Transaction Costs
Many financial exchanges that appear profitable on paper are not profitable in reality due to transaction costs. In There’s More Than One Ball Game, I illustrated how an investor who had invested $100 in a stock could have had a return of -8.4%, while an investor who had invested $1,000 in the exact same stock at the exact same time could have had a return of 3.6%. When investing small amounts of money, transaction costs (brokerage fees, etc) must be a more serious consideration than when investing larger amounts of money.
At the moment, I am currently auctioning off my Power Mac G5 on eBay. The bid-ask spread for items sold on eBay is absolutely gigantic; far greater than anything you would ever see on the stock market. Part of the spread is induced by the natural transaction cost of shipping. It doesn’t cost anything to “ship” a share of a stock, as a share may be transferred electronically. However, to ship a 50 lb. computer from Philadelphia to Chicago, it would cost $62.10. Assuming that the computer sells for an even $800, the person purchasing it would have to pay $862.10 to both acquire the computer and to receive it. My profit, as the seller, would be far less. After $62.10 is spent on shipping, the remaining $800 is divided between myself, eBay, and PayPal (an online payment service owned by eBay). It is rather difficult for consumers to determine the true cost of selling an item on eBay, as the cost is really the sum of three fees:
- The Insertion Fee (makes an item appear on eBay)
- The Final Value Fee (only paid if the item is sold)
- The PayPal Fee (only paid if money is exchanged via PayPal, which happens in most auctions)
The Insertion Fee and Final Value Fee are both piecewise functions that depend on the price of the item being sold. The fee becomes a smaller and smaller percentage of the value of the item as the value rises, but the fee decreases in a discontinuous fashion. In order to better show how these fees work, I have created:
The eBay Curve
On the vertical axis of The eBay Curve, you can see the percentage of money that you receive from a sale on eBay, as a function of the price. Thus, if my computer sold for $800, I would only receive about 93% of the value of the item, i.e. $747.14. So, if someone buys my computer and pays $862.10, and then I receive $747.14 from eBay (after allowing for shipping expenses), there has been a transaction cost of $114.96! From the seller’s perspective, that is over 15% of the revenue generated from the sale! As a result, there is a substantial amount of friction in the online market. If I see an computer worth $100 for sale for $95 on eBay, I will not try to arbitrage it (buy it for $95, and then sell it to someone else for $100), as then the item will have to be shipped twice, and according to The eBay Curve, I only receive $91 back from a $100 sale. Thus, this transaction makes no sense for me. As the value of an item increases, or the profit margin on an item increases, the more it makes sense to sell the item on eBay.
What does this have to do with investing? Well, buying a house has a very similar fee structure. Imagine that you bought a house yesterday for $100,000, and all of a sudden realize that you need to move. As a result, you sell it to someone else for $100,000 the next month. Did you break even? Absolutely not! As a result of transactions costs, you have suffered a substantial loss. When purchasing a home, the buyer is responsible for title insurance fees, inspection fees, and other fees, which are all analogous to the shipping costs of eBay. I believe that these fees are approximately $5,000 on a $100,000 home. As these fees are not included in the home, it would cost $105,000 to acquire a $100,000 home (just as it costs $862.10 to acquire a $800 computer). When selling a home, one must pay the commission of both the buyer’s agent and the seller’s agent, which usually is 6% of the sale price. So, instead of receiving $100,000 from the sale, the seller receives only $94,000. Thus, when buying and instantly reselling a $100,000 home, one can expect to spend about $105,000 to acquire the home, and to receive $94,000 in revenue from the sale of the home. The transaction costs associated on flipping the home in question are $11,000, almost 12% of the revenue.
So, why do people buy and resell computers and homes? People reselling computers buy computers that are severely under-priced, and then sell them as soon as they can, as computers tend to depreciate rapidly. People buying homes tend to wait to sell them, hoping that they will appreciate in value while they are being held, beyond the cost of the transaction. Whether selling a stock, a computer on eBay, or a home, it is important to be aware of the effect that transaction costs will have on your return.
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Very nice analogy, using eBay to point out the perils of transaction fees, especially since the eBay advice is useful in and of itself. I wonder how many people get burned without even realizing it when selling items on eBay. This post would probably find a good audience on a forum for people trying to make a living from eBay, although I’m not sure if they would need more explanation of the term “arbitrage.”
