The discrepancy between the purchase and sale price, identifiable before a transaction
The cost, which is often significant, is not completely invisible: you can calculate it by looking at a detailed market quotation. Also, for each security the market quotation lists not one price, but two:
- The Bid, or the price at which buyers are ready to buy it, and
- The Ask, or the price at which sellers are prepared to sell a security
The Bid (purchase price) is always lower than the Ask (sale price). The term “bid-ask spread” is typically used to identify the difference between these two prices.
An investor who buys a stock and then resells it immediately would incur a loss equivalent to the bid-ask spread – even if they weren’t paying a dime in commission.
This discrepancy between the sale and purchase price is used to compensate the market maker, in other words the organization that ensures that purchase orders and sale orders match, thus allowing transactions to happen.
For example, if a buyer wants to buy 125 shares of a security, the market can’t wait for a seller to decide to offload exactly 125 shares, while at the same time there are three sellers waiting to sell 50, 50 and 25 shares respectively. A market maker must therefore, at all times, buy shares from sellers to make them available to buyers. At the end of the day, it’s from this intermediary that buyers are purchasing securities, not other investors.
The market maker assumes the cost of temporarily holding the securities and of carrying out the transactions to buy and sell. Most importantly, they take on the financial risk of purchasing securities and potentially having the stock price drop before they can sell them.
To compensate themselves and cover their risk, the market maker buys for less than they sell, and inversely the investor buys for higher than they can sell.
For an investor interested in long term investments, the cost of the bid-ask spread is usually minimal, but for a more active investor who buys and sells securities frequently, it can become significant.
Additionally, the bid-ask spread is usually greater for less traded stocks, notably those from smaller companies that attract a lower number of investors.
Two other minimal costs for the majority of individual investors
When a transaction order is for a number of securities that is large in comparison to the number of securities available for transactions at that same time, the very fact of placing the order can change the value of the security to the detriment of whoever placed the order.
So, if there are few effective sales orders for a security, a buyer who turns up with a large purchase order will “wake up” securities holders who weren’t ready to sell at the current price, but who would be interested in selling a little higher. To be able to get all the securities they want, the investor will end up paying more than the price at the time they placed their order.
The inverse is also true: an order to sell that’s disproportionate to the liquidity of a security will force the price down, and the seller won’t be able to get the price they were expecting.
The cost of this impact on prices is generally negligible or non-existent for small investors negotiating small quantities of stocks in large companies.
But it can be considerable for institutional investors, when they decide to trade a significant proportion of a company’s share capital. It might also be substantial for individual investors who want to buy or sell a large amount of a less liquid security.
That might be a reason to divide one big transaction into several smaller transactions, so that each one is more discreet and blends better in the market. Also, the investor can protect themselves by placing an order at a fixed price (minimum or maximum, depending on the case).
In the end every investor needs to assume a certain opportunity cost related to the delays involved in each transaction. From the moment an order is given for a purchase or sale, the cash amount or number of securities in play is blocked until the transaction is complete. This cost is practically negligible for individual investors targeting the long term, but could be major for very active investors.
Smart management of costs is an important part of maximizing the performance of your portfolio. Every investor should therefore have an interest in thoroughly understanding all the transaction fees involved when setting up an investment strategy.
