Forgotten Costs of Stock Market Transactions

Once upon a time, you could truly buy a little piece of a company. You would receive a stock certificate, a real piece of paper, attesting to your ownership. Some owners stored their stock certificates in the attic and forgot about them. It was the ultimate buy and hold strategy.

Theoretically, buying stock still means buying a share of company ownership. But the trading environment has changed drastically. Gone are the days when your grandfather might leisurely read yesterday’s closing prices over breakfast, mosey on down to his office and call his broker.  Paper certificates have been rendered obsolete by trading speed. Today’s electronic communication networks (ECNs) and split-second order fulfillment ensure that transactions occur at a stomach-lurching pace.  Settlement speed has not caught up with transaction speed.  It still takes three days to record change of ownership, and it is quite possible to unwittingly sell stock you do not yet legally own.

The same block of shares may have changed hands innumerable times even within the same day. Buyers and sellers trade “positions,” rather than fractional ownership, and make “plays” with only oblique relationships to actual companies. Those with access to the highest tiers of information have distinct advantages. Some trades take place in pools” invisible to the market.  Even big brokers have taken to dividing a transaction into 100-share increments to detection by number-crunching computers.

The little investor is especially at risk. It used to be an investor needed substantial assets to secure the services of a broker. Today, anyone with a couple grand laying around can open an account at a discount brokerage where it is especially easy get into trouble.  Many discount brokerages advertise their services to the little investor while simultaneous expecting the little investor to be sophisticated and experienced enough to independently make sound investment decisions. For example, very few investors account for the erosive effects of the rate of inflation, historically averaging around 3 percent annually, in order to maintain purchasing power.  Thus, GE’s price would need to increase about 50 cents/year just to keep up. Unless you consistently cover your transaction costs and beat the rate of inflation, the gain is illusory.  In a normal interest-rate environment, a CD ladder may do as well with a lot less work.

Most surprising are the number of investing decisions made with no understanding of the tax consequences. For example, it is possible to buy a position in a natural resource company as easily as a position in any other stock. The difference is that most natural resource companies take the theoretical part-ownership philosophy seriously. Come tax time, they will send all their “owners” a form called a K-1, which details even the smallest owner’s share of the income and liabilities of the company. There may be only a dollar or two listed on the various lines of the K-1. Each line will likely generate a different tax form, making tax returns with K-1s potentially very expensive. This is just one example of a situation where even brokers and financial planners seem ignorant of tax consequences until it is too late. The stock gain must also exceed the cost of the tax return in order to post an actual profit.  Too often paper profits are undermined by unaccounted for costs.