Tuesday, December 4, 2007

The Costs of Trading Stocks

In my own portfolio, I choose to own several individual stocks. Even though I think that most people would be better off in index funds, I’m not against direct ownership of stocks. I happen enjoy tracking the progress of the businesses that I own, and I’m hopeful that I will prove to be slightly above average at stock picking.  (Rereading this nearly 12 years later, I no longer own any individual stocks, and I realize that being above average doesn't mean being better than my neighbour; it means being better than most investment professionals.)

If you are not interested in analyzing businesses, and the time you spend following stocks consists mainly of checking current prices, then owning individual stocks probably isn’t for you. Over the long term it is the sales and profits of the business that determine your profits. Predicting the long-term future of a stock is best done by trying to predict the future success of the business rather than looking at wiggles in the chart of stock prices.

Just as it is important to understand the cost of owning mutual funds (loads and the Management Expense Ratio, MER), it is also important to understand the costs of owning stocks. These costs come mainly from buying and selling stocks. Other possible costs are account opening and closing fees and yearly maintenance fees. Many brokerages offer accounts without these additional fees.

When it comes to trading stocks, most people are aware that they have to pay a commission on each trade. The first time I ever bought some stock I was charged a commission of $186.07. This seems outrageously high by today’s discount brokerage standards, but it is typical of the commissions charged by full service brokers even today. These brokers would be better named “full cost brokers.” Today I can make trades with my discount broker for $10.

Another cost in trading stocks that most people don’t think about is the spread. Each stock has a bid price and an ask price. The bid price is the highest price that someone is currently willing to pay for the stock, and the ask price is the lowest price someone is currently willing to accept for a stock. The difference between these two prices is called the spread. When you place an order “at the market”, you buy at the higher (ask) price, or sell at the lower (bid) price.

In the coming posts, I’ll have more to say about commissions and spreads.

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