Friction costs are the fees and other associated expenses that come with a financial transaction. They may be direct or indirect. By reducing these expenses, you may be able to significantly increase your long-term rate of return by lowering your overall cost basis.
Learn more about the different types of friction costs, how they affect your returns, and what you can do to reduce them.
What Are Friction Costs?
Friction costs are all of the associated costs that accompany a financial transaction. They include direct costs, such as fees, interest, or commission. They also include indirect costs, such as time, effort, and research.
Friction costs lower your total rate of return. That's why it's important to take them into account when evaluating an investment or other transaction. You'll have a more complete picture to base your decision on. After all, something that looks like a good deal may wind up being much less profitable once fees, commissions, and other costs are factored in.
Friction costs can apply to all types of transactions; however, here we'll be focusing on investing.
How Do Friction Costs Work?
To understand how friction costs work in an everyday situation, consider a simple stock investment. There is the quoted price of the stock, which is a clear cost. But you'll also likely have to pay a commission fee to your broker. If you want to short the stock, there will be a cost to borrow the funds to do so. Sell the stock, and you'll likely encounter a transaction fee.
Then there's the spread between the buying price and the selling price, which goes to the market-maker. The time you took to research the stock and execute the trade is a hidden cost, as is the time you'll need to hang on to a stock if you'd like to capitalize on its appreciation.
Finally, it'll cost you money later on, when you do sell, in the form of capital gains taxes (in the event the stock gains in value). In short, the price you see quoted is not the only cost you need to consider.
Types of Friction Costs
There many different kinds of friction costs to watch out for.
The most frequent frictional expense are brokerage commissions and fees.
With the advent of the discount broker, the cost of buying and selling securities has been dramatically reduced over the past few decades. Competition has driven the price of trading fees all the way down to zero for many brokerages, including Charles Schwab, E-Trade, Fidelity, and Ally Invest.
At some brokerages, you may encounter fees per trade or per share. If you call a broker, they may assist you live, over the phone, for an additional fee called a "broker-assisted trade fee."
If you're trading options, you'll likely have an options trading base fee. This fee may be charged per trade as well as per contract. If you exercise an option, that can incur an options trading exercise fee.
Asset management fees can be another obstacle to long-term wealth building. Many firms focusing on high-net-worth clients will charge fees of 1.5% of assets under management. Under this type of arrangement, a family with a net worth of $10 million would pay $150,000 per year in fees, even if they lost money on their investments.
When buying or selling an investment, a percentage of the investor’s principal is reallocated to the market maker. This reallocation is the bid-ask spread: the difference between the bid price (what the buyer is willing to pay) and the ask price (what the seller is willing to accept).
The spread is collected by the market-maker and is a cost of trading.
Capital Gains Tax
Capital gains tax is the tax owed on any investments that you sell at a gain. Capital gains taxes can be short-term (on assets owned less than a year) or long-term (on assets owned longer than a year).
If you sell your asset at a loss instead, it's called a "capital loss."
As an investor, you decide when the tax bill will come due by choosing when to sell the appreciated securities. Each year that goes by without selling, the value of these deferred taxes becomes greater.
Sales Loads and Other Mutual Fund Fees
The friction costs of mutual funds include sales loads and management fees. A sales load is a commission paid to the broker selling the fund. You may also encounter redemption fees if you try to sell your share of the fund in too short a time frame. And you may be charged account fees, simply for holding an account.
These costs make it more difficult for actively managed funds to outperform the returns of index funds, which do not have sales loads.
For an actively managed fund to break even with the overall market, it would have to earn returns that are higher by several percentage points in order to cover the friction costs.
What It Means for Individual Investors
Investors could find themselves missing out on additional returns if they don't take friction costs into account. Whether that means less money in their retirement account down the road or lost opportunity in the near term, friction costs should be evaluated carefully alongside other elements of an investment.
How to Determine Friction Cost
Calculating the friction cost of a transaction will require a little research. You'll need to look at each layer in the calculation—your own role, that of any intermediary, such as a broker, financial advisor, or sales representative, and that of the final counterparty, in the event of a trade.
Find out whether there are any fees or commissions, and how much they are. You may need to be specific: ask whether there are fees to hold a particular investment, fees to open or maintain an account, or fees to sell an investment. Ask the financial professional you're dealing with how they are paid: whether by commission, by fee, or another way.
You'll need to calculate your likely taxes, too. Plus, weigh how much time and effort it will cost you to research your investment, open an account, transfer funds, and execute the trade.
Reducing Friction Costs
It's possible to reduce your friction costs once you know what they are. You could choose an investment with lower fees; you could select a broker that offers free trades; you could choose to manage your portfolio yourself.
Don't forget to consider the alternative costs to these decisions, too. If you decide to manage your portfolio yourself, you may save on fees, but it could be a headache, too. You may decide in some cases that the assistance is worth the expense, but you'll need to do some calculations to know for sure.
Calculating the return on investment (ROI) will include total gains divided by total costs, and it's a great way to visualize what an investment will cost you.
- Friction costs are the expenses, both hidden and direct, of any financial transaction.
- These expenses can include fees, commissions, taxes, and even time or effort.
- Friction costs can eat into your returns and drag down your profits.
- To reduce your friction costs, evaluate each portion of the transaction, and analyze the cost. Look for alternatives that may save money or time.