Frequent trading can cost you more than you make
Any profits can be wiped out by fees and then taxes
NEW YORK » If you're trading stocks, especially small-cap stocks, unseen forces may be gobbling up your gains.
Trading costs have come down in recent years as commissions have been squeezed. But if you're buying and selling frequently, they add up. And if you're buying and selling stocks that aren't very liquid, they add up even more.
"Trading costs are way higher than most people think, including most money managers and certainly most clients," said Ted Aronson, a partner at Aronson Johnson Ortiz, which manages $25 billion.
He's a longtime rabble rouser on the issue of trading costs.
Let's say you buy shares of a small-cap such as Rocky Mountain Chocolate Factory Inc. at $15.50 and sell at $15.62. How much money have you made? It sounds like a trick question; the obvious answer is 12 cents. But the truth is, you're probably losing money.
The costs that eat into your gains start with commissions. At Charles Schwab Corp., commissions averaged $13.39 per trade during the first quarter, which ended in March. E-Trade Financial Corp.'s average commission per trade for 2005 was $13.82. Think about it: You may have paid $13.39 (or more) to buy a block of stock and then another $13.39 to sell it. Your gains will have to be greater than $26.78 for you to get close to breaking even. And that's without factoring in other costs.
The brokerage firms don't break down their commissions per share, but Wayne Wagner, a consultant to the brokerage and technology firm ITG Solutions Network who has spent three decades studying trading costs, estimates that commissions cost 3.2 cents a share on each side of the deal.
Wagner works with institutional investors, but retail investors can use the figure as a guide. That would mean 3.2 cents when you buy a share and another 3.2 cents when you sell, knocking 6.4 cents a share off your net gains.
The next problem is liquidity. Rocky Mountain Chocolate's average daily volume is 25,511 shares, but it's not unusual for the stock to trade half that many shares. As a result, it can be hard to find either a buyer or seller, which means buying the stock can push the price up, while selling it can push the price down.
"If you want to trade and no one else is there, you have to incent the sellers to sell by saying, 'I'll pay more,'" Wagner said.
The spread between the asking price and the selling price for the stock can be wide. Recently, the spread for Rocky Mountain was 6 cents a share. That can knock another 6 cents for each share your net gain.
Large stocks also have what's called "a bid-ask spread," but it's usually much narrower. For instance, Exxon Mobil Corp.'s spread is around 1 cent a share.
Your next cost is taxes, said Paul Larson, editor of Morningstar's Stock Investor Newsletter. If you've held the stock for less than one year, you will be taxed on short-term gains at your individual income tax rate. If you're in one of the middle tax brackets, that could lop a nifty 25 percent off your gain. If you're in the highest tax bracket, say goodbye to 35 percent.
If you've held the stock for more than a year, you'll be taxed at the capital gains rate, which is 15 percent.
"The more you trade, the worse you do; the less you trade, the better you do," Larson said.
For evidence, he pointed to a study of 60,000 households with accounts at a large discount broker between 1991 and 1996. The study, done by Brad Barber at the University of California, Davis and Terrance Odean at the University of California, Berkeley, found that the 20 percent of households that traded the most had an annual mean return of 10 percent. While that sounds great now, they trailed the average household's annualized mean return of 15.3 percent.
The title of the study: "Trading is Hazardous to your Wealth."