For a Beginning Investor, the Costs of Investing Can Be Painful

I’m going to make a little illustration about investments using the stock of Verizon (VZ) as an example.

On September 18, 2009, a share of stock in Verizon closed at 29.59. In the following months, Verizon issued four dividends of $0.475 per share. On September 24, 2010, a share of stock in Verizon closed at 32.64.

Let’s say, hypothetically, that we chose to invest $1,000 in Verizon on September 18, 2009, and chose to withdraw it on September 24, 2010. Our $1,000 would have bought 33.8 shares of Verizon stock. Over the course of the year, then, we would have received $64.22 in dividends. At the end of that year, we sell the stock for $1,103.23. Our total earnings on that investment would have been $64.22 in dividends and $103.23 in stock returns, right?

Not so fast.

First, the dividends would be subject to income tax. In this case, the dividends would appear to be qualified dividends, which means that they would be taxed at a rate of 15% by the federal government and possibly more by state and local sources. $9.63 of that dividend gain goes away.

Second, you’re going to have to pay your brokerage for the cost of buying the stock, as well as the cost of selling the stock. Let’s say, hypothetically, that you’re using E*Trade. The cost of the buy would be $9.99. The cost of the sell would be $9.99. That’s another $19.98 off the top – although that $19.98 is tax deductible.

Third, the gain on the sale would be a long tern capital gain, so 15% of that gain goes to the federal government. Your gain was $103.23, so you’d be paying $15.48 in taxes for that $103.23 gain.

All in all, your expenses for your gain add up to $45.09. Just like that, 25% of your gain is gone.

Even if your investment is a loser, you still lose more. Let’s say that over that same timeframe, VZ went from a starting price of 32.64 to a closing price of 29.59. You’re still out the $19.98 in brokerage fees (it’s tax-deductible, though). However, you only buy 30.64 shares of stock. You only earn $58.21 in dividends and you lose $93.36 on your investment, a net capital loss of $35.15. Add that to your $19.98 in brokerage fees and you’re down $55.13 on that investment.

What’s the point of this story? Investing has costs. You’re taxed if you gain anything and you’re getting hit with brokerage fees whether you win or you lose.

Some forms of investing have lower costs than others. If you invest directly with an investing house like Vanguard, for example, you can essentially invest without fees, meaning you only have to deal with the taxes on your gains. However, you’re limited to the offerings that Vanguard has available, plus there are often stiff minimums for investing.

You could also simply invest in the money market account at your local bank. There are no costs there, either, and your balance isn’t at risk; however, your returns will be low.

The bigger your investment, the smaller the impact such costs have on you. At the $1,000 level, the investment fees described above eat up about 2% of your balance. If you’re investing $10,000, the fees eat up only 0.2% of your balance. If you’re investing $100,000, the fees eat up only 0.02% of your balance.

Thus, for beginning investors, it’s absolutely vital that you know the total cost of ownership of an investment before you even consider it. Because even a small fee can really hammer your total return, such fees are very important to the beginning small investor.

That’s why my advice to beginning investors is this: invest your money in a savings account to start with and spend some time learning first. Know exactly what you’re going to invest in – and what all of the costs of that investment are – before you put your money in. Set up an automatic savings plan that keeps building the balance of that investing savings account so that when you do decide to make your move, you have a solid amount of money to make your first move.

Yes, you might “lose” some gains by only having the cash in a savings account. However, if it’s in a savings account, it’s not at risk of a loss, you’re not paying fees, and it is earning you a return. If you invest elsewhere without studying up, the fees and the taxes can easily eat up a big chunk of whatever you gain – and make a loss more painful than it already is.

Start slow. Don’t subject your money to fees or put it at risk without knowledge. Learn as much as you can and don’t make a move until you know the costs and feel confident about it.

How do you start learning? I suggest starting with The Bogleheads’ Guide to Investing. Read it slowly. Read it again. Move on from there by digging into some of the recommended titles. Keep going until you feel confident and comfortable with investing, then move forward. You’re better off taking it slow and making good moves from the start than flailing about and losing a bunch of your money to fees and taxes.

