A Great Example Of Why “Better Returns” Are Often Not All They’re Cracked Up To Be

In a recent post about starting a savings account for a newborn, Jeremy Joslin left the following comment:

I’m doing this for a best friend’s newborn. Problem is that I’m putting the money into a custodial account at my brokerage. I do $20/month but they take $4 per trade. Perhaps the commission isn’t worth the extra rate of return?

My gut reaction is that even over eighteen years, it’s not worth it.

If you put $20 a week into an HSBC Direct savings account, returning a 5.05% APY, after eighteen years you would have $29,783.83 in the account. That’s not bad, considering your actual investment is $18,720 – your positive return is $11,063.83.

On the other hand, if you put $20 a week into your brokerage and they take $4 of that in a trade, you’re effectively investing $16 a week and paying $4 to the brokerage. In order to get an amount equal to that savings account, you have to get a 7.8% return on your investment. Now, this is quite possible to do in a brokerage – in fact, I’d say that the possibility is a bit better than 50/50, but you have an awfully high expectation there.

Assuming that you’re planning on giving the child cash that isn’t strictly earmarked for education (if you are, the best choice is a 529 plan handled by a different broker), your best bet is to look at an index fund that is very low in fees. I would take that $20 a week and put it in a savings account until it reached $3,000, then invest it in an index fund at Vanguard (directly through vanguard.com) and put that $20 a week directly into Vanguard rather than the brokerage. There’d be no fee at all and you can get very nice returns out of Vanguard (10-12% at the very least). This would mean amounts closer to $40-50K for that kid when he/she reaches his/her eighteenth birthday.

Even though Jeremy is doing okay over the long haul with the brokerage, the fee is awfully high for that. The better approach is to look for a better brokerage, or to at least change the investing plan (save up the cash in a savings account and do a trade only once a year or so instead of weekly trades). That way, Jeremy and that beautiful baby won’t be nickel and dimed out of a lot of potential gains.

The take-home message? Fees can eat a lot of your investment return so put in the effort to look for lower-fee investment opportunities or at least choose a strategy that minimizes the fees (like minimizing your trades).

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8 thoughts on “A Great Example Of Why “Better Returns” Are Often Not All They’re Cracked Up To Be

  1. Jim Lippard says:

    $4/trade is not bad for an individual stock investment–in fact, it’s quite good. But it’s not good for an automated monthly investment of a small amount of money. That should either go into a money market sweep account which you use less frequently for stock trades, into savings, or into automatic no-load mutual fund investment (and again, you should be looking for low management fees–e.g., my S&P index fund expense ratio is 0.19%, and if I had $100,000 for an S&P index fund, I could get an expense ratio of 0.09%).

  2. That is definitely not worth it since the investment is only $20 a month and the $4 fee is fixed. I would go with the index fund as well if I were him, the most passive stock investment available with low fees. It’s not worth the potentially higher returns, which isn’t guaranteed, while the $4/trade cost is guaranteed.

    Personally I’m invested in Etrade’s SP500 index fund, to my knowledge it has the lowest expenses of them all.

  3. Vin says:

    Can you even open a custodial account with major banks that offer good interest rates? Most offer like less than 2% for custodial accounts.
    Opening it on your own name on behalf of your minor will lead you to pay higher rates on taxable income.
    Am I correct with this, or wrong?

  4. Colin says:

    Can you explain how you will only need 7.8% return to offset the cost, when 20% of your investment is lost right off the bat? It seems to me that you would need a return of greater than 25% to justify using the brokerage account.

  5. ben says:

    Why not put the 20 a month in a savings account and then every 3 months (or 6 or 12) put combined sum into the custodial account? If it really is for the long term, (ie 10-20 years) then dollar cost averaging isn’t an issue. Also the deposit into the savings account can be automatic so force savings benefit is also fulfilled.

  6. Toby says:

    A good guideline for considering brokerage fees (what I would call frictional costs) is to keep them below 1-2% of the principal being invested. 20% is outrageous! To meet the 2% guideline, he’d have to invest $200 at a time with $4 commissions.

    This is why so many financial writers recommend against investing in individual stocks when you only have a small amount of capital. The brokerage fees really kill your returns when you are dropping $100 here and $100 there.

    I prefer to keep my fees to fractions of a percent. When your trades fall into the $5-$10k range, your frictional costs grow very small.

    It takes patience to grow a sizable bank roll. Kick back, send the money to an index fund regularly, study investing principles, run a virtual portfolio, etc. while you build that bankroll. You’ll be much better prepared to invest them money.

  7. Dominic says:

    The commenter mentioned that he was doing $20/month, whereas you use $20/week in your example.

  8. Jon says:

    I like the Vanguard idea because there are no transaction fees and investing in an index fund requires a lot less research than individual stocks.

    That said, for those who do want individual stocks there are at least two decent options. First, with Sharebuilder, you simply queue a few months’ worth of contributions, letting them earn 4% in Sharebuilder’s money market. That way you end up buying in larger amounts so the transaction fee is not too bad (20% is ridiculous, 5% less so).

    Second, open an account at Zecco instead. There are no commissions. However, I’m not sure if they allow purchase of fractional shares, so with $20 you’d be limited in what stocks you can buy.

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