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Consideration One: Commissions are
not quite as important as you think they are.
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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. In Wrap Accounts
which combine Management and Brokerage costs, the difference between
the two is no longer discernable.
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Consideration Three: The Day Limit Order Saves the Really Big
Bucks... it's a matter of smart buying, and even smarter selling!
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?
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 investor will tell you, if you don't have
reasonable selling targets, what do 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
effective... particularly in relatively "flat" equity markets.
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?
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.
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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" 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.
Pre-paid commission arrangements have some other benefits that are
worth considering, particularly if you are in a brokerage environment
where there is some flexibility to move between a pay-as-you-trade and a
flat fee arrangement.
- 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?
- 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?
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 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.
Regular Commissions at 2%
Flat Fee Arrangement at 1.5%
Total Cost of our Inventory $102,000 $100,000 Sale price to produce 10%
net/net profit (has to be enough to cover commissions
both ways) $114,240 $110.000
Less commissions to employees @ 2% and at 0% Cost
Basis -$2,040 -$0
Net Receipts on sales of merchandise $112,200
$110.000 Less Increase in Overhead Expense -$0 -$1,575 Total Profit on
sales $10,200 $8,425 Total profit as a % of original price 10.00% 8.43%
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.
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.
- 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:
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"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.
"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 may produce the cash needed
to shop for bargains.
- In an emergency, the pain of unplanned selling
can be eased.
Tax Benefits of the Flat Fee Commission Arrangement...
maybe (subject to your accountant's advice on the subject):
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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 i
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