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  1. Rick says:

    Nice to see an entry about investing on here. Hope to see more.

  2. Kevin says:

    You noted that capital gains are taxed at 15%, but are capital losses deductible? In Canada, losses can be carried forward several years, to offset future capital gains. Is there a similar provision in the US tax code?

  3. You’re right, Trent. Buying individual stocks makes little sense when you have little money to invest. Buying mutual funds directly from Vanguard is a little better, but you still need at least $1,000 there (and $3,000 if you want a target date fund or anything other than the STAR fund). ETFs are another choice if you can get free trades, but then you have higher bid/ask spreads to deal with since you’ll be trading such small amounts.

    One technical point – your commissions aren’t really “tax deductible”. It works out that way, but you’d be better off saying that they reduce your cost basis. So instead of calculating a 15% capital gain on $103.23, you should calculate it on $83.25. Doesn’t make a lot of difference in this example (just $3) but that’s the way it should be calculated.

  4. Greg says:

    The situation not much better for an experienced investor who wants to hold a diversified portfolio and therefore buys only small quantities of each stock. His brokerage fees and taxes will be the same as for the beginning investor, although his overall risk will be lower due to the diversification.
    Another piece of advice: if you work in an industry that you know well, you may be tempted to invest in companies in your industry. However, if a crisis hits your industry, both your job *and* your investments are at risk!

  5. Kevin says:

    A great introduction for newcomers. Yes, it glosses over a few of the finer nuances of investing (paying taxes and fees on a $160 gain still leaves you with more money than paying less taxes and no fees on a $15 gain from a 1.5% savings account), but it gets the broad strokes right.

    Like Rick, I hope to see more of these kinds of articles on TSD.

  6. Steve says:

    The trading fees are a barrier to entry for many middle- and low-income families. I’m pretty good at picking stocks, but I don’t have thousands of dollars to invest because I’m still in debt. If I were to buy $500 in stock at a time, I’d have to gain 2.8% just to cover the $7 transaction fee (x2) from Vanguard. In other words, I’m already down almost 3% just for buying in. The big boys in the industry can drive their buy-in costs down to near zero, which is why the trading machines can turn profits playing single up-ticks.

  7. MacKay says:

    Trent I think an interesting article might be comparing different types of ways to make your money work for you.

    If you have $1000 to invest, are you better off buying stock, paying down debt, or weatherizing your house? All if these things are ways to invest. It’s just that with paying down debt or weatherizing your house, the returns are a sure thing. (And I’m not talking windows which have a really long pay-back time, but more basic stuff).
    When you buy a tool, or learn a skill, you get a payback for the time invested. My parents bought a deep chest freezer twenty years ago, and in that time it has surely saved them twenty times what they originally invested.

    Each of us has a finite amount of free time. It seems like investing is an effortless way to make money grow, but in fact it does take some brain energy if you DIY.

  8. BeccaT says:

    Greg, great point about not investing in your own industry.

    I more often think a similar thought. Couples should both not work in the same profession. My uncle and his wife worked together in the same architectural firm they owned. Talk about two canaries in a coal mine. Indeed, with each economic downturn they both were unemployed for long stretches. Also as two self-employed people they paid for all their health insurance and the full value of their social security… no employer to pick up part of the costs. They would have been better off if one of them was employed in a field that was somewhat recession resistant.

  9. Balsamic says:

    Great post Trent. Infact, I am reading the Boglehead’s Guide to Investing right now.

    One question -(and I have been trying to figure this out for a while) – Is there a Canadian equivalent to “Boglehead’s Guide to Investing”. I understand that the principles of investing remain the same, however, some things are just not applicable to the Canadian Market.

    Can anyone recommend a book?

  10. aaron says:

    I just cant see stocks as a wise investment…
    all the money you have invested in the stock market could dissapear tomorrow..

    If you have your money invested in real estate you cant lose your investment. even if its value drops at least you still have your property.
    plus you can rent out your property and get a passive income way better than anything on the stock market.

    I dont understand why stocks are promoted as the best place to invest your money rather than real estate.

