Transaction costs are expenses incurred when buying or selling a good or service, aside from the cost of the good or service itself. These costs represent the labor required to bring a good or service to market or to connect a buyer with a seller. Entire industries exist to facilitate these exchanges.
Transaction costs can include fees such as brokers’ commissions and spreads - the differences between the price the dealer pays for a security and the price the buyer pays. Commissions paid to professionals like real estate agents are other examples.
Key Takeaways
- Transaction costs are payments that banks, brokers, and other facilitators receive for their roles in connecting buyers and sellers.
- Transaction costs significantly influence net returns.
- Different asset classes have various ranges of transaction costs; investors should select assets with the lowest costs within their types.
- Transaction costs only incur when purchases or sales are made; ongoing fees relate to continuous service time.
- Traders can minimize transaction fees through aggregating trades or by adopting a more passive investment strategy.
Embrace Efficiency: Understanding Transaction Costs
Transaction costs to buyers and sellers are the payments to facilitators such as banks and brokers for their roles in connecting buyers and sellers. For example, fees paid to a brokerage for executing a trade are a transaction cost. In real estate, transaction costs include the agent’s commission and closing costs.
Transaction costs are crucial for investors because they are key determinants of net returns. High transaction costs can significantly diminish returns over time. Therefore, selecting assets with low associated costs is essential.
The Long Haul: Ongoing Fees vs. Transaction Costs
While similar, ongoing fees and transaction costs are technically different. Ongoing fees are charged periodically over the product’s or service’s lifespan. In contrast, transaction costs are incurred each time a transaction happens.
Broker offerings may include unavoidable ongoing fees. Notably, there may be chances to forgo some transaction costs by agreeing to ongoing fees instead. Careful selection of brokers or agents can help minimize these fees.
Revolution in Motion: Elimination of Transaction Costs
When transaction costs decrease, economies become more efficient, freeing more capital and labor. While this transition has growing pains, it often leads to increased wealth production.
Technological advances have reduced communication barriers, allowing consumers direct access to information and reducing the need for intermediaries. Consequently, many traditional roles and industries are evolving rapidly.
For example, technology startups are replacing insurance agents, and e-commerce is reducing retail markups. Similarly, government or judicial actions, such as those impacting real estate commission rates, are altering transaction costs.
Case Study: Understanding Transaction Costs Through Mutual Funds
Mutual funds typify services with transaction costs, like load fees paid to brokers to incent choosing particular funds. These fees can range between 1% to 2%. Additionally, investors might face 12b-1 fees, ranging from 0.25% to 1%, these are typically one-time fees.
Are Transaction Costs Legal?
Yes, transaction costs for buying and selling goods are often legal. These fees reward parties facilitating transactions. Governments and regulatory bodies may cap or restrict transaction costs within industries.
Journey to Minimalism: How Can You Avoid Transaction Fees?
While eliminating all transaction fees is seldom possible, reducing them is achievable. Reduce transaction frequency and group transactions together. Choose brokers offering free trades for specific contracts to minimize fees.
The Long-Term Impact of High Transaction Costs
High transaction costs have significant long-term financial implications. For example, investing $10,000 annually for 30 years with a 6% return results in an approximate ending value of $838,000. An annual expense of 1% would reduce the ending portfolio value to about $700,000.
The Bottom Line
Transaction costs are necessary rewards for intermediaries facilitating exchanges of goods. In investments, where brokers and other entities impose fees, mindfulness of these fees and leveraging strategies like passive investing can help minimize costs.
Related Terms: commissions, spreads, mutual funds, asset classes, e-commerce, real estate.
References
- National Association of Realtors. “Settlement Factsheet”.
- U.S. Securities and Exchange Commission. “How Fees and Expenses Affect Your Investment Portfolio.”
- Fidelity. “ETFs vs. Mutual Funds: Cost Comparision”.
