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Consideration One: Commissions are not quite as important as you think they are. 

Consideration Two: Flat Fee Commission arrangements are different from Wrap Accounts, providing a practical way to change a large variable cost into a smaller fixed cost... in many instances, depending on trading volume.  In Wrap Accounts, management and brokerage costs are combined and the difference between the two is no longer discernable.

Consideration Three: The Day Limit Order saves the really big bucks... it's a matter of smart buying, and even smarter selling.

Consideration Four: Pay-as-you-go commissions become part of a transaction and can be dealt with in buy and sell order prices. Commissions that are turned into fees are simply needless withdrawals from portfolios.

Consideration Five:  Flat Fee Commissions require an "uninvestable" reserve to assure the availability of funds to pay the fees.

Nothing in the Investment World is misunderstood more than the impact of commissions. Since Charles Schwab first shocked Wall Street by offering discount commission rates, a new industry has developed with a huge, cult like, following of investors. Investment Managers are often called upon to explain why they prefer to operate using full service firms as, I’m told, most independent managers do. Many of you may even stop reading when I utter my blasphemous opinion that commissions are simply a variable cost of Portfolio Management and not something to get particularly stressed about. 
  • In order to construct a properly diversified portfolio from scratch, you have to pick and choose many different securities to attain the proper balance and diversification. If the relationship is in the six figure area, arrangements can generally be made to reduce the impact of start up costs even at the most expensive of full service brokerage firms. 
  • Although there are serious benefits working with larger, well known firms, the key issue is the relationship you develop with your account executive. He or she is there to help you plan and implement your program. They are trained to deal with individual securities, and should understand them as well as they do mutual funds... but remember, this needs to be your program so you may have to steer them in the individual security direction. Your financial advisor needs to impress you with a knowledge of securities, markets, and the fundamentals of investing like those that you have been introduced to around this website.
  • Actually, if you read the fine print in several discount brokers client agreements, you will learn that there are firms out there that tell you up front that they have no intention of making any effort to obtain Best Execution for their clients. So, in effect, you may pay a lower commission but a higher price for the security. Who wins?
Contrary to popular belief, successful investing requires the conscious coordination of two sets of well-documented principles, not just the placement of securities orders in one medium or another, or at high or low commission rates. These principles are the Quality, Diversification, and Income (QDI) tenets of Investments 101, and the Planning, Leading, Organizing, and Controlling (PLOC) basics crammed into the brains of all Sophomore Management students. 

As every experienced Manager knows, it is the fixed costs of an operation that require tight control, and the variable costs that require creative direction. 

  • There are few Fixed Costs in Investing. Investment Management Fees are one, Flat Fee Commissions would be another.
  • Variable Expenses are directly related to buying and selling the securities in the portfolio. Theoretically, variable costs are zero if there is no activity.

For most stock purchases, the costs are up front and visible. For most Bond, and new issue purchases, the commissions are hidden from the investor, as they are with all Mutual Fund and Insurance/Annuity products. Still, all of the acquisition costs of an investment are included in the Cost Basis of the security, and it is this Cost Basis that you should be using to establish your selling targets. As every eighth grader knows, x% of a big number exceeds x% of a smaller number every time, and as experienced investors will tell you, you must have reasonable selling targets if you hope to gain from investing in securities.

If you are managing the investment enterprise properly, your variable costs will move ever higher while your fixed costs remain relatively constant. Understand? As the portfolio grows from income generation and from profit taking, the commission expenses will grow because there will be more things to do more frequently. 

  • But, you need to replenish and increase inventory if you want growth, and so long as you maintain your profit margin at a reasonable level, service can be more important than the commission rate. A Flat Fee arrangement in an actively traded account can be visually and emotionally effective... but economically, it just ain't so! 

Much to your surprise, your realized profits will probably increase at a higher rate than the increase in your variable costs... at least in dollar terms. Could it be true that: if commissions are a function of profitable sales, paying more in total commissions means more profits in the portfolio?  And is the payment of more taxes because of increased profits really such a problem? Yes, and No.

All too often, commission avoidance and tax reduction issues are allowed to Wag the Dog, causing millions of unrealized profit dollars to hit the books next year as realized losses.  In The Brainwashing of the American Investor, I’ve illustrated how (in a percentage-target trading environment) investors who pay higher commissions actually make more money, in dollar terms, than their frugal discounterparts [sic].  The Math is simple; 10% of a larger number is a larger number, period. But it just plainly should not be an issue at all. And, if it were really as big a deal as it is purported to be, there just wouldn’t be any full service/high commission brokers, would there?

  • As with most things in life, if it's free, or really cheap, it's probably worth just what you've paid for it.