  11. Patrick says:

    This may just be a matter of semantics, but in my mind there is a clear difference between saving and investing. Investing implies a long-term commitment with inherent elements of risk and potential for a return. Saving is simply protecting money against the risk of loss. In other words, you don’t “invest” in a money market account or savings account. With regard to investing, costs make a bigger difference you might think over the long run. Choose low cost investments (e.g. Vanguard)and buy for the long-term.

  12. George says:

    I think the article is somewhat misleading, because I think the intent of the article is to illistrate that there are fees to investing that may not be readily apparent. In your example, the only fees that you would incur additionally is $20 (the brokerage fee). The tax component is the same for any investment, stocks or savings. In fact, it would be more for savings if you were in a higher income tax bracket.
    So, for example, if you had invested the $1000 in a savings account @1.1% (ING Direct rate), you would have earned $11, and if you were in the 28% tax bracket, would have paid ~$3 in taxes, leaving you with $8. Whereas investing in VZ netted you 122 in the first scenario.
    In the second scenario, where the stock price went down, you are absolutely better off investing in a savings account, because thats the risk tradeoff.

  13. George says:

    It’s a good demonstration of why one shouldn’t trade a dividend growth stock when one is an extremely small investor. Just hold it and collect the dividend; skip the capital gains.

  14. Such a good tip. So eager was I to “jump in” to investing once I finally accrued some savings, I learned the hard way that commissions on a small stock purchase eat up most of your investment, even if it does perform well (which, unfortunately, mine did not!) Just another reminder that making money doesn’t come without putting in some work.

  15. Tim says:

    I enjoyed the post. I have hesitated to buy stocks with my limited extra$ for this reason, but I never had the math. This helps.

  16. Dom in Buffalo says:

    I’ve been investing since I was 13 – when I had my Bar Mitzvah and put the money into a mutual fund and earned 70% in about 5 years – works out to about 14% a year. (Cashed it out when I left for college..)

    There are some trading firms out there that have very low commissions – but they’re discount brokers. You don’t get much in the way of help..but you don’t pay much in fees. My current broker only charges $3 for all kinds of stock trades – market, limit, stop, etc.

    Most of the big brokers (Vanguard, Fidelity, Schwab, etc) now offer commission free ETF trades. As a previous poster mentioned, your spreads aren’t as good but it can be an easy way for someone with little cash to get in on stocks without “wasting money” on commissions.

    The most important thing to remember about investing is to do your research – don’t follow the next hottest stock or a tip from a friend. Check out any investment – look at the income statement, the balance sheet, the cash flow. Find out what the terms mean. If you don’t do your research and lose money, it’s your own fault.

  17. Lexi says:

    Trent, I loved this article and I hope there are more like them!

  18. AnnJo says:

    If all I had to invest was $1,000, I’d invest in:

    40 – 4 lb. packs of assorted pastas at my local Cash & Carry, at $3.77 ea.= $150.80

    4 – 25 lb. sacks of rice at $13.78 ea. = $56.12

    144 cans of tuna on sale for 50 cents ea. = $72.

    120 cans of vegetables/tomatoes on sale for 50 cents ea = $60

    120 cans of fruit on sale for 50 cents ea = $60

    3 – 25 lb. sacks of various beans – white, black, pinto, for $14 ea = $42

    2 – 50 lb. sacks of flour for $36 total

    miscellaneous bulk spices – $30

    10 12pks. of canned milk – $110

    20 lbs. kosher salt – $13

    About 200 rolls of toilet paper on sale – $90

    20 cases of bottled water on sale – $40

    2 – 25 lb bags sugar – $13

    And about $200 worth of other supplies purchased in bulk and on sale (batteries, kerosene or lamp oil, cleaning supplies, aspirin, vitamins, etc.)

    As long as you buy roughly what you’d normally use in a year or two, if you buy on deep discount sales or at inexpensive bulk stores, you can earn a guaranteed tax-free 30-50% annualized rate of return with zero risk and zero transactional cost (fees, commissions), plus you’ll be well secured against disasters, personal emergencies like job loss, and the hassle of running to the store to get some basic you’ve run out of.

