Opinions and observations expressed on this blog reflect the authors' individual experiences and should not be construed to be financial advice. None of the members of this blog are licensed financial advisors. Please consult your own licensed financial advisor if you wish to act on any recommendations here.

Sunday, July 4, 2010

Strategy: How to manage future transaction costs in a small portfolio

As I am not a wealthy man, nor will I likely be working for my state's government, I, like many others, must pay a great deal of attention to transaction costs when executing trades. In what follows, I try to provide a few examples, all reasonably straightforward, of how to reduce the potential for ruinous costs.

Let us take the example of a brokerage account with $5,000 in it. You have this divided among five holdings at $1,000 each because you took the advice previous mentioned on this blog and attempted to build out core, meso, exploratory, and speculative holdings. That's all well and good, but let's say that you suddenly decide that you think all hell is about to break loose and you want to shield your assets in a bond ETF, say TLT. For the purposes of this demonstration, I'll say brokerage fees are $10 per trade just because it makes the math easier. First, in your initial sales, you incurred $50. Then, in your purchase of the bond ETF you incurred another $10. When the crisis passes you sell your bond ETF, incurring another $10, and then you buy back into your original five positions at another $50. Your total fees were $120 or 2.4%.

Now, you might say that 2.4% is not so bad because you may have averted far worse in the market as a result of your move. However, even among the best portfolio managers are wrong about as often as they are right. Over time, these decisions, even executed properly, are likely to be a wash for the typical investor. I know, speaking for myself, that they have been for me. The cumulative effect of multiple swaps over several years' time can be the loss of multiple percentage points of your assets with a devastating effect on your total return over the long run.

Even in a larger portfolio, if one divides their positions too thinly, the situation repeats itself. For example, the costs as a percent of assets for a $50,000 portfolio divided amongst 25 holdings at $2,000 a piece works out to be $520 total or slightly over 1% of total assets lost via fees. If this person is an active trader and does this a few times a year on average attempting to pick each point at which the market might turn, they could rack up 3 or 4% in fees. That's to say nothing of bad capital gains management, which I will discuss at some other point.

Now, the lower proportion of fees in the second example makes the point I would like to make. If you wish to engage in more active market timing, keep your number of holdings down significantly. In the first example with the $5,000 brokerage account, if you have only two holdings at $2,500 each your transaction costs for the whole series of transactions are only $60 or 1.2% of your portfolio. It's still a steep price to pay, but with larger portfolios keeping the number of holdings down drives these costs right through the floor. In the $50,000 portfolio example, if that investor only had five holdings at $10,000 a piece, they incur $120 in transaction costs or 0.24% in fees for a whole cycle of transactions. As such, the lesson is that consolidated, larger holdings give you a greater ability to engage in market timing if you feel that's what you should be doing. The risk is that, depending on how you do it, you lose out on diversification. You can make up for this in choosing broad market index ETFs and then have both flexibility and diversification.

Now, as to whether or not market timing is a good idea, that's a tricky one. There were people who sold out after the first 10% up from the March lows of last year waiting for a correction that never came. Even with the recent rout, we are still far above the levels that these traders were waiting for. At the same time, selling in early April of this year would have been a very prudent thing to do especially if you then stuck that money in TLT. You would have a spread of something like 2600 basis points over where your money would have been otherwise. Not bad.

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