buy at $1.00, and then once to sell at $2.00), and so he pays just $20. Investor A would have made a gain of $1,000, but he has to deduct fees of $200, leaving him with just $800 of profits, while investor B gets to enjoy $980 of profits ($1,000 minus $20).
The simplistic example above shows the effects of how frequent trades can result in fees sandpapering away the gains on your portfolio, and assuming some investors trade very frenetically, the cumulative stacking of fees is definitely not a laughing matter. Hence, investors should be aware of this and ensure they make infrequent transactions and to stay vested for the long-term.
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