5. Account Fees and Commissions

This is part five of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part four.

My thoroughly researched scheme to fund my retirement account had hit a huge pothole.  It seems that my recent love affair with ETFs had blinded me to their huge downside: paying trade commissions every time you bought a fund.  The one advantage of mutual funds is that once you buy the fund, you can buy more shares without having to pay trade commissions.  In part four, I was quibbling over differences in expense ratios of less than 1/10 of 1 percent to save myself $20 over a ten year span.  But now I was faced with the prospect of spending $70 every time I put money into my retirement account.  I had a feeling that this $70 dollars was going to make my ETF strategy less effective than buying mutual funds (gasp!) so I decided to take a look at the numbers.

How do trade commissions affect my annual rate of return?  As an individual investor, the only sensible way to buy stocks, bonds or ETFs is to have an online brokerage account (like Zecco, Scottrade, Schwab, ETrade etc.).  In all of these brokerage accounts, every time you make a transaction, you are charged a trade commission, usually between $4 and $12 dollars.  If you want to buy 1 share of SCHB at $30 dollars a share, and you have a Scottrade account ($7 a trade), the whole transaction will cost you $37.   If you want to buy 10 shares of SCHB, the transaction will cost you $307.  Clearly, the commission per trade and the amount of shares you buy will determine the effect on your annual rate of return.  Below is a screenshot of an spreadsheet I made to determine the “trade commission expense ratio.” In other words, given a certain monthly contribution and a certain cost per trade, how will paying for trade commissions reduce your portfolio’s annual return?

Lets say that I plan to put away $500 a month in my retirement portfolio and I use Scottrade for my online broker who charges $7 dollars per trade.  To stick to my asset allocation plan, I will make 10 transactions every month, which will cost me $70 a month and $840 a year in trade commissions.  So out of the $6,000 I contributed over the course of the year, I will have spent 14% (840/6,000) of that money just on trade commissions.  In other words, in order to be my own “fund manager,” I have slapped myself with a ridiculous expense ratio of 14% – in addition to the expense ratios of each ETF that I own. When you look at it like that, picking a mutual fund with a 2% expense ratio and 1% underperformance of the market looks like a pretty good decision.

I wasn’t ready to give up there.  I started looking around to find cheaper brokerages and found there were a few brokerages offering things like “100 free trades” or “3 free trades a month.”  More importantly, though I saw that both Schwab and Vanguard offered free trades if you bought their brand of ETF index funds.

How much money will switching brokerage firms save me? As I mentioned in part 4, both Schwab and Vanguard make their own version of ETFs for almost all the asset categories I was looking for.  Here is a quick summary of what is out there:

You’ll notice that with a Vanguard account, you can buy all but three of the asset classes that you need for your retirement portfolio for FREE.  With a Schwab account you can buy all but five assets for free. Effectively, having your portfolio in a Vanguard account would reduce your monthly trades from 10 to just 3.  So how would that affect my trade commission expense ratio?  Below I’ve done the calculation, but there are two important things to note.  First is that Vanguard charges an Annual Fee for all  accounts with a balance less than $50,000 (what you don’t have 50 grand saved???).  I have included this annual fee in my calculation of “trade commission expense ratio.”  Second, Vanguard charges $7 for the first 25 trades each year and $20 for each trade after that.  At 3 trades a month, you will complete 36 annual trades with an average trade commission of $10.97.

Based on this spreadsheet, having either a Schwab or a Vanguard Brokerage account looks like a much better deal than having a Scottrade account as shown in the previous example.  Still, if I make a $500 monthly contribution in a Vanguard account, I am stuck with a whopping 6.92% expense ratio – much higher than the expense ratio of even the worst mutual fund you could buy.  It seemed like no matter how I tried to change the game, even one extra trade per month would put a serious dent in my retirement savings.  If transaction costs are the killer, then shouldn’t I try to limit the number of transactions I make?

What if I only put money in my retirement portfolio twice a year?  Instead of putting in $500 a month why not just put in $3,000 every six months?  Or better yet, just put in $6,000 at the end of every year?  First the good news – adding to your retiremnent portfolio only twice a year will save you in trade commission expense ratios.  It actually makes the ETF investing strategy look pretty good.

But there are three major reasons why investing annually or even semi annually is a bad idea.  1. You know the old addage “pay yourself first?” What happens every month if I am not putting money into your retirement account?  Will I have enough restraint to let it sit there in my savings account until I am ready to invest?  2.  While I am waiting to put money into the market, it will probably be sitting in some really low interest savings account.  If I had invested my money the moment it was available, it would be earning money in the stock market.  With an average annual return of about 8% in the stock market, having my money sit around for 6 months would cost me 4% interest!  3. Even if you only once or twice a year, you still might have to make trades in order to rebalance your portfolio.  It is this last point that I devote part six to.

To continue reading, follow the link to Part 6 – Portfolio Rebalancing.