Right now, I'm listening to the main theme for the movie The Great Escape, which is completely appropriate for today's topic: How to destroy your portfolio by allowing cash to escape through the trap door of high transaction fees.
Listen to your accountant
Stop me if this sounds at all like you. Last month, I'm sitting in a meeting with my accountant when he tells me how he had a particular client who, during the dot-com years, decided he and his wife would quit their high-paying jobs to day trade. The goal, the client told him then, was to earn 10% a month.
Sure, that sounds silly now. But it didn't to many people back then. We all thought the rules of stock market gravity had been permanently suspended. Unfortunately, that's not the only mistake this couple made. They forgot that trading for a living is like running uphill in the mud; it's too easy to be tripped up by transaction costs.
Let's do some math and you'll see what I mean. Assume you have $1,000 to invest. Using all of that to buy stock in, say, drugmaker GlaxoSmithKline
Now, if you're lucky enough to get preferred pricing from brokers such as Fidelity, E*Trade, or Charles Schwab, you'd pay roughly $10 in commissions for that trade, or 1% of your total. Your cost basis would be $984.52, or $54.69 a stub.
So, for you to earn just 1% on your investment, you'd need the stock to rise to $55.23, or 2% from your buy-in price. That may happen overnight, or it could take months. Either way, you have a higher hurdle to clear, thanks to fees.
Make your trade make sense
That's why you'll find us Fools preaching that you save up a significant stake before investing in individual stocks. Sure, Sharebuilder is a great service, but $4 per trade is a huge fee (4%!) if you have only $100 to invest.
So, consider these two Foolish questions before you buy:
What return do I aim to achieve? Great investors always use valuation to discern what returns they can expect before they buy. That way, they can compare how fees and transaction costs will eat into their total expected return versus a risk-free choice. So, for example, if you pay 1% to purchase shares of Boeing
(NYSE:BA), which you expect to return 9% annually, your expected return before inflation is 8% (9% minus 1%). After inflation, which tends to average 3% annually, that's 5%, which isn't much better than many fixed-income choices.
- Is this the best possible investment I can make? As with the example above, transaction fees have a funny way of making what seems like a good investment look really bad. I mean, 9% annual gains should be great! But it isn't if you have to pay 2% in fees and 3% in inflation to get that return. That's why many of our advisors shoot for 20% average annual gains with their buy-to-hold selections.
Follow the money
My accountant couldn't really say what had happened to his former clients, but I have the awful feeling that it ended badly. Bear markets happen. So do stock-picking mistakes. Don't give comfort to these enemies of your portfolio by piling on unreasonable transaction fees. You could end up the sad subject of a conversation with someone else's accountant.
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GlaxoSmithKline is a Motley Fool Income Investor recommendation, and Charles Schwab is a Stock Advisor pick.
Fool contributor Tim Beyers is a cheapskate when it comes to clothes, groceries, and stocks. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. Get a peek at everything he's invested in by checking Tim's Fool profile. The Motley Fool's disclosure policy is worth every penny.