What Are Friction Costs?

Friction Costs Explained

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In the world of finance, friction costs are costs incurred as part of completing a transaction. These costs can be direct, such as fees charged by a broker, or less obvious, such as capital gains taxes.

In some scenarios, friction costs can be non-monetary. For example, additional time spent to complete a transaction can be a cost. Learn what friction costs look like and how they can affect your investment decisions.

Definition and Example of Friction Costs

A friction cost is a cost someone pays as a part of completing a financial transaction. Friction costs can be monetary or non-monetary. In short, they include anything that interferes with a trade or completing transactions.

Friction costs are named as such because just as friction slows moving objects, friction costs can slow down financial transactions.

An example of friction costs would be the fees you may pay to have a robo-advisor manage your portfolio.

How Friction Costs Works

Friction costs work by interfering with free and easy financial transactions, making them harder to complete, and causing at least one of the parties to accept a cost to complete the transaction.

Friction costs are common for investors. In a perfectly efficient market, for example, someone wishing to sell a stock would simply find someone willing to pay their asking price and exchange that stock for money. In reality, most transactions involve some form of friction. The person selling the stock may have to pay a broker commission to complete the transaction.

They may also find there is a spread between the bid and ask prices for a stock, forcing them to accept a slightly lower price to complete the sale immediately. Alternatively, they can accept a cost in time, waiting to find a willing buyer at their desired price.

However, the investor pays the frictional cost, as it results in the transaction taking longer or the investor receiving less money after the sale.

When shopping, accepting a lower-quality product could be considered a friction cost. Some consumers may be willing to deal with lower product quality to avoid other costs, such as paying more for a better product or waiting to purchase a new model of a product.

Types of Friction Costs

There are two primary types of friction costs: direct and indirect costs. However, some costs can fall into multiple categories, making it hard to pin down some types of costs.

Transaction costs

Transaction costs are the simplest type of friction cost to understand. They’re typically things like commissions you have to pay to complete a transaction, or asset management fees a broker charges to maintain your portfolio throughout the year. However, they can also include things like the opportunity cost of time spent to find a better deal on a product or to research the best product to buy.

Taxes

Taxes are a common friction cost. Sales taxes or capital gains taxes add additional costs to transactions such as buying a product or selling investments.

Regulation

Government or industry-group regulations can create friction costs by forcing participants in a transaction to spend time completing documentation or other required processes before they can complete a transaction.

Regulation can also add costs to operating a business. For example, banks need to maintain a set amount of money on hand based on the deposits they’ve accepted, which is an opportunity cost because those banks can’t use that money for other purposes.

Information

Information is essential to completing a transaction. If you’re interested in buying shares of a company, you’ll likely devote time to researching who the company’s leaders are, what their financials look like, and metrics such as P/E ratio and past performance. The time spent on gathering information is a cost.

What It Means for Individual Investors

Individual investors need to pay attention to various friction costs when designing their portfolios. In particular, investors should look at commissions that the broker they choose charges, and taxes.

Capital gains taxes are charged on profits investors earn from selling securities. An investor who wants to rebalance their portfolio will need to think about the tax implications of selling some of their investments. They may be willing to accept the slightly higher risk or slightly lower potential returns to avoid those costs.

Over time, friction costs, especially management fees for things such as mutual funds and ETFs can add up to large amounts, so investors should take steps to minimize friction costs where possible.

Key Takeaways

  • Friction costs are additional costs involved with transactions.
  • Friction costs can be monetary or non-monetary, such as the opportunity cost of using time to complete a transaction.
  • Investors should look to minimize friction costs to improve portfolio performance.

Article Sources

  1. Federal Reserve Bank of Atlanta. “Financial Market Frictions.”