Kleenton Ken
Introduction
What may appear to be very nominal fees for purchase and sale of securities may prove quite impactful on the investment outcome. Most of the time these trading costs silently chip away at the investment returns. Such costs consist of elements such as commissions and spreads and market impact and may prove very virulent to the profitability of any given investment strategy. In addition such costs represent another critical factor in market efficiency and price discovery and therefore open up probable channels for market manipulation. Any investor individual or institutional needs to know the trading costs well enough in order to make an appropriate decision that will help in maximizing the investment performance.
Trading Costs on Investment Returns
Trading costs are the most unheeded factor in the desire for higher returns. In reality they can eat substantially into investment performance over time. Even small fees and when compounded and turn into large losses and especially for those investors who trade frequently or manage smaller portfolios.
The Stealthy Erosion of Returns
Compounding Effect
Most trading costs are portrayed as trivial costs since they are of microscopic magnitude. However these costs lack transparency and accumulate over time and thus erode the investment return over the investment period.
Frequent Trading
Investors who trade more frequently are the easiest victims of the erosion by trading costs. Incurring costs at every transaction eats into their excitement in the investment since any potential gains are eroded by the magnitude of costs associated with these transactions.
Small Portfolio Sizes
For investors with smaller portfolios and trading costs represent a greater percentage of their investment and make their impact on overall returns very strong.
The Mechanics of Cost Erosion
Commissions
The explicit fees charged by brokers for executing trades can erode investments directly.
Spreads
The difference between the bid and ask price of a security can add to the cost of trading if investors buy at the ask price and sell at the bid price.
Market Impact
Executions can move market prices and especially if they involve a large trade and thereby affecting prices adversely and adding to costs.
The Opportunity Cost of Trading Costs
Reduced Reinvestment
Increased trading costs affect re investment opportunities. Lower re investment opportunities decrease growth in the future.
Missed Investment Opportunities
High trading costs tend to make an investor stay in an underperforming investment much longer than they would like to. Otherwise it may prevent them from making better investment opportunities.
The more an investor is apprised of the insidious nature of trading costs and their drag on investment returns and the better a choice of trade strategy and broker or type of investment vehicle they can make that serves to minimize these costs.
Role of Trading Costs
This cornerstone of the theory of finance posits that security prices fully reflect all available information. One of the major factors determining market efficiency is the level of trading costs. If trading costs are low and the conditions are more ripe for a very efficient market they may impede price discovery and cause distortions.
Information Aggregation
Information flow is one necessary feature of an efficient market and in which security prices absorb new information. If trading costs are low and it can inspire active participation by informed traders and thereby hasten price dissemination of such information. In contrast high trading costs could provide disincentives to act on their information by informed traders and retard the process of price adjustment.
Price Accuracy
The lower the trading costs and the more market participants can afford to find the true value of a security more competition results in prices that reflect underlying fundamentals more accurately. On the other hand high trading costs result in price differences and less effective allocation of capital.
Trading Costs and Market Manipulation
Reduced Arbitrage Opportunities
With reduced transaction costs and arbitrageurs can respond promptly to price differentials and enhance market efficiency. Higher transaction costs reduce profit margins from arbitrage and foster knavery in markets.
Increased Information Asymmetry It is tougher for investors to access as well as to process information amid high trading costs. This kind of information asymmetry supports insider trading and other market manipulation strategies.
The Role of Technology
Over the last couple of decades technological progress has brought down the cost of trading dramatically. On one hand the proliferation of electronic trading platforms and algorithmic trading and high frequency trading has improved liquidity in markets and supported price discovery tremendously. On the other hand it has also been believed to contribute to problems in the stability and fairness of markets.
In other words trading costs determine to a large extent how efficient any market is.
In affecting information aggregation and price accuracy and and arbitrage opportunities and trading costs bear strongly on the integrity and hence fairness of financial markets. With technology reshaping the trading scene and affecting the overall features of trading costs in so many ways market policymakers and participants would do well to be increasingly careful with the implications of trading costs for market efficiency.
Trading Costs and Market Structure
The structure of a market significantly affects trading costs and as different models of markets provide different levels of competition and liquidity and transparency and all of which impact the cost of trading for traders.
Market Structure and Trading Costs
Exchanges vs. OTC Markets
Exchanges
Most of them have a centralized trading platform and thus and usually have lower trading costs because of increased competition among the different participants. This concentration of order flow allows for effective price discovery and tighter spreads.
OTC Markets
In such decentralized markets and trading costs are usually higher due to lower liquidity and higher information asymmetry. Without a centralized platform to provide liquidity and transparency and spreads can be wider and prices less transparent.
Auction vs Dealer Markets
Auction Markets
The price competition of the buyer seller pairing process of an auction market usually results in lower trading costs.
Dealer Markets
In a dealer market both the bid and the ask are quoted by the market maker and with trades occurring with the dealer. Dealer markets are very convenient but may be more expensive due to the inclusion of the dealer’s profit margin in the bid ask spread.
