Low commission costs from discount brokers make trading stocks more affordable than ever. But even if the actual dollar amount per trade is affordably low, you may still sandbag your returns if you don't also keep an eye on what percentage of your purchase that fee represents.
Imagine that you've saved $300, and you're eager to invest in Iditarod Express (Ticker: MUSHH) -- "For when it absolutely has to get to a remote corner of Alaska in, oh, a few weeks, give or take." Now suppose your brokerage charges $15 per trade. At that price, commissions would eat up 5% of the cost of the trade -- meaning you're essentially 5% in the hole from the get-go. Even if your investment gains 5% over its first year, you'll only be breaking even.
Lower isn't always better
Brokerages have been aggressively cutting their commissions in recent years. E*TRADE (Nasdaq: ETFC ) , for example, lowered its top rate from $12.99 to $9.99 last year. This may seem like good news for its customers and bad news for its investors, but that's not necessarily the case. Revenue per trade might fall, but lower rates can attract more customers. Indeed, E*TRADE has reported both a rising number of brokerage accounts and an increased average asset value per account.
Meanwhile, a drop from $12.99 to $9.99 does save investors money, but keep it in perspective. If you're investing only $200 or $400 at a time with those fees, you're still paying too much. With a $10 commission, try to make sure that each trade involves $500 or more. Some brokerages charge as little as $7 per trade or less; at that price, you can clear the 2% rule with a just a $350 trade.
E*TRADE and other brokerages offer even lower rates, but they come with strings attached -- like having to place 150 orders per quarter, or 50 trades per month. That runs counter to the infrequent trading that helped many master investors build their fortunes. As respected global investor Jim Rogers has explained, "One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do." Warren Buffett and his partner Charlie Munger agree, with Munger saying, "It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities."
Pay little -- or nothing
Investors of modest means aren't out of luck. You can meet the 2% threshold by waiting until you accumulate enough for a cost-effective trade. Better yet, why not trade with no commission fees whatsoever?
A bunch of good brokerages now offer their customers broad index-based ETFs with zero commission fees. At Fidelity, customers can invest in a host of iShares ETFs from BlackRock (NYSE: BLK ) for free. Want established dividend payers in your portfolio? Look to the iShares Dow Jones Select Dividend ETF (NYSE: DVY ) , which recently yielded 3.4%. Want seemingly undervalued small-caps, which hold the potential to grow faster than most companies? Check out the iShares Russell 2000 Value Index (NYSE: IWN ) . Want a basket of mid-caps, with a balance of stability and reasonably rapid growth? Behold, the iShares S&P MidCap 400 ETF (NYSE: IJH ) . Whatever you're looking for, your friendly online brokerage may let you buy into it at no extra cost.
Just be careful about buying into funds not specifically offered with zero fees. The discount commission fee your broker quotes for stocks may not apply to mutual funds. While TD AMERITRADE (Nasdaq: AMTD ) and Charles Schwab (Nasdaq: SCHW ) both charge no transaction fee for many mutual funds, they do charge around $50 for each trade involving certain no-load funds -- perhaps in an effort to recoup the money they're losing by offering low- or no-commission trades elsewhere.
Investing in strong stocks and funds for the long haul is generally a smart move. Just make sure you're going about it in a smart way. Try to keep your commission costs at 2% or less -- or better yet, nothing at all.
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