Transaction costs and their effect on rate of return

Transaction costs are a necessary evil every investor has to deal with when buying or selling securities. These costs vary widely from broker to broker, but are never zero. Depending on the amount, these costs can severely lower an investor’s annual rate of return. For investors with limited budgets, transaction costs are something to be very aware of.

Let’s say our broker charges €10 for every transaction. If we buy €1,000 worth of stocks, the €10 accounts for a loss of 1% over this transaction. The 1% loss should easily be earned back if the stocks do well. If we want to monetize the earnings however, we will eventually need to sell our stocks. This again amounts to an additional loss of €10. With this particular investment and with transaction costs included, we would need a 2% profit just to get even.

In the particular case described above, it wouldn’t make a lot of sense to start investing with small budgets. The transaction costs would destroy any decent rate of return over the year. That’s why it is always important to take a critical look at the transaction costs a broker charges. Take these into account every time a transaction is about to be made. People with small budgets should keep the number of transactions to a minimum. Only buy and sell when you need to.

This article ties in with my recent article Beware the speculative side of today’s market. Naturally, a speculator would make a lot more transactions than an investor who carefully picks his investments and only buys and sells when he needs to. For instance, if a speculator would make two transactions a week, it would amount to 104 transactions in one year. With our example broker, in one year that would be €1040 down the drain on transaction costs alone. This is an additional reason why speculation more likely leads to losses than to profits.

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