Transaction cost best Practices

What is the minimum amount of money that be should invested at one time?

We are always trying to control costs for our clients.  We do this by investing in low-cost exchange traded funds (ETFs) and mutual funds, and by selecting Scottrade as our primary custodian, who provides an industry low $7/per stock or ETF trade. But, even though we have an ultra low $7 transaction cost. We need to ask what is the most efficient way to trade a client’s account to minimize trading costs and without sacrificing return.  Below are some things to consider and what we have determined to be the best course of action.

Our first rule of thumb is to minimize the impact of transaction costs but not let it prevent us from placing important trades. Generally, we won't trade under $1,000 at a time.  This, of course, is only a starting point and depends on each client's situation.  For example, if we are anticipating additional cash coming into an account, such as dividends or deposits, we will wait and invest the money all at once.  Or if the market has been very volatile we may rebalance a client's portfolio multiple times a year to either change the allocation or harvest tax losses.  Below are some numbers to think about related to trading costs:

  • Hypothetical Funds Invested = $850
  • Annual Rate of Return = 10% (approx. historical return on the stock market)
  • $ Annual Rate of Return = $85
  • Months in a Year = 12
  • Projected $ Return per Month = $7.08

This means the cost of placing a trade through Scottrade is approximately equal to one month of return from the general stock market.  Therefore, based on these numbers you should be indifferent to investing $850 in one month versus waiting to save on trading costs. 

To prove this I calculated these numbers in a spreadsheet and the results are as follows:

Click to enlarge

Note the total amount invested over a year is $10,200 in each scenario. You will see that investing monthly versus bi-monthly is almost no different, even though you save on transaction costs by investing bi-monthly. Investing quarterly the investor is worse off because you are losing out on return from not being invested. This calculation will change if you adjust your expected rate of return and other factors.

Overall, do not get stuck on the transaction cost as they are a cost of investing.  Control what you can by choosing a custodian like Scottrade to control transaction costs but add even greater value for your by being efficient with your investing.  Scottrade also has non-transaction fee funds (NTF Funds) which can save you even more depending on your investment strategy.

You should also consider using Scottrade's Flexible ReInvestment Program (FRIP).  This allows you to pool your dividends and reinvest transaction cost free in a basket of predefined securities. It’s an interesting take on traditional DRIP investing.

The bottom line is costs matter when investing. It might seem insignificant but it adds up to a lot over time. While we cannot control the stock market, certain costs are well within our control. If you have questions about this or other investing best practices put it in the comments section below and you might even get your very own blog post!

Happy Investing!