YOU AREN’T LIKELY to earn market-beating returns either by picking individual securities on your own or hiring a fund manager to do so on your behalf. That doesn’t mean your stocks and bonds won’t enjoy occasional market-beating years. But long term, even if your investment picks are better than average, any edge will likely be more than offset by the investment expenses you incur, including these trading costs:
Brokerage commissions. These get all the advertising attention, but don’t let those $0 commission trades fool you. Brokerage commissions are often the least important cost when buying and selling stocks.
Moreover, even if you aren’t paying a commission, your brokerage firm is still making money from you. For instance, your brokerage firm might direct your trade to another firm, where it’s executed. In return, your brokerage firm receives “payment for order flow,” which is part of the money made off the bid-ask spread. Your brokerage firm may also make money off your account by, say, charging you interest if you borrow on margin or paying you little or no interest on the cash you leave in the brokerage firm’s sweep account. The brokerage firm can then reinvest that sweep-account cash at higher interest rates and pocket the difference.
Bid-ask spreads. Every stock has two prices, the price at which you can buy (the ask) and the lower price at which you can sell (the bid). Result: If you bought and immediately resold a stock, you would lose money, perhaps as much as 5% with a thinly traded small-cap stock.
Markups. If you buy a bond that has been issued and is now trading in the secondary market, the brokerage firm involved will take the current asking price and add a markup. The markup on bonds sold to individual investors might be 2% or 3% of the price.
Sound grim? The good news is, if you invest through mutual funds, you should enjoy lower trading costs because funds can use their buying power to demand tiny commissions, markups and bid-ask spreads, plus they can make a little money by lending out the fund’s securities.
There are, alas, also two pieces of bad news for mutual fund investors. First, funds suffer market-impact costs. Their own buying can drive up the price of a security, making it more expensive to accumulate a position, and their selling can drive down a security’s price, so they end up with less money when they sell. Second, if you invest in mutual funds, you have to pay all the fees charged by the funds themselves.
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