Beware of those Sneaky, Leaky Money Holes
Do you think you’re on course with a slick new investment strategy? Not so fast. Let’s talk about those hidden costs that can drain your wealth away on the sly. But first, a true story to help make the information stick.
Losing It on the Black-Diamond Run
I, my dad, brother, and nephew recently shared a male-bonding ski adventure in Utah. I won’t admit to any machismo attempts to outdo each other, but I decided to veer off on a black-diamond, mogul run, not realizing until we met at the bottom that my father had done the same. What can I say? We’re cut from the same, stubborn wool.
“Hey, look what I found!” said my dad, and held up a nice iPhone he’d spotted on the way down.
You can probably tell where this story is headed. Sure enough, after a closer look at the lock screen image (just like mine), and a few other details (just like mine), we realized the phone was, indeed, mine. Figure the odds in all that snow.
The ironic thing is, I lost it out of an arm pocket on my ski jacket that I’d been extolling earlier that same day, saying how cool it was that I could get to my phone so easily. It turns out the pocket was poorly constructed. Glued instead of stitched, it had given way, and my expensive iPhone had slipped out the bottom. Not so cool after all.
A picture of the faulty “phone
pocket” on the arm of my jacket.
Hidden Holes in Your Portfolio
At least my skiing experience offers a good analogy for hidden trading costs in your portfolio. Earlier this year, we covered investment costs in general, including the assortment of hidden trading costs that don’t show up as directly reported expenses.
Like a torn pocket, they can cause assets to slip away from you without your ever knowing they’ve escaped, but the loss is real and potentially significant. In “Shedding Light on ‘Invisible’ Costs,” published in the January/February 2013 Financial Analysts Journal, “The authors found that funds’ annual [hidden] trading costs are, on average, higher than their expense ratio and negatively affect performance.”
Hidden trading costs can be difficult to combat; they are by definition elusively observed and slippery to measure. Most investors are unaware they even exist. So the first step in minimizing them is to familiarize yourself with them. Some of the more notorious hidden costs include bid-ask spreads, market-moving costs and opportunity costs.
Bid-Ask Spreads
Bid-ask spreads are the difference between the highest price a buyer wants to pay for a security (the bid) and the lowest price a seller wants to accept (the ask). For example, if a buyer hopes to purchase a security for $10/share but the seller hopes to receive $11/share, the bid-ask spread is $1. Whoever “loses” in the transaction by selling for less or paying more than desired incurs a hidden cost; they are essentially starting out $1 behind from the get-go.
Market-Moving Costs
If you or I decide to sell or buy 50 shares of Apple stock today, the current price will be the price at which you trade all 50 shares. The rules change when a major market player such as an institution or mutual fund seeks to rapidly trade enormous blocks. In a classic case of supply and demand, when the market notices a trader who is anxious to buy or sell large lots, it reacts by temporarily moving the supply price up or down and widening the bid-ask spread against the demanding trader. This generates market-moving costs before the trading is completed.
Market Opportunity Costs (Moving to Cash)
In the broadest sense, opportunity costs are incurred when you commit to one opportunity that is less desirable than another. In investing, it means committing your assets to one strategy when another would have offered better results for your particular goals. In the absence of a disciplined strategy, it’s easy to torment yourself with every “opportunity” the markets make available. Fund managers can fall prey to this same angst, which is why significant market opportunity costs can occur when they seek to second-guess the market, moving to cash during market turmoil and then trying to predict when to get back in.
Patching up the Holes
To combat hidden costs, an investor’s goal is to seek fund managers who are best positioned to:
Reject unfavorable bid-ask spreads when they’re trading
Avoid having to place large, hurried trades that incur market-moving costs
Avoid market timing and its related opportunity costs, and instead focus on market factors that are more readily under our control.
In the case of my iPhone, I did my best to resuscitate it after its miraculous return (quick tip: try the bag of rice trick). It came to life a few hours after its fall, but then it would randomly shut off every few hours until, a week later, it flat-lined. Admitting defeat, it became a convenient excuse to update to a new iPhone 5. On that count, things didn’t turn out so badly. In contrast, when you lose investment returns to hidden costs, there is no consolation prize.