Wednesday, March 9, 2016

Transaction Cost Meltdown

Imagine that you've just hit pay day and your budget looks great. You've got some funds left over for the month that you can use to invest with. In no time at all, you've uploaded those funds into your investing account and you're already scouring the market for a good deal. The problem however is that even though you may have a large amount of money to invest in stocks, you question whether or not you should buy some of stock A and some of stock B or if you should invest it all into stock A. We've then reached a turning point that will decide what kind of investor we will be. 

Investing in stocks generally involves the payment of not only the purchase price of the stock itself but also some transaction costs. If you're trading with TDAmeritrade such as myself, you know that you've got a $10 transaction fee with each trade and another $10 fee when you decide (if you decide) to unload that stock down the road. These fees may not seem like much when you're investing in shares because likely what you're buying is much more expensive than $10 but I urge you to think about how these numbers can add up over time and how much more they add up if you consistently find yourself breaking your investing funds up into smaller parts simply to diversify your portfolio faster. 

If we assume that we have $1,000 to invest for the month and we decide that we will invest it all into a one-time buy of company A, we only pay $10 in transaction fees to obtain the stock. If we decide to do this, our $10 trade fee for investing $1,000 is only a mere 1% of our actual purchase price. This means that we barely paid anything at all to load into company A. If on the other hand, we decide to split it up into two separate companies, A and B, we then pay 2%. That's double what we paid in our first transaction. Now, even though it still doesn't sound like much when you think about the fact that we're only losing another $10 on the trades, in the long run we are simply burning cash for no reason. 

I can't tell you how many times I am browsing the blogs that I keep up with and I see people who are just starting out with only a few hundred dollars of investing capital and they've found a way to invest in ten companies with that amount of cash. To the investor who only bought one company with their $1,000 this is easy math - only 1% trade fee overall to grab the company. On the other hand, the investor who only had $500 to invest who decided to split up their purchases and grab ten companies with only half of the working capital has a much higher percent trade fee. In fact, if you break it down, the investor who took the ten companies instead of waiting until they had $1,000 to work with to invest in one company paid 20% in trade fees to acquire each company rather than 1%. Working math below:

$500 working capital divided by 10 (companies) = $50/company = 20% trade fee

Even if you take this and go a little bigger for someone who had $1,000 to invest and decided to do the same but on a little bit bigger scale, the numbers are still not in favor of the split investment at the amount of working capital.

$1,000 working capital divided by 10 (companies) = $100/company = 10% trade fee

When you think about how your investment works in percentages rather than in dollar amounts, the results of your attempt at diversification become strikingly apparent. This is why I urge anyone that I talk to about investing if they have never invested before to think about how much they will be paying in trade fees. Where we are becoming less and less worried about smaller dollar amounts such as $1, we should really care about $10. This is true even if it's only a small amount compared to $500 that we believe to be a good amount to invest. 

This isn't to say that if you only have $500 that you shouldn't invest it. When a portfolio is starting out, unless you have a well paying job, you may not have more capital than that to invest but you need to be investing as soon as possible to help yourself with compounding interest. It simply means that if you only have $500 to invest, think about placing it all into one company rather than trying to diversify with a low amount of money. Then, in the upcoming months, grab one more company with your next $500 and that will serve the purpose to diversify you even further so that your trade fees end up being a much lesser percentage than you would be paying to diversify right from the start. Diversify over time rather than right at the beginning if you don't have enough working capital to equal to a low percent trade fee.

No comments:

Post a Comment