    Anyone who would invest $1,000 in stocks but doesn’t have a good reserve, purchased at their lowest prices, of the day-to-day goods they need, is giving up a great investment opportunity.

  19. deRuiter says:

    Switch to Fidelity discount brokerage and cost to buy or sell a stock drops to $7.99. That’s saving $4. on each combined buy/sell trade. Every dollar saved adds to your bottom line. You can move your stocks from one discount broker to another at no cost (check first with both brokerage houses on this!) and if you have more than $5,000. invested (check several airline freqwuent flyer sites to see who is giving the best deal) you can get some free miles towards a free flight. Every little bit helps.

  20. I’d add that while Trent is right, there can be painful costs to investing (hidden or otherwise), those costs are a small fraction of what they were a generation ago, before the spread of the discount brokerage industry. Can you imagine what your returns would be like if you did this Verizon/VZ trade with a commission of $200?

    Dan @ Casual Kitchen

  21. Andrew says:

    I also recommend paper trading before you put up any real money. The two biggest mistakes novice investors make are not having enough starting capital and jumping right in without making sure they know what they’re doing. Take advantage of sites like investopedia.com, which has a free stock simulator. You can trade without putting up any of your own money, and once you are consistently profitable and have enough saved up (I’d recommend a minimum of $10,000 if you’re investing in individual stocks), then you can start risking actual money.

  22. Telephus44 says:

    I just wanted to add that if you’re looking to invest in stocks and don’t have much money, you can also consider DRIPs. Some of the plans (not all, do your homework) have very low fees and you get the benefit of dividend reinvestment.

  23. Matt says:

    Another fine point: in the example, if you had sold VZ before holding it a year, you’d be subject to short-term capital gains tax. Long-term capital gains tax is 15%, but I believe short-term is taxed at whatever your taxable rate is. So, depending on your income, you could be on the hook for considerably more than 15%, further eroding your profits.

    Personally, I think the lesson here is that unless you have fairly large amounts of money with which to trade (say, greater than $10k), your best bet is to stick with a buy and hold scheme. And I mean LONG term holding, on the order of at least five years. In other words, active buying and selling is best left to the pros.

    Trent, perhaps you could do a series on “beginning investing”, in the same vein as your GTD series? Maybe you could even get fancy, and create a fake savings account that you update every week. In other words, for your next post, say you’re investing $1k in a bank savings account, $1k in an ETF, etc. Then every week or so, you show where those accounts are. Include dividend payments, subtract out brokerage fees, etc. It would be kind of boring initially, but over the course of several years, it would be quite instructive. Especially if you invest in individual stocks, you could show how much more volatile they are in the short-term, relative to a broad ETF like SPY.

    I guess there’s plenty of historical data out there that you could re-create this. But it would be fun to have a little section of your website dedicated to this experiment, complete with graphs and charts.

  24. tas says:

    I have done the small investing, quite successfully (last 5 years, average 8-10% return/year), with anywhere from $0-250/month to put in the market. I pay $5 to buy & $5 to sell (though I rarely sell — why would I?) with ThinkorSwim. If I’m interested in a new stock I always put it in a google finance portfolio and watch it for months (usually at least 6, though a few for years); this way I keep an eye on price fluctuations and news about that stock since it’s on my radar.

    The big thing I’ve done to keep the costs that Trent mentions here down is not to sell my stocks after holding them only a year. While I appreciate that for purposes of an example, one needs to sell the hypothetical stock (and keep variables simple), but in real life investing, successful investors sit on that money for the long term, not sell regularly. (Not least of which because currently capital gains are taxed differently with short & long term holdings.) So the gains should be more significant than realized in this example and if there are losses, the extra time might help them grow again.

    While I think paying attention to the costs of stock ownership is important, a few caveats about such an approach. If you’re not investing, what are you doing with the money? Before I started, I wasn’t adding to my savings, I was just spending it as extra money (after savings, of course). Second, $5 is on the one hand a lot of money to buy shares (it’s a full 5% of my monthly buying right now), but I spend $5 on a lot of things that might seem silly to other people; a monthly $5 commission is, worst case scenario, like buying a burrito once a month. I think there’s a risk of over thinking the costs if it prevents you from moving forward — when you have the money to do so.

