Having been a broker at what was largely a self-service, online firm, I had an opportunity to observe how investors acted when they were empowered with low-cost trade commissions. What I saw was pretty scary.
It won't surprise you to learn that cheap commissions make it much easier to justify trading more frequently. And what's more, that higher trading volume was especially evident in tax-deferred accounts like IRAs -- much more so than in regular accounts.
Dancing with the devil
You already know the reason why ... taxes. There's no tax liability with a transaction in an IRA. Too many investors, keenly aware of that fact, developed a tendency to trade actively using their IRAs. The activity of course cost nothing in taxes, but ended up costing a small fortune in commissions.
Obviously, the bigger the account and larger the trades, the less of a toll commissions take on your profits. For instance, if you've got $5,000 that you want to invest in a single stock, a $10 commission is only 0.2% of your investment. That's not so bad.
But for little investors who don't have as much to invest, even small commissions add up quickly. See how expensive a five-stock portfolio can get with a $10 commission:
|
Stock |
Cost of 10 Shares |
Commission as % of Share Cost |
|---|---|---|
|
General Electric |
$276 |
3.6% |
|
Google |
$4,337 |
0.2% |
|
Wal-Mart |
$629 |
1.6% |
|
Campbell Soup |
$390 |
2.6% |
|
Yahoo! |
$185 |
5.4% |
And the scary part is that these small investors trade frequently, paying these commissions over and over again. Given that the market's historical average return is only 10% or so, you can't afford to trade much even with small commissions -- at least not until you have more capital to invest.
It's easy to nickel and dime yourself to death without even realizing it.
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