To Truly Make Money, One Must Consider: Trading Costs

Whether it's bank-managed investment products, funds, or stocks, investors face a range of costs, from handling fees to management fees and transaction fees. While each fee might not appear substantial on its own, these trading costs undoubtedly affect investors' returns, occasionally causing a notable reduction in investment income and significant profit loss.

 

Hence, investors ought to thoroughly comprehend potential investment costs, incorporate them into their evaluations, and opt for products with comparatively lower costs among those offering similar returns.

 

Trading Costs Include the Following Fees

 

In any financial transaction, there will inevitably be certain trading costs, and online trading such as stocks, options, and futures are no exception. The fee structure of an online broker mainly includes three aspects: spreads, transaction fees (commissions), and overnight interest.

 

Spread Costs

 

Spreads are the primary source of income for many online brokers. As a trader, you need to pay spread costs for each transaction. The spread is the difference between the buying price and the selling price. Brokers charge you for each transaction, regardless of whether you profit or lose, enabling them to earn spread costs. Therefore, brokers prefer high-frequency traders who conduct a large number of trades every day, as each trade brings profit to the broker.

 

Transaction Fees

 

Generally, transaction fees refer to "commissions." Typically, the main trading costs for stocks, futures, and on-exchange options products are commissions plus fees collected uniformly by exchanges or regulators.

 

For instance, a prominent U.S. online broker like Interactive Brokers employs the "IBKR Tiered" model, levying commissions (based on monthly trading volume) and handling fees for clients associated with exchanges, regulators, clearinghouses, and third parties. It also employs a "Fixed" model, where regardless of monthly trading volume, fees remain fixed, with third-party fees only requiring payment for regulatory charges.

 

Overnight Interest

 

Day traders usually hold positions for a short time during the day and exit trades before the market closes. However, for long-term traders, their holding period may exceed one day. This involves overnight interest costs.

 

For example, in the case of currency pairs, as the two currencies in a trade are constantly fluctuating, there is a difference in the interest rates of the two currencies, and the overnight interest fee you need to pay is calculated based on this interest rate differential. If you are trading the GBP/USD pair, the overnight interest fee will be determined by the difference in benchmark interest rates between the UK and the US. Assuming the UK interest rate is 5% and the US interest rate is 4%, then this 1% difference is the overnight interest you need to pay.

 

Profit is Actually Taken Away by Trading Costs by 40%

 

For ordinary investors, the most common investment method is to purchase various types of funds, and the expenses involved in buying a fund can be as many as ten items...

 

Suppose a fund has a management fee of 1.5%, a subscription fee of 1.5%, and a redemption fee of 1.5% within 7 days. If you hold it for about 3 years, you will incur expenses of around 3% per year.

 

Even if this fund maintains an average annual return of 10%, various fees reduce your actual profit to approximately 7%.

 

If you initially invested $100, according to a 10% annual return, after ten years your $100 would become $259, and after twenty years your $100 would become $673, nearly tripling and septupling, respectively.

 

However, deducting trading costs, calculated at 7%, your $100 after ten years is $197, and after twenty years it's $387.

 

This implies that over ten years, 40% of your profit is claimed by others; over twenty years, the figure rises to 50%.

 

The Compounding Effect Highlights the Significance of Costs

 

So why would seemingly small costs each year significantly affect our investment returns? The reason is quite straightforward—it's the familiar phenomenon of compound interest.

 

Suppose Buffett established a hedge fund and also charged various industry standard fees, how much of the profits generated for investors would he consume?

 

The typical fee structure for hedge funds is the so-called "2+20," meaning an annual management fee of 2%, and if profits are made, the fund manager and you split it eighty-twenty, with you taking 80% and him taking 20%.

 

Consider that from 1956, over a span of more than 60 years, you invested $10,000 with Buffett, with no additional fees charged; this sum would eventually grow to $600 million. However, if he implemented the "2+20" fee structure, your eventual return would amount to just over $20 million.

 

In other words, by charging this fee, Buffett would ultimately take away 96% of your investment return.

 

Funds with Lower Fees are More Likely to Succeed

 

Overall, among the common funds in the market, index funds such as passive broad-based index funds have the lowest fees. For example, Vanguard's S&P 500 Index Fund (ticker: VOO) has a management fee of only a miraculous 0.02% per year. Including other various fees, the annual cost might not even reach 0.05%.

 

Through analysis, even professional fund managers find it difficult to beat the market. Instead of trying to find a needle in a haystack among countless active funds, it's better to invest in passive index funds, at least guaranteeing average returns.

 

But if we must buy active funds and want good fund managers to manage our money, is there a way to predict which funds are better?

 

Morningstar has conducted a small study on this. After various statistical and calculation on global capital markets, they found that the best predictor is surprisingly the fund's fees. Funds with lower fees are generally more likely to succeed. That is to say, if you think about saving yourself some money before investing, not only can you save costs, but you may also achieve higher returns.

 

And this principle doesn't just apply to stock funds; it also applies to other similar types like bond funds, balanced funds, and even international funds.

 

How to Reduce Trading Costs

 

Choose the right broker: The difference in costs between different brokers can be significant. Look for brokers with low trading fees, tight spreads, and no hidden fees.

 

Trade during high liquidity periods: Execute trades during times of high liquidity (such as overlapping forex market trading sessions), which can result in smaller spreads and lower trading costs.

 

Use limit orders: Utilize limit orders to control the highest price you're willing to pay or the lowest price you're willing to accept. This can help reduce slippage, the difference between the expected price of a trade and the price at which it's actually executed.

 

Monitor and reduce leverage: Although leverage can increase potential returns, it can also amplify costs, especially in overnight financing costs for leveraged positions. Manage leverage carefully to control these costs.

 

In summary, when investing, never underestimate the importance of cost savings. Even if you can only save a little each year, it can greatly help long-term investment returns.