When I was doing my annual investing review recently, I came to a stunning realization about an error I made last year. Last year, I traded far too much. When I sat down to determine how much the overtrading had cost my portfolio, I realized that I had lost 0.5% in trading fees.
This figure likely understates how much I ended up paying out during the year. The figure only includes commission costs, which are not always applicable. It does not include taxes, the cost of the spread, the cost of fund management fees or the cost of any platform charges. The cost of investing is not just related to commission costs. Even with free trading apps, there is a cost for the investor.
According to my calculations, it only takes a few thousand dollars of investments on a free trading app to incur more costs than one would pay in a platform that charges commissions. Costs such as the spread between the bid and offer price and the commission effectively paid to market makers to fill the order for free all eat away at returns.
The costs of trading
Warren Buffett (Trades, Portfolio) has frequently spoken about how important it is for investors to minimize costs when trading. It is all too easy to overlook the cost of investing because these costs are hidden away from the average investor more often than not. One has to sit down and work out the figures themselves rather than rely on third-party institutions to provide a simple, easy-to-read breakdown.
Buffett has said that the best way to get around this issue is to use a low-cost passive index tracker fund. That is certainly one strategy investors can use. Another strategy is to copy Buffett and Charlie Munger (Trades, Portfolio)'s investing approach and focus on buying and holding stocks for the long-term rather than frequently trading in and out of names.
For example, if I wanted to buy $100,000 of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shares, I could go out and find a fixed cost commission broker. A fixed-cost broker is likely to be more efficient than a free trading app for an order of this size. The cost of trading through commission-free platforms is effectively priced at a percentage of the overall trade rather than a fixed figure.
The bigger the order, the more likely it is that paying commissions will be cheaper. For example, a company like Interactive Brokers (IBKR, Financial) charges a fixed, low commission of a few pence a share. I estimate the commission on $100,000 trade through Interactive would be in the region of $1.20. In percentage terms, this works out as a 0.0012% commission.
If I held this position for the next 20 years, I would pay no other fees. Assuming the stock returned a conservative 10% per year, the final investment value would be somewhere in the region of $673,000.
In another scenario, if I made the same $100,000 investment but incurred 0.5% per annum in commission fees, the final balance would be somewhere in the region of $614,000. That is a huge difference of $59,000.
Keeping costs low
This simple example illustrates the importance of keeping commission costs low. It also demonstrates the importance of keeping an eye on commission costs. Without this vital information, it can be difficult for investors to determine how much of an impact the additional costs and charges are having on their wealth.
If one does not have the information available, one cannot develop a plan to overcome the problem. The impacts of commission and trading fees on long-term performance also illustrate the benefit of fixed buy-and-hold investing.
If an investor can find something they are willing to buy and hold for a decade or two, they don't have to worry about additional commission costs. That is something certainly worth considering when choosing equities for a portfolio.