The Commission Controversy --- Smoke and Mirrors

Nowhere in the world of investing is "Brainwashing" more apparent than in investor (regulator) attitudes toward commissions. Since Charles Schwab first shocked Wall Street by offering discount commission rates, a new industry has developed with a huge, cult-like, following.

Investment Managers are often called upon to explain why they prefer to operate using full service firms as, I'm told, most independent managers do. Many of you may even stop reading when I utter my blasphemous opinion that (once a portfolio is in place) commissions are simply a "variable cost" of portfolio management and not something to get particularly stressed about.

I often wonder if there is some correlation between discount brokerage "diehards" and people who think certified pre-owned is the same as new---checked out that Schwab smile recently? 

Contrary to popular belief, successful investing requires the conscious coordination of two sets of well-documented principles, not just the placement of securities orders in one medium or another, or at high or low commission rates.

These principles are the Quality, Diversification, and Income (QDI) tenets of Investments 101, and the Planning, Leading, Organizing, and Controlling (PLOC) basics crammed into the brains of all Sophomore Management students.

As every experienced manager learns, it is the fixed costs of an operation that require tight control, and the variable costs that require creative direction. Brokerage commissions are, in fact, one of these variable costs, as are income taxes. If you are managing the investment enterprise properly, your variable costs will move ever higher while your fixed costs remain relatively constant.

Much to your pleasant surprise, your realized profits will increase at a higher level than the increase in your variable costs.All too often, commission avoidance and tax reduction issues are allowed to "Wag the Dog", causing millions of unrealized profit dollars to hit the books in later years as realized losses.

The Brainwashing of the American Investor illustrates how (in a percentage-target, trading environment) investors who pay higher commissions actually make more money, in dollar terms, than their frugal "discounterparts"[sic]. The Math is simple; 10% of a larger number is a larger number, period. But it should not be an issue at all. If it was really as big a deal as it is purported to be, there just wouldn't be any full service-high commission brokers anymore. 

Think about it this way. The major full service firms on Wall Street charge backbreaking, obscene, commissions and they stay in the retail business. Would they allow clients with as little as $100,000 to opt for a flat fee arrangement if they thought that they would make less money? 

In investing, fixed costs are minimal unless you go out of your way to increase them by adopting some form of flat fee, commission-replacement arrangement. A management person responsible for directing your portfolio is a fixed expense. But if he or she really understands money, you will be discouraged from adopting prepaid commission arrangements on a permanent basis.

If you are paying a flat fee on any form of income portfolio, you really are being criminally abused --- but not by the brokerage firm. Fixed income investing is much like furnishing a home ---- when you are done, you have low fixed expense and fewvariable costs.

Equity portfolio investing is more like running an active retail business---the more turnover, the better. Most retailers have a standard mark-up policy, and most understand the turnover issue. The last thing they want to see is a higher inventory "value" from quarter to quarter---this means that the merchandise isn't selling. Higher sales and profit numbers are the key issue.

In fact, many companies send their highest commission earners on  vacations. Variable expenses are the fertilizer that grows sales, without which there are no profits. And, in equities, if there are no realized profits, why bother? 

Retailers' shelves are full of merchandise, purchased at different times, at different prices, and from countless wholesalers who, themselves, have varying markups. Items that move slowly are marked down for easier sale, damaged items are sold at a loss, etc.

Employees get their commissions, suppliers of replacement merchandise get their markups, and the cycle continues. Just like running an equity portfolio, right? The more commissions the retailer pays out to his sales persons, the more profit he brings to the bottom line. Just like running an Equity Portfolio, right?

Now, what really happens when retailers: reduce their buying and selling expenses to zero, but add an additional 1.5% to overhead, while keeping a profit target of 10%? This is precisely how the flat fee commission arrangement plays out. Even without the increase in overhead or fixed costs, the profit is a bigger number.

Sometimes, the old fashioned way is better. Do the Math, you'll always get better bottom line numbers with larger commissions. 

So by cutting both our acquisition costs and our selling costs, we've effectively reduced our gross sales by $2,200 and our actual dollar profit by $1,775 while locking in a 15.7% smaller profit margin. This Math is flawed in one respect. The lower level of service and/or commitment you get from suppliers and salespeople will absolutely cause other costs to rise, as sales people will provide their best service to better customers. You won't sell as much stuff, and you won't sell it as quickly. 

Applying this illustration to the stock market and equity trading, one would find similar results. With a full service broker, you may wind up with a sales target for a particular stock that is somewhere between 25 and 75 cents per share higher (the larger the position, the smaller the differential). But you'll get a phone call when a selling target is reached, or an old favorite has come back into range. And, with independent brokerages all over the place, you need not pay for service with your body parts.