Saturday, November 21

Misers Avoid Transactional Costs... Part 2

On Tuesday I discussed how the transaction costs associated with trading stocks (as opposed to investing in publicly traded companies via a buy-and-hold strategy) will eat up a large percentage of your gains and negatively impact your net worth. Today I wanted to quantify this through an example. Let's consider a stock purchased in a regular (not tax-deferred) brokerage account and what happens when you sell the stock:

  1. Buy 100 shares of XYZ company at $20 per share. Let's use a discount broker where we may pay a $5 fee to buy the shares.
  2. Sell 100 shares of XYZ company 6 weeks later at $22 per share. Looks like a $2 per share profit on 100 shares, or $200 profit, right?
Wrong...
  1. Not only will you pay $10 to your brokerage account, you will also be responsible for short term capital gains, which are taxed at your standard income bracket. Let's assume you are single and you earn $50,000 a year at your job. That puts you in the 25% federal bracket. We'll also use a middle-of-the-road state tax rate of 8%.
  2. $200 profit, less $10 in transaction fees, leaves $190 in profit for the tax man to assess. Uncle Sam gets $47.50 and your state revenue department collects $15.20.
  3. Total profit of $200, less ($10+$47.50+15.20) = $127.30 in actual profit.
We're not done. That $62.70 in taxes and fees is gone...a lost cause. What if you had held onto that stock? Since study after study says you can't time the market, let's assume that holding the stock of XYZ company would have yielded a similar return to the stock of whatever you would have replaced it with. If this is the case, that $62.70 in taxes and fees you paid represents a lost opportunity.

Historically stocks have outpaced inflation by 7% a year. Let's say inflation averages 2% per year for the next 25 years, so your average stock will yield a 9% annual return.

How much did you really lose?
Much more than $62.70. At 9%, in 25 years you would have turned that $62 into about $600! A single transaction resulted in $600 in lost opportunity.

It doesn't take a genius to see that several trades each year will literally reduce your net worth by hundreds of thousands of dollars in a lifetime.

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