Stock prices aside, small investors will lose money on fees

I’m going to make a little illustration about investments using the stock of Verizon (VZ) as an example.

On September 18, 2009, a share of stock in Verizon closed at 29.59. In the following months, Verizon issued four dividends of $0.475 per share. On September 24, 2010, a share of stock in Verizon closed at 32.64.

Let’s say, hypothetically, that we chose to invest $1,000 in Verizon on September 18, 2009, and chose to withdraw it on September 24, 2010. Our $1,000 would have bought 33.8 shares of Verizon stock. Over the course of the year, then, we would have received $64.22 in dividends. At the end of that year, we sell the stock for $1,103.23. Our total earnings on that investment would have been $64.22 in dividends and $103.23 in stock returns, right?

Not so fast.

First, the dividends would be subject to income tax. In this case, the dividends would appear to be qualified dividends, which means that they would be taxed at a rate of 15% by the federal government and possibly more by state and local sources. $9.63 of that dividend gain goes away.

Second, you’re going to have to pay your brokerage for the cost of buying the stock, as well as the cost of selling the stock. Let’s say, hypothetically, that you’re using E*Trade. The cost of the buy would be $9.99. The cost of the sell would be $9.99. That’s another $19.98 off the top – although that $19.98 is tax deductible.

Third, the gain on the sale would be a long tern capital gain, so 15% of that gain goes to the federal government. Your gain was $103.23, so you’d be paying $15.48 in taxes for that $103.23 gain.

All in all, your expenses for your gain add up to $45.09. Just like that, 25% of your gain is gone.

Even if your investment is a loser, you still lose more. Let’s say that over that same timeframe, VZ went from a starting price of 32.64 to a closing price of 29.59. You’re still out the $19.98 in brokerage fees (it’s tax-deductible, though). However, you only buy 30.64 shares of stock. You only earn $58.21 in dividends and you lose $93.36 on your investment, a net capital loss of $35.15. Add that to your $19.98 in brokerage fees and you’re down $55.13 on that investment.

What’s the point of this story? Investing has costs. You’re taxed if you gain anything and you’re getting hit with brokerage fees whether you win or you lose.

Some forms of investing have lower costs than others. If you invest directly with an investing house like Vanguard, for example, you can essentially invest without fees, meaning you only have to deal with the taxes on your gains. However, you’re limited to the offerings that Vanguard has available, plus there are often stiff minimums for investing.

You could also simply invest in the money market account at your local bank. There are no costs there, either, and your balance isn’t at risk; however, your returns will be low.

The bigger your investment, the smaller the impact such costs have on you. At the $1,000 level, the investment fees described above eat up about 2% of your balance. If you’re investing $10,000, the fees eat up only 0.2% of your balance. If you’re investing $100,000, the fees eat up only 0.02% of your balance.

Thus, for beginning investors, it’s absolutely vital that you know the total cost of ownership of an investment before you even consider it. Because even a small fee can really hammer your total return, such fees are very important to the beginning small investor.

That’s why my advice to beginning investors is this: invest your money in a savings account to start with and spend some time learning first. Know exactly what you’re going to invest in – and what all of the costs of that investment are – before you put your money in. Set up an automatic savings plan that keeps building the balance of that investing savings account so that when you do decide to make your move, you have a solid amount of money to make your first move.

Yes, you might “lose” some gains by only having the cash in a savings account. However, if it’s in a savings account, it’s not at risk of a loss, you’re not paying fees, and it is earning you a return. If you invest elsewhere without studying up, the fees and the taxes can easily eat up a big chunk of whatever you gain – and make a loss more painful than it already is.

Start slow. Don’t subject your money to fees or put it at risk without knowledge. Learn as much as you can and don’t make a move until you know the costs and feel confident about it.

How do you start learning? I suggest starting with The Bogleheads’ Guide to Investing. Read it slowly. Read it again. Move on from there by digging into some of the recommended titles. Keep going until you feel confident and comfortable with investing, then move forward. You’re better off taking it slow and making good moves from the start than flailing about and losing a bunch of your money to fees and taxes.

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