In this segment from Motley Fool Answers, special guest Seth Jayson joins Alison Southwick and Robert Brokamp as they seek out the murky origin of this Foolish rule of thumb: to never let your trading costs exceed 2% of your investment.
But why not a lower limit (or a higher one)? The cast dives into this question as well as the overall importance of managing transaction costs.
A full transcript follows the video.
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This podcast was recorded on Oct. 18, 2016.
Alison Southwick: It's time for Answers, Answers, and this week's question come from Adrian. Adrian writes: "Really enjoy your podcast, and I'm a big fan of Alison. Bro's cool, too ... just not as cool as Alison." It's their Debbie Downer. Wah wah!
Robert Brokamp: Wah wah!
Southwick: Sorry, Bro. Anyway, "I was wondering ..."
Seth Jayson: You need more honk horns and jingle bells and stuff on the table.
Southwick: We are our own jingle bells and wah wahs ...
Brokamp: That's right.
Jayson: I'm going to go to the dollar store and get you guys some more sound effects.
Southwick: We would use them.
Jayson: High-quality stuff.
Southwick: We could use the sound effects.
Brokamp: We would.
Southwick: All right. Adrian writes: "I was wondering about the Foolish maxim of not allowing your trading costs to exceed 2% of your total transaction. How is this derived? Why 2% and not 1%? Or 3%?" Bro, do you want to kick that off?
Brokamp: Sure. Well first off, Adrian, you are absolutely right. I am nowhere as cool as Alison.
Southwick: It's true. It's true.
Brokamp: And you're also right that the Fool has long suggested that investors keep their commissions to 2% or less of their investment. So, if you're with a discount broker that charges $10 for a commission, you should invest at least $500 in that stock. That said, I couldn't really determine how we came up with this ...
Jayson: It's like eight glasses of water a day. Somebody made it up at some point in time ...
Brokamp: Anyways ... so I asked around some old-time Fools. The Motley Fool has been around since 1993, so there are still some folks that have been around since then, and no one could really remember how we came up with it. I think it was sort of a rough rule of thumb. And I found other articles on our site that suggest you keep it to 1%. So it is ...
Jayson: As little as possible.
Brokamp: Right. Exactly. And it makes sense. The more that your commissions take up of your investment, the more you're kind of starting behind the starting line, and your initial returns are going to be just enough to get you back to break-even. So it makes sense.
Jayson: Yeah, and in fact, the whole Malkiel approach and A Random Walk Down Wall Street is predicated on, if you're not doing anything, your returns are absolutely determined by how much money you're giving away ...
Brokamp: Right ...
Jayson: ... to your brokerage or your fund or whatever, the answer being try not to give away anything if you can, because it's all money out of your pocket.
Brokamp: Exactly. The old 2% guideline is not set in stone, so if you want to get started investing and you haven't yet accumulated enough cash to put in thousands of dollars, it's OK if your commission is 3%. Maybe even 4% of an investment as long as you plan to hold onto it for years. If you're day trading, it's not going to work out so well for you.
Jayson: And anything you give away, like that ... if you want it back, you've got to make that much in excess return.
Brokamp: Right. And you've got the commission to buy it and you have the commission to sell it on the other side, too. So that said, it's a lot easier, these days, to pay much less than $10 for a commission, including even services where you don't have to pay a commission. Or even the big-name brokerages, many of them will give you a certain number of free trades, whether it's on stocks, or they'll let you trade exchange-traded funds (ETFs) without any commission. So it's pretty easy to keep that limited.
It is important to know that when you look at a broker, and they say their commission is $7 or something, that's just for market orders. For stocks. There are other types of orders, and we've talked about this on previous episodes. Like good-to-cancel and limit, and those are even higher. Mutual funds -- with some brokers you actually have to pay for those, and those commissions are actually higher, so you want to make sure if you like a certain mutual fund family, and you're going with a broker, make sure those funds are commission-free.
Most, but not all brokers actually allow dividend reinvestment for free, but some still charge commissions for that, which could really eat into your returns, so you want to make sure that your dividend reinvestment is free, as well.
And one thing a lot of people don't think about when they have a taxable brokerage account (in other words, not an IRA) is that the commissions are actually, to a certain degree, tax-deductible. So if you pay $10 to buy the stock, and then $10 to sell it, you take that $20 off of your gains, so you don't have to pay taxes on that.