In Compound Return Investment Lessons,  we saw the significant impact taxes and transaction costs have on wealth accumulation.
The more you pay others, the less remains to compound. To maximize returns, you need to minimize expenditures.
In Minimizing Investment Costs – Taxes , we explored ways to reduce the impact of taxes. Today, let us consider how to reduce transaction costs.
Transaction costs are typically defined as the brokerage fees on investment purchases or sales and any costs arising due to the liquidity of the investment.
Brokerage fees are what you pay to buy or sell an investment. Also known as commissions. It may be $100 for a full service brokerage house. It may be the $13 flat fee for an on-line broker. Or it could be somewhere in between.
It is sometimes hard to compare costs between brokerage houses. Some offer flat fees. Some charge scaled fees depending on the number of shares traded. Some offer “wrapped” fees, so that you pay an annual fee (usually a percentage of your assets) and get unlimited trades. The combinations are almost infinite and are primarily used to make price comparisons between brokers difficult.
But regardless of fee calculation, why would anyone pay $100 when they can get the same transaction for $13? Why do you buy clothes from Hollister when you can get essentially the same things at Walmart much cheaper?
There are many reasons why people pay 10 times the price for the same basic transaction. I have two on-line trading accounts and one full service account. One on-line account meets certain needs, namely price. The other provides a better selection of investments, especially derivatives. The full service allows me access to global markets that my on-line accounts cannot.
For a young adult just starting to accumulate wealth, a single, low-cost, on-line cash trading account is likely the best route for now.
In a subsequent post, I shall compare the different account options and you can arrive at your own conclusion.
No-Load Mutual Funds
You can invest in a wide variety of no-load mutual funds. No-load means that you do not pay a commission on the purchase or (usually) sale.
You can consider individual funds. Or, there are families of no-load funds that allow you to switch within a family at no cost. This facilitates asset allocation strategies.
Also, consider no-load funds that allow relatively small investments; that can be made automatically from your bank account without cost. This might be useful now, when your disposable income is limited.
Sounds great. Even cheaper than the best priced broker, no-load funds must be the way to go.
Yes and no.
Unless there is a family of Mother Teresa funds I am unaware of, mutual fund companies are in the business of making money. Be aware of other fund costs before purchasing. These can significantly impair the returns your fund generates for you.
I will review the various fund costs next week, so please check back on this important topic.
Buy Direct from the Company
Products such as Dividend Reinvestment Plans (DRIPs) and Direct Purchase Plans (DPPs) allow for purchasing shares without transaction costs.
With a DRIP, you are a current investor in a company that pays dividends. But instead of receiving a cash dividend, the amount you would receive is invested in additional shares of the stock, usually commission free.
With a DPP, you do not already have to be an investor of the company. You can also invest relatively small amounts of money on a recurring basis, usually commission free, and build up a decent position over time.
In the coming weeks, I will dedicate a post to investing directly through a company.
For a young investor, liquidity should not be a major concern. But it is a cost to understand.
With transaction costs, liquidity refers to the spread between the bid and ask on an investment.
For example, you sell your home. A realtor or appraiser has valued it at $300,000. A few years ago, in many cities, there might have been a bidding war. You would have sold the house for the asking price of $300,000 or possibly more. Today, in many areas, there are a lot of houses for sale but very few buyers. The best bid or offer on your home might only be $250,000.
That spread between the $250,000 bid and your $300,000 ask is the liquidity cost. The more you need the money, the greater the probability that you will sell for less than you want. That is a transaction cost.
With stocks, the markets are structured so that liquidity is not a significant factor for major companies. Large companies have many shareholders. So the spread between the bid (the highest price someone will pay for the stock) and ask (the lowest price that someone will sell the stock for) tends to be quite small or non-existent. When they meet in price, the trade is completed.
The smaller the company though, the less capitalized it will be. The less capitalized means the less shares outstanding. Few shares means fewer buyers and sellers. This can lead to significant spreads in the bid-ask prices. It may take compromise by the buyer and/or seller to make the trade. This means greater time is required to find someone willing to compromise and either higher cost or less proceeds to the compromiser. So be careful if you consider buying small capitalized companies, especially if they do not trade on a major exchange.
While a big problem for smaller companies, larger stocks are not immune. We saw the impact liquidity has on major stocks during an investment bubble . In the latter stages, when no one wants to buy, it can be difficult even selling established companies.
Liquidity may also affect funds. Some funds only allow redemptions at certain times. The less opportunity you have to buy and sell, the more liquidity can impact your purchase or sale price.
Cost minimization is important for investment success and we shall continue to examine this.
But remember, the objective is to maximize your net return over time. Do not blindly invest your money into a fund because it is no-load or a company because it offers a DPP. You must consider the return potential as a whole before investing.
How to do this is a subject for many future posts.