What are Transaction Costs?
Transaction costs are fees incurred during the process of buying or selling a good or service. These costs may include brokers' commissions and spreads in the sale and purchase of securities.
How Transaction Costs Work
When investors purchase or sell securities via a broker or other financial intermediary, the intermediary charges a commission or fee for providing this service. These are transaction costs to the client that generally contain two components: 1) the basic fee charged by the intermediary, and 2) the spread, or differential, between the price paid by the broker for the security and the price at which he is selling it.
To illustrate, suppose Bob purchases 100 shares of XYZ stock from his broker, Jack. He pays $200 for the shares at $2 per share. Jack originally purchased the shares for a total of $180, incurring a $20 spread charged to Bob. In addition, Jack charges a base $20 brokerage commissiom. Bob pays Jack a total of $220 (due to the additional transaction costs) even though the actual cost of the shares was $180.
Why Transaction Costs Matter
For investors with a finite amount of money to spend on investment activities, transaction costs need to be carefully considered since they diminish the number of securities that may be purchased.