In investing, fixed costs are minimal unless you go out of your way to increase them by adopting some form of commission replacement arrangement. A management person responsible for directing your portfolio is always a fixed expense, and the fee charged generally moves lower as the account relationship grows. Many Wall Street firms offer arrangements called Wrap or Managed Accounts  that combine commissions and management fees into one charge. 
  • Where true Individual portfolio construction and management is involved, investors should have the option of choosing to pay commissions viewed as a variable cost, trade by trade, OR as a combined fee that could significantly reduce commission expenses... most of the time. The higher the percentage of income securities in the portfolio, the lower the flat fee would have to be to reduce overall transaction expenses.
  • Fixed income investing is much like furnishing a home with durable goods… there should be very low fixed expense and almost no variable costs at all. BIG BUT, if you are using tradable securities (CEFs, Preferred Stocks, etc.), go for the Flat Fee during the downward cycle of interest rates, and straight commissions when rates are rising. Ya follow? (But this has to be fair to all concerned parties.)
  • Equity portfolio investing is more like running an active retail business… the more (profitable) turnover, the better. Most retailers have a standard mark-up policy, and most understand the turnover issue. The last thing that a retailer, or any businessperson, wants to see is a higher inventory market value from quarter to quarter! [Read that again and think a minute.] 
  • Higher sales numbers are the key issue, and turnover is what you should want your Equity Portfolio to produce. If  the product isn't selling, in the Investment Portfolio World, it means that the portfolio Working Capital isn't growing. 
  • Focus on the profits, not on the cost of obtaining them. I know this sounds flawed right now, but it won't once you've gained some experience. 
  • Properly directed variable expenses are the ideal fertilizer for growing sales, and without sales, there are no profits. And, in equities, if there are no realized profits, why bother?
Retailers’ shelves are full of merchandise, purchased at different times, at different prices, and from countless wholesalers who, themselves, have varying markups. Items that move slowly are marked down for easier sale, quantity purchasers obtain discounts, damaged items are sold at a loss, etc, etc. Employees get their commissions, suppliers of replacement merchandise get their markups, and the cycle continues. Just like running an Equity Portfolio, right? The more commissions the retailer pays out, the more profit he brings to the bottom line. Just like running an Equity Portfolio, right? 

Now, what really happens when retailers: (1) reduce their buying and selling expenses to zero, but (2) add an additional 1.5% to overhead, while (3) keeping a profit target of 10%?   This is precisely how the normal Flat Fee Arrangement plays out. But, even without the increase in overhead or fixed costs, the profit is a bigger number. Sometimes. the old fashioned way is better.         

Regular Commissions at 2%

Flat Fee Arrangement at 1.5%

Total Cost of our Inventory  $102,000 $100,000
Sale price to produce 10% net/net profit (has to be enough to cover commissions both ways) $114,240 $110.000
Less commissions to employees @ 2% and at 0% Cost Basis -$2,040 -$0
Net Receipts on sales of merchandise $112,200 $110.000
Less Increase in Overhead Expense -$0 -$1,575
Total Profit on sales $10,200 $8,425
Total profit as a % of original price 10.00% 8.43%
So by cutting both our acquisition costs and our selling costs (and abusing our employees in the process), we've effectively reduced our gross sales by $2,200 and our actual dollar profit by $1,775 while locking in a 15.7% smaller profit margin.  This Math is flawed in one respect. The lower level of service and/or commitment you get from suppliers and salespeople will absolutely cause other costs to rise, as they  will provide their best service to better customers. You won't sell as much stuff, and you won't sell it as quickly.

Applying this illustration to the stock market and equity trading, one would find similar results. With a full service broker, you may wind up with a sales target for a particular stock that is somewhere between 25 and 75 cents per share higher (the larger the position, the smaller the differential). But you'll get a phone call when a selling target is reached, or an old favorite has come back into range. And, with independent brokerages all over the place, you need not pay for service with body parts.

The Commission Virus attacks the cerebral cortex and creates mathematical dementia, an almost true story!
  • After a year of trading, the Investment Manager proudly presented the Capital Gains report which showed an 11% gain on trades equaling approximately $11,000, with an average six-month holding period. 
  • The client fired the manager because his RIA Accountant calculated that the real gain was only $5,800 because he had paid $4,200 in commissions and $1,000 in management fees.
  • How so cried the manager, these profits are after commissions. You are deducting them twice! You'll be paying taxes on the $11,000.
  • Oh, you are right! My real gain is only $2,500!
  • But your account value reads $113,000! (Tell me how for a free book!)
  • Don't confuse me with the facts.

          Beware the DICV (Dysfunctional Investment Commission Virus). It's out there!

The Day Limit Order Saves the Really Big Bucks... regardless of how you pay the commissions. You may get some resistance, (or be resistant yourself) to using this type of order, but try it for a while and be prepared for some enlightenment, so long as you are using a brokerage firm that guarantees its Best Execution efforts. You will observe:
  • Buy executions at varying prices below the limit you've specified. If you are watching the proper market statistics and numbers, and are asking for complete real time quotes (bid, asked, last), you'll be able to dig deeper below your original buy price for savings far better than the simple discount commission.
  • Sell executions above your limit... sometimes by significant amounts. 
  • Absolutely no unfortunate surprises.
Downside and emergency benefits of the Flat Fee Commission Arrangement:
  • If an issue you hold is downgraded, a realized loss may be changed to a small realized gain if no commission is to be paid.
  • In a down trending market, a small profit or breakeven transaction my produce the cash needed to shop for bargains.
  • In an emergency, the pain of unplanned selling can be eased.

Possible Tax Benefits of the Flat Fee Commission Arrangement... maybe (subject to your accountant's advice on the subject):

  • A way of removing assets from a retirement program without ever paying any taxes on the money withdrawn. This goes for Investment Management Fees as well. However, the withdrawals must be for charges that are actually associated with services for the account in question.