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Consideration
One: Commissions are not quite as important as you think they
are.
Consideration
Two:
Flat Fee Commission arrangements are different from
Wrap Accounts, providing a practical way to change a
large variable cost into a smaller fixed cost... in many
instances, depending on trading volume. In Wrap Accounts,
management and brokerage costs are combined and the difference between the two is no longer
discernable.
Consideration
Three: The
Day Limit Order saves the really big bucks... it's a matter of
smart buying, and even smarter selling.
Consideration
Four: Pay-as-you-go
commissions
become part of a transaction and can be dealt with in buy and sell
order prices. Commissions that are turned into fees are simply
needless withdrawals from portfolios.
Consideration
Five: Flat Fee Commissions require
an "uninvestable" reserve to assure the availability of
funds to pay the fees.
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Nothing
in the Investment World is misunderstood more than the impact of
commissions.
Since Charles Schwab first shocked Wall Street by offering discount
commission rates, a new industry has developed with a huge, cult
like, following of investors. Investment Managers are often
called upon to explain why they prefer to operate using full service
firms as, I’m told, most independent managers do. Many
of you may even stop reading when I utter my blasphemous opinion
that commissions are simply a variable cost of Portfolio
Management and not something to get particularly stressed
about.
- In order to construct a properly diversified portfolio
from scratch, you have to pick and choose many
different securities to attain the proper balance and
diversification. If the relationship is in the six figure area, arrangements can generally be made to
reduce the impact of start up costs even at the most expensive
of full service brokerage firms.
- Although there are serious benefits working with larger, well
known firms, the key issue is the
relationship you develop with your account executive. He or she
is there to help you plan and implement your program. They are trained to deal with
individual securities, and should understand them as well as
they do mutual funds... but remember,
this needs to be your program so you may have to steer them in
the individual security direction. Your
financial advisor needs to impress you with a knowledge of securities, markets, and
the fundamentals of investing like those that you have been introduced to
around this website.
- Actually, if you read
the fine print in several discount brokers client agreements,
you will learn that there are firms out there that tell you up
front that they have
no intention of making any effort to obtain Best
Execution for their clients. So, in effect, you may pay a
lower commission but a higher price for the security. Who wins?
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Contrary to popular belief, successful
investing requires the conscious coordination of two sets of
well-documented principles, not just the placement of securities
orders in one medium or another, or at high or low commission rates.
These principles are the Quality, Diversification, and Income (QDI) tenets of Investments 101, and the Planning, Leading, Organizing,
and Controlling (PLOC) basics
crammed into the brains of all Sophomore Management students.
As every
experienced Manager knows, it is the fixed costs of an operation
that require tight control, and the variable costs that require
creative direction.
- There are few
Fixed Costs in Investing. Investment Management Fees are one,
Flat Fee Commissions would be another.
- Variable Expenses are
directly related to buying and selling the securities in the
portfolio. Theoretically, variable costs are zero if there is no
activity.
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.
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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.
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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 that 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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| Retailers’
shelves are full of merchandise, purchased at different times, at
different prices, and from countless wholesalers who, themselves,
have varying markups. Items that move slowly are
marked down for easier sale, quantity purchasers obtain discounts,
damaged items are sold at a loss, etc, etc. Employees get their
commissions, suppliers of replacement merchandise get their markups,
and the cycle continues. Just like running an Equity Portfolio,
right? The more commissions the
retailer pays out, the more profit he brings to the bottom line.
Just like running an Equity Portfolio, right?
Now,
what really happens when retailers: (1) reduce their buying and
selling expenses to zero, but (2) add an additional 1.5% to
overhead, while (3) keeping a profit target of 10%?
This is precisely how the normal Flat Fee
Arrangement plays out. But,
even without the increase in overhead or fixed costs, the profit is
a bigger number. Sometimes. the old fashioned way is better.
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Regular Commissions
at 2%
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Flat Fee Arrangement
at 1.5%
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Total
Cost of our Inventory
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$102,000
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$100,000
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Sale price to produce
10% net/net profit
(has
to be enough to cover commissions both ways)
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$114,240
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$110.000
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Less commissions to employees
@ 2% and at 0% Cost Basis
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-$2,040
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-$0
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Net Receipts on sales of merchandise
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$112,200
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$110.000
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Less
Increase in Overhead Expense
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-$0
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-$1,575
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Total Profit on sales
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$10,200
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$8,425
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Total profit as a % of original price
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10.00%
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8.43%
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So
by cutting both our acquisition costs and our selling costs (and
abusing our employees in the process), we've effectively reduced our
gross sales by $2,200 and our actual dollar profit by $1,775 while
locking in a 15.7% smaller profit margin.
This Math is flawed in one respect. The lower level of service
and/or commitment you get from suppliers and salespeople will
absolutely cause other costs to rise, as they will provide their
best service to better customers. You won't sell as much stuff, and
you won't sell it as quickly.
Applying
this illustration to the stock market and equity trading, one would
find similar results. With a full service broker, you may wind up with
a sales target for a particular stock that is somewhere between 25 and
75 cents per share higher (the larger the position, the smaller the
differential). But you'll get a phone call when a selling target is
reached, or an old favorite has come back into range. And, with
independent brokerages all over the place, you need not pay for
service with body parts.
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The
Commission Virus attacks the cerebral cortex and creates
mathematical dementia, an almost true story!
- After
a year of trading, the Investment Manager proudly presented the
Capital Gains report which showed an 11% gain on trades equaling
approximately $11,000, with an average six-month holding period.
- The
client fired the manager because his RIA Accountant calculated
that the real gain was only $5,800 because he had paid $4,200 in
commissions and $1,000 in management fees.
- How
so cried the manager, these profits are after commissions. You
are deducting them twice! You'll be paying taxes on the $11,000.
- Oh,
you are right! My real gain is only $2,500!
- But
your account value reads $113,000! (Tell
me how for a free book!)
- Don't
confuse me with the facts.
Beware
the DICV (Dysfunctional
Investment Commission Virus).
It's out there! |
The
Day Limit Order Saves the Really Big Bucks... regardless of how
you pay the commissions. You may get some resistance, (or be resistant
yourself) to using this type of order, but try it for a while and be
prepared for some enlightenment, so long as you are using a
brokerage firm that guarantees its Best Execution
efforts. You will observe:
- Buy
executions at varying prices below the limit you've specified.
If you are watching the proper market
statistics and numbers, and are asking for complete real
time quotes (bid, asked, last), you'll be able to dig deeper
below your original buy price for savings far better than the
simple discount commission.
- Sell
executions above your limit... sometimes by significant amounts.
- Absolutely
no unfortunate surprises.
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Downside
and emergency benefits of the Flat Fee Commission Arrangement:
- If
an issue you hold is downgraded, a realized loss may be changed
to a small realized gain if no commission is to be paid.
- In
a down trending market, a small profit or breakeven transaction
my produce the cash needed to shop for bargains.
- In
an emergency, the pain of unplanned selling can be eased.
Possible
Tax
Benefits of the Flat Fee Commission Arrangement... maybe (subject to
your accountant's advice on the subject):
- A
way of removing assets from a retirement program without ever
paying any taxes on the money withdrawn. This goes for
Investment Management Fees as well. However, the withdrawals
must be for charges that are actually associated with services
for the account in question.
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