This post is was originally published on The College Investor
Commissions are a fact of life for investors but are there times when they don’t really matter?
You might be surprised to know that yes – there are times when commissions have a significant impact on your investments and times when they don’t.
Commissions are always a drag on investments. It’s just a matter of how much.
In this article, we’ll learn how to identify scenarios in which commissions can have a significant impact on your portfolio’s performance and when you shouldn’t care as much about commissions.
When Commissions Matter
Let’s look at a few different scenarios where commissions have a large impact on investment returns.
When you have a small account, everything is amplified. This includes losses. Here’s an example:
Account size: $5,000
Purchase 100 shares of ABC at $30/share: $3,000
Sell all shares at $25: $2,500
Round trip (buy & sell) commissions: $13.90 at E*TRADE
The account has realized a $500 loss. That’s a 16.6% loss on the account, which is a significant amount. What about commissions?
While $13.90 seems like a small amount, what happens when the account does ten round trip trades and nets only $250? Ten trades cost $139. On a $5,000 account, that’s 2.78%.
With just 20 trades, 5.5% of the account has already been eaten up by commissions.
To put it another way, $139 is over 55% of the profit.
Contrast that with a $50,000 account. $139 is only 0.278% of the account value. 20 trades aren’t even 1% of the account (0.556%).
Going back to our ten trades at $139, the $50k account is ten times larger than the $5,000 account. Let’s say its profits on those ten trades are 10X or $2,500. $139 is only 5.6% of the profit.
It’s difficult enough to make money with a small account but once commissions are factored in, it’s nearly impossible.
Abnormally High Fees
Just like buying a home, you want to get a good price and not overpay. That’s done by knowing what the surrounding home prices are. The same can be said for commissions.
Online trades shouldn’t cost more than $10, with many around $5. There isn’t any reason to pay more for online trades.
If you have a nice size account and are getting good rates on your commissions but they are still eating into your returns, what might be the reason?
This can usually happen due to the frequency of trading. You don’t have to be a day trader for commissions to eat away at returns. But being an active investor can have a negative impact on your returns.
One way to avoid jumping into and out of funds is to simply invest in index tracking funds. These funds and ETFs track popular indexes such as the S&P 500.
Basically, they do the work for you and help keep commissions low because you aren’t trading as much.
Your Advisor Is Fee-Only
If you are working with a fee-only financial advisor but find you are being charged commissions on different products, the advisor isn’t fee-only. Fee-only advisors should not charge commissions.
However, if your advisor is fee-based, he might charge a flat fee for advising but then charge a percentage of AUM (assets under management) for managing your investments. For AUM, a fee-only advisor simply charges a flat fee to manage investments.
When Commissions Don’t Matter
Turning to the other side of the table, there are times when commissions aren’t a factor and are just part of investing, assuming the commissions are reasonable.
You’re Having Great Success
Whether your investing on your own or having an investment advisor do it when you are having great success, commissions tend to go unnoticed. After all, outsized profits decrease the percentage impact of commissions.
Day traders are one group that rack up huge amounts of commissions. While 4 out of 5 lose money, 1 in 100 is profitable. In this case, those who are winning are doing so because of the volume of trades.
Paying Higher Commissions When It’s An Emergency
When you have to get out of or into a trade immediately but don’t have access to a computer, making a call to your broker and doing a phone assisted trade might be your only choice. Phone-assisted trades are expensive, with many costing $25. But with no other options, the high commission doesn’t outweigh the need to complete a timely transaction.
Percentage Of AUM
As mentioned above, some financial advisors will charge a commission as a percentage of AUM. The commission rate drops at different stages as AUM increases.
Your Advisor Is A Fiduciary
A fiduciary should have your best interest in mind. But this doesn’t exclude advisors from charging a commission, even under the DOL’s new fiduciary rule.
Merrill Lynch has even setup a model where some clients are charged fees only while others are charged commissions.
Andy Sieg, the head of Merrill Lynch Wealth Management, said, “We have analyzed the limited situations where recommending a fee-based arrangement might not be in a client’s best interest and have considered alternatives to IAP [Investment Advisory Program] for these situations.”
Knowing when to avoid or reduce commissions can certainly increase your investment returns.
However, there are still some scenarios where the commissions you are receiving don’t matter as much, especially when they fall within the range of reasonable cost.
Do you think your investment commissions could be lower?