Electronic vs. Open Outcry Markets
Electronic Markets
Computer systems enter and collect orders to be matched. With computer systems involved the trading costs associated with electronic markets are usually lower because of the efficiency and speed provided by the computer systems.
Open Outcry Markets
Historically and open outcry markets entailed face to face trading which made it much more expensive due to human error and slow execution.
Retail Investors
The retail investors are typically those who have small portfolios and therefore tend to be most sensitive about the cost of trading. Open access to low cost electronic markets is advantageous for them.
Institutional Investors
Larger institutions can and at times enjoy lower trading costs due to the volume of their trading. However they might experience higher impact costs arising from their large order sizes.
The Role of Market Regulation
That is and the market regulators play an excessively dominant role in shaping the market structure and and therefore and in influencing trading costs. Regulators can and therefore contribute to reducing investors’ costs by facilitating competition and transparency and dealing with fairness. For instance regulations that allow for easier access to the market and the leveling of the playing field for the various participants in the market may help reduce trading costs.
In summary it is related but complex with respect to market structure. Therefore understanding the characteristics of various models of markets is very vital in making effective decisions by both the investors and the market players to help lower their respective trading costs.
Impact of Trading Costs
Retail investors are typically characterized by smaller portfolio sizes and less frequent trading and are particularly vulnerable to the read across effects of trading costs. Such costs can be highly erosive to investment returns and ultimately restrict the potential for wealth accumulation.
The Disproportionate Burden
Higher Percentage Costs
Trading costs and even relatively low ones are a far higher percentage of the invested capital for retail investors than for institutional investors with larger portfolios. Almost any modest fee tends to have a significant impact on returns.
Limited Bargaining Power
The retail investors’ limited bargaining power with reference to the trading cost means a limited scope for bargaining for oneself against high expenses.
Increased Trading Activity
The temptation to beat the market will prompt a retail investor to trade frequently and thus increasing the negative effect of the trading cost.
Underperformance
In effect high trading leads to weak returns because of the transaction fees coupled with the market impact.
Low Cost Index Funds Are Important?
Cost Efficiency
By investing in index funds one is bound to invest in the overall market at a low cost. Consequent reductions in trading costs and expenses will significantly improve the long term return cumulative characteristics for the retail investor.
Diversification Well being
Through broad diversification and investment risk is minimized and while long term growth possibilities are increased by index funds.
Role of Financial Education
Trading Costs Awareness
The general awareness of retail investors on trading costs is considered extremely important in order to ensure informed investment decisions.
Encouraging a view toward long term investment can help stay off the impulses of trading and reduce the negative impact on trading costs.
Understanding the disproportionate impact of trading costs on retail investors can better inform the decision making process of investors and behavioristic ally encourage strategies that are more cost efficient and in turn better for long term wealth creation.
Role of Technology?
Certainly one of the most revolutionary impacts of technological improvements to the financial world has been in the reduction of trading costs. Through various improvements in efficiency and enhanced access to the markets it is technology that has served to further empower both the individual and institutional investor.
Electronic Trading Platforms
Direct Market Access (DMA)
Eliminates all the intermediaries and allows investors to transact directly on exchanges and which reduces the enormous burden of commissions and fees.
Algorithmic Trading
Advanced algorithms scan market data and place trades at the right prices and thus ensure that there is less slippage compared to other outlets and better quality of executions.
High Frequency Trading
Although it is very controversial HFT channels liquidity into the market and probably means narrower spreads and therefore cheaper commissions and bid–ask prices.
Increased Access to Data
Real time Market Data
Real time market data helps investors become informed about various decisions they take in executing trades faster and hence reducing the chances of market fluctuations in prices.
Advanced Analytics
The use of advanced analytics tools allows investors to identify trading opportunities and manage risks most efficiently. This potentially reduces trading costs.
Fractional Shares and the Democratization of Investing
Lower Entry Barriers
Fractional stock shares make investing available to more people and including even those with small amounts of capital.
Increased Trading Activity
The more people participate in the market the higher the trading volume. This in turn could lead to tighter spreads and reduced costs.
Decentralized Exchanges
Even rich traditional trading models of innovation and blockchain technology will take away intermediaries and reduce fees further.
In conclusion technology has taken the lead in the game in pushing costs of trading to levels as low as all times and thereby bringing out features of affordability and accessibility to investment. As the technological surge for cost pit reduction continued and the same is expected to do for changing the face of investment.
Conclusion
Trading costs are often overlooked and exert a huge impact on investment outcomes. Their impact goes beyond monetary loss to the efficiency of markets and investor behavior and and and generally and market structure. While technology has impressively cut down on cost and challenges are still experienced.
It is the retail investors who bear the brunt of all these costs and therefore making the case for robust regulatory oversight. There is a need for having policies aimed at transparency and fair competition and investor protection. The regulatory frameworks will have to evolve with changing finance landscapes to meet new challenges and provide a level playing field.
In the final analysis a good understanding of trading costs is the most critical part of any market participant. Lowering such costs and maximizing returns on investments are sure to increase financial well being and from the micro level in individual investors and institutions to the macro level in terms of market health.