  25. Jonathan says:

    Thanks for the good advice. I would like to point out that much advice on investing, (and when folks write about investing, it is usually investing ‘in the stock market’) says to “Get started now.” So for me, someone who didn’t “Get started now,” this perspective makes me feel a little less guilty about my non-investments.

    I would like to point out that even with the fees and taxes, the investor in this example still makes over 10% on his money in a year, those are great numbers; for the risk involved of course.

  26. ChrisD says:

    On a related note, in the UK there is a nice option, the ISA. I have no idea if you can do individual stocks with that (I think not) but you can buy an index fund, saving on the individual transaction costs, and then all capital gains and income are protected from tax (with a maximum investment of £10,000 a year for stocks, but savings are also an option). Only tangentially related to this post, but thought I’d mention it.

  27. JFR says:

    In Canada, income from interests is taxed more heavily than dividends and capital gains. Dividends benefit from a tax credit and only 50% of capital gains are taxed.

  28. Almost there says:

    Great comment AnnJO, good advice. I should stock up. We got into the habit of depleting our pantry and try to use just in time stocking up but the sales are hard to pass by.
    After converting my growth roth ira into target retirement funds and watching them dump I am investing in one stock through monthly purchases in share builder at 4 bucks a purchase. I am planning long term to have enough for a vehicle purchase with cash. The div pays more than bank savings for sure.
    More posts like this in TSD please.

  29. Kevin says:

    I’ve been trading stocks for several years, and every year, I end up losing money. But I keep doing it anyway, for no apparent reason.

    See how stupid that looks? All of you who are claiming that you’re able to “successfully” trade stocks and beat the indices are implicitly assuming that there is are people out there like the one I just described, who are on the losing end of all your “winning” trades.

    It’s simple math. If you believe you are above average, then there MUST be a corresponding individual out there who is below average. And if you think that there are thousands and thousands of you “winners,” then there MUST be an equal number of “losers,” who for some reason, keep trading, even though they’re losing money compared to the market indices.

    The only consistent “winners” in the trading game are the banks and brokers. There’s a reason their fees are a flat rate, and not a percentage of your gains. They know that on average, your gains will trail the market! But they encourage you to keep trying, because your “churn” is their profit.

    If you think you’re smarter than the market, you’re not. There are skyscrapers full of grey-haired “expert” stock pickers in fancy suits, who have been doing it for years, and who have access to up-to-the-second information and quotes, who can execute trades instantaneously, with billion-dollar analysis and alerting software, who literally have lunch dates with the CEOs of the companies they’re considering investing in, and EVEN THOSE PEOPLE CANNOT CONSISTENTLY BEAT THE MARKET AVERAGE.

    What hope do you think YOU have?

    Stop trading stocks. You can’t win. Buy index funds.

  30. Elisabeth says:

    You have had a couple of recent posts regarding the high cost of adoption. I work in the social services field and wanted to let them know about the joys of foster care. There are literally THOUSANDS of children in each state that are on adoption lists waiting for a “forever home.” Yes, this might mean not adopting an infant, but the joy and satisfaction of opening up your home to kids who need one is indescribable. Not to mention, if you do foster-to-adopt, the cost is free and you often get a monthly subsidy to help with the costs of college, as well as keep their Medicaid benefit. I’d also encourage having them look into straight foster care. Once again, there are THOUSANDS of children who need homes for a temporary period of time until their parents can take them home again. For those who are looking to parent, these are all options that allow you to make a huge difference in the life of a child, as well as become a parent without incurring thousands of dollars of debt.

  31. Harm says:

    Kevin, stock trading is NOT a zero sum game.
    Winners and losers do NOT have to cancel each
    other out.

  32. GadgetBoy says:

    Money market is not risk-free. Although money market funds strive to maintain a $1 per share value at all times, they are not obligated to do so. Very few money market funds have gone below $1 per share, otherwise known as “breaking the buck.”

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