It is very tempting to manage one’s own investments and many dive head first into it. There are two aspects that drive people to try this: being in control and save money. Although most of the people that claim that the latter is the reason, the fact is they want to be in control. Because of that there are zillions of companies and individuals advertising and teaching the “hidden secrets of trading (or investing) success”. However, one aspect that not a single one touches is the costs of trading for a living. So, let’s get to it and do some number crushing. In this first article let’s discuss the long term investor. In the second part we will evaluate the day trader. In the third article, we will crunch the numbers for the swing trader. The last article will wrap it all with some considerations and suggestions.
Investing for the long term
If your plan is to invest for the long term, let’s say, to have enough to retire comfortably, you have a daily job or business that you like and want to keep doing. But the entire buzz around becoming a millionaire by adding a small number of hours to your work week seems tempting. When you start digging deeper you find some discrepancy in the numbers though. Some will say you can get by with two hours per week. Others will recommend two hours a day. That’s a huge difference! Let’s stick with the average here. So, between two and fourteen hours, the average is eight hours. How much these hours cost you? I will use a few figures, from $25.00 to $100.00.
Another cost you are going to have is the operational costs. There are few things that everyone will need. First, everyone needs research material. I am talking about the several market and company analysis reports. Many institutions supply them “for free”. I used quotes because it is not really free, there is a reason to do that, but I will explore this in the last article of this series. So, let’s go back to our considerations. I will assume that your account is with one of the large institutions that provide the research material at no additional cost. You can also use Google to search free resources on the web, but these are harder to sort out and find the really good ones. In the last article of this series I will discuss how free can be damaging to your investing account. If you decide to go and pay for a reputable market commentary letter the cost can go north of $1,000.00 for an annual subscription.
The second cost is the transaction cost. Since you are investing, there is no need to be buying and selling every day or even every month. However, are you going to be able to stick to the plan when you see your hard earned money going down? Well, reality is that more than 80% will not stick to the plan and overtrade. That is, start buying and selling as soon as they see losses and gains. Keep in mind that managing money in the financial markets is like being stuck in quick sand, the more you move around, the deeper in the hole you go. Let’s assume you are part of the 20% that stick to the plan.
The next aspect is the number of different stocks or ETFs you invest on. There are great investors that believe in diversification and there are great investors that believe in focusing. However, the vast majority of the population believe in diversification. Note that I used the word “believe” for all of these groups. There is no proof that diversification works at all. Portfolio theory relies on assumptions that are far from how the real market behaves… Well, we need some guideline for our simulation, so, according to Portfolio Theory, the effect of diversification starts to be less significant when you have around 20 different companies in your investment basket.
But there are more to the diversification aspect and this is where things start to get complicated… How much money you need to diversify? Well, if you want to stick to the minimum purchase on the stock market, you need to buy 100 shares at a time. That’s why many prefer the lower price stocks. Personally, I steer away from penny stocks and prefer to focus on the companies that take part of the S&P 500. This is already 500 companies to look at! And it may not include some companies that you may like and follow… Most of people will stick to a range from $10.00 to $50.00 per share. So, any trade will range from $1,000.00 to 5,000.00 invested in a company. With that in mind, you are going to need at least $50,000.00 to start investing on a basket of 20 companies.
So, how much it would cost (in trading costs) to maintain this diversified basket with 20 different companies? I will assume again that you are emotionally fit for the financial markets and to not overtrade. You might need to do on average one round trip trade a month (one buy and one sell trade) and a full rebalancing once a year (so, 20 buys and 20 sells). That adds up to 64 trades a year. This number will vary tremendously from one individual to another, but seems fair for a simulation.
Now, let’s look at the following table.
Trading cost ($/Year) | Hours per week invested in managing the portfolio | Hourly wage ($/h) | Labour + trading cost ($/Year) | Amount invested ($) | Profits to cover cost (%) |
$639.36 | 8 | 25.00 | 11,039.36 | 50,000.00 | 22.08% |
$639.36 | 8 | 40.00 | 17,279.36 | 50,000.00 | 34.56% |
$639.36 | 8 | 70.00 | 29,759.36 | 50,000.00 | 59.52% |
$639.36 | 8 | 100.00 | 42,239.36 | 50,000.00 | 84.48% |
Well, the historical market index average is around 14% and few active portfolio managers with great professional support from research analysts and professional communication channels with companies C-level managers can beat that. One needs to be damn good (or lucky) to cover these costs alone… Things do not change much with three times more money, as we can see on the next Table.
Trading cost ($/Year) | Hours per week invested in managing the portfolio | Hourly wage ($/h) | Labour + trading cost ($/Year) | Amount invested ($) | Profits to cover cost (%) |
$639.36 | 8 | 25.00 | 11,039.36 | 150,000.00 | 7.36% |
$639.36 | 8 | 40.00 | 17,279.36 | 150,000.00 | 11.52% |
$639.36 | 8 | 70.00 | 29,759.36 | 150,000.00 | 19.84% |
$639.36 | 8 | 100.00 | 42,239.36 | 150,000.00 | 28.16% |
I am sure most of the people that invest their money and life in managing their portfolios would not have even started if they looked at these numbers… Even if we consider minimum wage the cost of doing it yourself is still high.
There is another pitfall. One might argue that it is best to buy an index ETF and just leave it there. Well, I don’t know anyone that would not panic in a situation like the one that occurred in 2008, when the index fell by more than 50%. And even the ones that kept invested had a hard time waiting until 2010 to get back to the original level and do not bail out at break even. I can bet that, among the index ETF or Mutual Fund DIY passive investors very few endured through all the process and now average more than 10% in yearly profits (considering the index average from 2007 to 2017)
Vanguard Asset Management (the largest manager of index funds in United States) did a research and found that their advisors add about 3% to a client overall profits. And the biggest reason is behavioural coaching…
We will discuss this aspect in depth on the fourth article of this series. Stay tuned!
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