Saturday, March 3, 2012

Diversification and Commissions

Many stock pundits and advisors strongly recommend diversification, that is, holding more than one stock to reduce risk.  This is the idea that it is a good idea to put all your eggs in one basket.  More on the concept later, but I wanted to address the impact of diversification on commissions here.

Different experts (and I will use the term loosely) recommend different numbers of stocks to be diversified, but for our example we will use five.  Assume a starting portfolio of $10,000, a not insignificant sum for most people.  In order to purchase five stocks at $8 per buy, the investor is down $40 from the get-go.  Of course, in order to unwind the positions, that is, sell the stocks, he will have to pay another $40.  Diversification has cost him $80, or 0.8%,   He could have put all $10,000 in one stock and been better off even if the stock went down in value by one half of one percent. 

Whatever the benefits of diversification, and there is some debate on the value, it does create a financial hole that the investor has to dig out of.  It may be better to put all of your eggs in one basket if the cost of buying many baskets is going to cause you to go broke anyway.       

Friday, March 2, 2012

Commissions Add Up Over Time

Commissions are insidious.  For each transaction, they are relatively small, but after repeated buys and sells, they add up quickly.  And they always come in pairs.  Every time you commit to buying a stock, you will eventually have to sell it to get access to your money, whatever might be left. 

If there were commissions for movie theaters, you would have to pay to get AND to get out, though it might be worth it for some films.  If there were commissions for bank accounts, you would have to pay ATM fees to deposit and withdraw funds, which is likely to happen soon anyway.

Thursday, March 1, 2012

Getting Lucky on Stock Picks

I understand that you didn’t intend to sell the stock at the same price you bought it.  Your goal was to buy the stock at $425 and sell it at a zillion dollars.   Or two zillion, if you hold it a bit longer.  Sadly, the former example is much more likely.  But, even if you were successful, the stock would have had to rise to $443 just to break even, a 4.2% increase. 

Logically, the way to reduce your breakeven point is to invest even more.  Instead of one share, you buy the 10 at $4,250.   Then you only need a 0.42% increase in the stock to break even.   Mathematically, it makes perfect sense.  If it goes up to $443, you are making some money. 

If it goes down to $420, you are not only paying for the broker’s lunch, you are also doing a favor to the guy who sold it to you at $425.  The more shares you buy the more risk you are taking on. 

The downside of a drop in prices is obvious.  But what happens if you are successful?  You buy 10 shares of AAPL (the stock symbol for Apple Computer) at $425 and sell it at $443, making a nice profit of $164 ($180 less $16 in commissions.)  Then what do you do?  Go out and buy another stock, locking in another $16 (you’ll have to sell that one too) until you aren’t smart or lucky anymore.