When investors buy shares of a public company that are traded on a stock exchange or over-the-counter, the money they need to shell out is made up of two components — the price of the stock and the fee charged by the intermediary. While retail investors may buy and sell shares through an online broker, institutional investors may work with an investment bank. In either case, for executing the transactions, the intermediaries charge an amount, which is over and above the current market price of the stocks.
Actual Stock Price
There are two ways by which a company’s stock price is calculated. First, if shares are issued to the public for the first time through an initial public offering, or IPO, then it can only be bought from the primary market against a fixed price decided by the issuing company, within a specified period of time. Shares that are outside the purview of an IPO are traded in the secondary market, where investor sentiment and market psychology determine the stock price by matching supply and demand.
However, irrespective of market, the money spent to acquire these financial assets should not be deemed as actual spending by investors as they get ownership in exchange, which can be liquidated at their discretion.
The commission paid by investors to the intermediaries to facilitate trade forms the second component of share purchase price. Hence, this is the actual cost that you have to incur to acquire assets/shares.
The brokerage fee varies from one broker to another. Some charge a flat or nominal rate per share, while others may charge a percentage of the total trade value. Most online broker houses charge between $7 and $10 per trade. Though this doesn’t sound like much, brokerages can have a big impact on small accounts.
For example, let’s say you have $1,000 to invest in a single stock and your broker charges a flat $10 per trade. So, each order (buy and sell) will cost you $10 x 2, which is a transaction cost of $20. The sum equates to a 2% reduction in your actual returns. Once you start factoring in the costs, your profit may not justify the risk of trying to pick an individual stock if you are investing a small amount in a taxable account.
Here is another example: An investor wants to buy 100 shares of XYZ Inc. Since the shares are not being issued through an IPO, he or she has to purchase it from the secondary market for the current market price of, say, $20 per share. The investor uses the service of an online broker who charges 2% of the total trade value, with a minimum commission of $50. The total price of the shares is $20 x 100 or $2,000, with the commission being $2,000x 2%, or $40. As the actual commission is lower than the minimum rate in this case, the broker will directly charge $50, bringing the total share purchase price to $2,050 and weighing more on the investor’s pocket.
On the flip side, if you have a larger sum of money to invest in stocks, the brokerage fee declines as a percentage of your investments. For example, $20 to buy and sell equates to only 0.2% of an investment of $10,000. Here, “economies of scale” boosts your realized returns.
It is possible to buy shares with almost any amount of money. With as little as a few hundred dollars, you can start investing in stocks. However, the cost to invest is determined by the stocks you want to buy and the purchase method you select. While direct purchase plans allow you to invest with small dollar amounts, an online discount brokerage account lets you buy and/or sell with small commission charges.
Investing Through Mutual Funds
Instead of buying individual stocks and paying a fair amount of commission, you can invest in mutual funds, which only hold stocks in their portfolio. With this, you can get exposure to an expensive stock without paying its full value. Moreover, investing in mutual funds helps you benefit from professional money management and diversification. To keep costs low, it is wise to buy no-load funds with low expense ratios.
Exchange-traded funds (ETFs) are securities that closely resemble index funds but can be traded during the day just like stocks. It allows investors to purchase a broad basket of securities in a single transaction while offering the convenience of stocks along with the diversification of a mutual fund. The cheapest option is a commission-free ETF. If you work with a brokerage firm that waives the commission, you will incur no transaction costs. However, taxes may still be levied on realized capital gains.
If you are willing to incur the cost of buying stocks for solid returns, you may want to consider the following stocks that possess impressive long-term earnings growth potential and have been witnessing solid earnings estimate revisions.
The Zacks stock rating system significantly rewards stocks that have been witnessing positive earnings estimate revisions, as research shows that there is a strong correlation between the trends in earnings estimate revisions and near-term stocks price movements.
EPS estimates for New York-based wireless equipment manufacturer Ubiquiti Networks, Inc. (UBNT - Free Report) , Santa Clara, CA-based cloud networking solutions provider Arista Networks, Inc. (ANET - Free Report) and Corte Madera, CA-based home furnishings retailer RH (RH - Free Report) have been consistently moving up. These three stocks also possess solid long-term EPS growth expectations.
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