Anyway, your point about stock transaction fees is a good one and I think that is where new investors with their shiny new eTrade accounts often make mistakes. First of all, those advertised deals with low transaction fees often apply only to people investing large amounts of capital. So if you’re buying and selling your 5 shares of Google, it’s absolutely ridiculous. New investors would be much better off buying some nice tidy S&P index funds, which have the advantage of not having to pay a pricey mutual fund manager or do the research that can be difficult for newcomers AND pay transaction fees for individual trades. But I guess that wouldn’t be nearly as exciting for a new investor, and certainly less profitable for those collecting transaction fees! Now if you’ll excuse me, I’ve got to go liquidate my Roth IRA’s to invest in Beanie Babies to sell on eBay. (Just kidding!)
I like your example on the house. This is also a good example of how “replacement” fees can bite you. Obviously you need a house, so not only do you pay the transaction fees when you sell it, but you also pay the price of replacing the house you just sold, which could be much higher even for the same quality of home.
The bottom line, unless you have a lot of money to put into something (and hopefully you can invest with a flat fee instead of a percentage) you should stay away.
I thought the ebay example was very easy to relate to. I’ve often wondered about where all the money goes and why sometimes the prices and shipping are outrageous.
I don’t know much about economics myself, but this made things very easy to understand, in my opinon. I never really thought about things that way. Thank you.
Arrgh, forgot to add this.
I’d always wondered how people could get away with selling things so cheap on ebay…It’s easy to fall into the hype of new things, especially on ebay, because often times you end up paying much more than you intend to for something that is “worth the investment”. I’ve done it.
The house thing hit especially close to home, as my father is currently trying to invest in his house and fix it up to sell.
Very true and good information. The points made about transaction fees are some of the reasons I haven’t attempted to trade stocks online. I don’t have a lot of money to invest and if I did I would lose a lot of profit in these fees. These types of fees are things to consider when ordering goods online. Not only may you have to pay shipping and handling you may also have to pay your state’s sales tax if there is a store of the company you are buying from in your state. So it may be cheaper to actually go to the store and buy the product thus paying only sales tax and avoiding the shipping and handling fees. However, if you get a “deal” and the shipping and handling are waived then you would profit from the convenience of getting the items shipped to your home.
All of the analogies used here were very easy to relate to and understand. It makes a lot of sense. The cost of doing business is often more than presented at face value.
I have noticed lately that the s/h costs on ebay have gotten outrageous for some items. Many sellers don’t offer mailing options, so even if you could wait several days for the item and would be willing to pay for it to be sent regular mail, they only will send it 3 day UPS or something.
I always count the true cost when I shop ebay, b/c you just have to….I refuse to buy anything with a crazy s/h price, and usually shop acc to the total cost of the product. Sometimes I will buy a more expensive item on ebay if it’s total cost is going to be cheaper with s/h than the total cost of a cheaper item with a more expensive s/h. You have to do your homework.
This post was a good reminder about true cost. Thanks!
Your idea is very interesting, which makes me wonder what role institutions can play. I am not sure if you are academic researcher, so maybe the following is kinda boring to you. In economics, there is one famous theory called neo-liberal institutionalism, which stands institutions function as reducing the transaction cost as when proceeding transactions two parties who are not familiear to each other can’t share common information. To facilitate the information sharing hence avoiding asymmetric information, institutions should be built as transaction platforms on which information can be shared. However, your argument stands institutions will function well only when the transaction is big-scaled as the cost for running an insitutions will offset the gains brought by proceeding by institutions sometimes.
Anyway, your argument is very interesting. Maybe what we are transacting here is also the case.Cheers!
So many times I’ve _almost_ started investing, but the transaction charges would make it pointless at the kind of small scales I’d be dealing in.
Obviously, sites like etrade (and ebay) are successful for a reason. It makes sense that they’d take a chunk of everything that goes through. But as you say, those chunks can be more significant than one might think at first glance.
Well, real estate and ebay are not quite the same thing. I can ship a laptop, a rare stamp, or a pez dispenser anywhere in the world. My house, I can’t.
So here is free advice from an EX-ebay powerseller:
try craigslist.org for big stuff. Try amazon.com or abebooks.com for books. Save ebay for high end collectibles – we shipped vintage cameras all over the world, for good $$$, until we ran out of cameras.
Ebay has gotten failry greedly with fee structures, and the market is pretty darn saturated.