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Commissions are no Big Deal... Period - Part 2

Submitted by Steve Selengut | RSS Feed | Add Comment | Bookmark Me! print

For most stock purchases, the costs are up front and visible. For most Bond, and new issue purchases, the commissions are hidden from the investor, as they are with all Mutual Fund and Insurance/Annuity products. Still, all of the acquisition costs of an investment are included in the Cost Basis of the security, and it is this Cost Basis that you should be using to establish your selling targets. As every eighth grader knows, x% of a big number exceeds x% of a smaller number every time, and as experienced investors will tell you, you must have reasonable selling targets if you hope to gain from investing in securities.

If you are managing the investment enterprise properly, your variable costs will move ever higher while your fixed costs remain relatively constant. Understand? As the portfolio grows from income generation and from profit taking, the commission expenses will grow because there will be more things to do more frequently. 

  • But, you need to replenish and increase inventory if you want growth, and so long as you maintain your profit margin at a reasonable level, service can be more important than the commission rate. A Flat Fee arrangement in an actively traded account can be visually and emotionally effective... but economically, it just ain't so! 

Much to your surprise, your realized profits will probably increase at a higher rate than the increase in your variable costs... at least in dollar terms. Could it be true that: if commissions are a function of profitable sales, paying more in total commissions means more profits in the portfolio?  And is the payment of more taxes because of increased profits really such a problem? Yes, and No.

All too often, commission avoidance and tax reduction issues are allowed to Wag the Dog, causing millions of unrealized profit dollars to hit the books next year as realized losses.  In The Brainwashing of the American Investor, I’ve illustrated how (in a percentage-target trading environment) investors who pay higher commissions actually make more money, in dollar terms, than their frugal discounterparts [sic].  The Math is simple; 10% of a larger number is a larger number, period. But it just plainly should not be an issue at all. And, if it were really as big a deal as it is purported to be, there just wouldn’t be any full service/high commission brokers, would there?

  • As with most things in life, if it's free, or really cheap, it's probably worth just what you've paid for it.

In investing, fixed costs are minimal unless you go out of your way to increase them by adopting some form of commission replacement arrangement. A management person responsible for directing your portfolio is always a fixed expense, and the fee charged generally moves lower as the account relationship grows. Many Wall Street firms offer arrangements called Wrap or Managed Accounts.

Wrap or Managed Accounts combine commissions and management fees into one charge.

  • Where true Individual portfolio construction and management is involved, investors should have the option of choosing to pay commissions viewed as a variable cost, trade by trade, OR as a combined fee that could significantly reduce commission expenses... most of the time. The higher the percentage of income securities in the portfolio, the lower the flat fee would have to be to reduce overall transaction expenses.
  • Fixed income investing is much like furnishing a home with durable goods… there should be very low fixed expense and almost no variable costs at all. BIG BUT, if you are using tradable securities (CEFs, Preferred Stocks, etc.), go for the Flat Fee during the downward cycle of interest rates, and straight commissions when rates are rising. Ya follow? (But this has to be fair to all concerned parties.)
  • Equity portfolio investing is more like running an active retail business… the more (profitable) turnover, the better. Most retailers have a standard mark-up policy, and most understand the turnover issue. The last thing that a retailer, or any businessperson, wants to see is a higher inventory market value from quarter to quarter! [Read that again and think a minute.] 
  • Higher sales numbers are the key issue, and turnover is what you should want your Equity Portfolio to produce. If  the product isn't selling, in the Investment Portfolio World, it means that the portfolio Working Capital isn't growing. 
  • Focus on the profits, not on the cost of obtaining them. I know this sounds flawed right now, but it won't once you've gained some experience. 
  • Properly directed variable expenses are the ideal fertilizer for growing sales, and without sales, there are no profits. And, in equities, if there are no realized profits, why bother?

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