Many investors, if not all, trade through brokerage houses. Usually this involves filling up a couple of forms to open a brokerage account, being assigned a dealer to facilitate your trades and recently, having an online platform to execute your buys and sells. Trading has never been easier with increases in technology and the existence of numerous trading platforms in the market. However, one thing does not change: the thirst for profits.
The only reason why brokerages and trading platforms are increasing over the years is because there is an increase in the number of individuals who want to trade in the stock market. The higher of potential trades, the more attractive it is to start a brokerage house. From the looks of it, it seems like a very lucrative business and if you look deeper into it, the bulk of their profits come from one source: the investor’s pockets through brokerage commissions.
EXAMPLE OF HOW BROKERAGE COMMISSIONS AFFECT YOUR PORTFOLIO RETURNS
Investor A is your typical investor in his or her late 20s, investing as a secondary form of income in addition to their day job. He or she has about $50,000 of excess capital and trades about once a week. We can see that based on the assumption that each trade is about $10,000; the brokerage per trade is $27.50. With a trading frequency of one trade per week, this adds up to around 50 trades in a year. Remember that this is only one leg of the transaction. When Investor A sells the stock which he/she has bought, there is also another similar brokerage commission charged for the sale. For simplicity sake, I am ignoring the fact that the sell amount might be higher or lower than the original buy amount because it will not make a significant difference in the calculations. If anything, if a stock is sold at a higher price which registers a gain for the investor, he/she will actually have to pay a higher commission compared to if the stock was sold at a loss.
Now, let us assume that investor A had a good year in the market, recording a 15% gain from the beginning of the year. Mind you, a 15% return is more often than not considered above average since the long term average return of equities is around 7 to 8%. That will give a year end portfolio gross amount of $57,000, before commissions. Brokerage commissions based on the trading amount and trading frequency will amount up to $2,750, which essentially is about 5.5% of investor A’s beginning portfolio amount! Just like that, out of the 15% gain that was earned, 5.5% of it is eaten away by brokerage commissions, which adds up to more than a third of the profits! This resulted in the portfolio only gaining 9.5% instead of 15%, a huge difference. Do take note that if the other transaction fees are also taken into account such as the clearing fee and GST, the gain will be even less.
To further illustrate my case, let us move on to another example.
Investor B is your trader who has no secondary form of income and trades on a full time basis. He/she depends fully on profits on investments and therefore monitors the market on the daily basis. Hence, it is not uncommon for these types of investors to execute one or two trades per day. Also, these investors typically have a higher starting capital than investors who are of Investor A’s type. For this example, we start out with a beginning portfolio amount of $1 mil. Since Investor B is deemed to be more in tune with the market than Investor A, let us assume that he/she earns a return of 20% for the year.
Given the rest of the assumptions in the table above, his/her year ending portfolio amount will be $1.2 mil and brokerage commissions will be $68,750, amounting to 7% of the beginning $1 mil that he/she started out with. 7% also forms about 35% of the 20% profits earned during the year, resulting in Investor B’s portfolio only gaining 13%.
From these 2 examples, we can see how a seemingly small brokerage amount of 0.275% can play such a huge part in affecting a portfolio’s income. I will also show you how a change in your trading style can vastly improve your portfolio results.
INCREASE YOUR PORTFOLIO RETURNS BY TRADING LESS
The above shows Investor A having the same assumptions except that instead of trading once a week, he/she trades less frequently to around once every 14 days, or about once every 2 to 3 weeks. By trading less frequently while holding the rest of the assumptions constant, the brokerage commission that he/she has to pay will drop significantly from 5.5% to 2% of the original portfolio amount. This means that with a paper gain of 15%, Investor A will be able to reap the rewards of about 13% compared to only 9.5% in the first example, an increase in returns of about 3.5%!
The same goes for Investor B if he/she trades less in the market.
The above shows that if Investor B had traded once every 2 days instead of twice a day, his commissions will fall from around $70k to only $17k, resulting in an 18% portfolio net gain instead of 13%, an increase in return of 5%!
IS IT POSSIBLE TO MAINTAIN RETURNS BY TRADING LESS?
Some people might argue that if the trading frequency is less, the portfolio return will be less as well. However, I beg to differ on this point. Not every trade that you make will result in a gain. Some trades make a gain and inevitably some trades will result in a loss as well. The key to earning in the stock market is to ensure that your gains outweigh the losses, in terms of frequency and magnitude of investment. That is, given that the amount for each transaction is similar, an investor with a higher winner to loser ratio will perform better than one with a lower ratio. An investor can trade less and pay less brokerage while maintaining the same winner to loser ratio than another investor who trades more frequently, resulting in the former having a much better performance due to less trading costs.
I hope the article is insightful and shows you the costs of trading in the stock market. In conclusion, do not undermine brokerage commissions the next time you place a trade. Make sure that every time a trade is made, it is done after a thorough analysis of the underlying company. You do not want to pay your broker a fee in addition to a bad investment decision – a double whammy.