1. Dealing commissions: what you pay per trade

Costs 1: What you pay and can see

There is an asymmetry at the heart of investing that is worth facing squarely: the return you are going to get is an unknown, and the cost you are going to pay is a figure you know in advance. With the first you can be as wrong as you like and still come out ahead by sheer luck. With the second there is no luck: it is charged just the same in the year you get it right and in the year you crash. This level is about the costs that are written down somewhere, and this module about the most visible of them all: what you are charged every time you execute an order.

What you are actually paying for when you pay a commission

When you send an order, your broker executes it against a market and then sees to it that the securities end up registered in your name. The bill usually rolls three distinct things into one:

• The broker's own commission. This is its margin, the part it sets freely and the only one that genuinely competes when you shop around.
• The exchange fee. The exchange where the order is executed charges its own tariff, normally tiered by size, and the broker passes it on to you.
• The cost of clearing and settlement. Recording the change of ownership at the central securities depository is not free either.

Some brokers itemize all this line by line and others melt it into a single number. The distinction matters little to your pocket and enormously when you compare: two tariffs that look identical are not, if one includes exchange fees and the other bolts them on afterwards. On top of that, several European countries levy a tax on certain financial transactions, which gets a level of its own further on.

The four ways they charge you

Almost every tariff on the market is a variant of these four:

• A flat fee per order. You pay the same to move 300 euros as to move 30,000. It shamelessly favors large orders.
• A pure percentage of the cash amount. Proportional and neutral with respect to size, but rare to find without strings attached.
• A percentage with a minimum, and sometimes with a cap. This is the commonest structure in traditional European banking and the one that does the most damage without being noticed.
• A fee per unit traded, standard in the American market: so many cents per share or per contract.

The per-trade minimum is what really decides your bill

Take a tariff very typical of traditional banking: 0.20% of the cash amount, with a minimum of 8 euros per trade. That 0.20% sounds harmless. The minimum is not.

The first thing to work out is the point at which the percentage overtakes the minimum: 8 euros divided by 0.002 is 4,000 euros. Below that figure, the percentage you actually pay is not 0.20%: it is higher, and it grows without limit as the order shrinks.

• An order of 500 euros: you pay 8 euros, which is 1.60%.
• An order of 1,000 euros: you pay 8 euros, 0.80%.
• An order of 4,000 euros: you pay 8 euros, 0.20%. This is where the two tariffs cross.
• An order of 20,000 euros: you pay 40 euros, a genuine 0.20%.

The small order pays eight times the advertised rate, and this is no contrived example: it is exactly what somebody starting out with little money does when they want to spread it across several companies.

Nobody buys in order never to sell: you always pay twice

The commonest miscalculation is to count the commission only on the way in. Every position is opened and closed, so what matters is the round-trip cost, which sets the threshold below which the trade loses money even if the share goes up.

Stay with the same tariff. You buy 500 euros of a share: you lay out 508. To get those 508 back net you have to sell for 516, because the sale pays another 8-euro minimum. In other words, the share has to rise 3.2% just for you to break even. With an order of 20,000 euros that threshold is 0.40%: a bar eight times higher for the small investor, same tariff, same day.

Commission does not scale with your wealth, it scales with your activity

Here lies the structural difference from the other costs in this level: custody or the TER are charged on what you hold; dealing commission, on what you do. You control it directly.

Take a portfolio of 20,000 euros in ten positions of 2,000. Each position pays the 8-euro minimum when it is bought and another 8 when it is sold: 16 euros per complete position. Turning the whole portfolio over once a year costs 160 euros, 0.80% of the portfolio. Somebody who turns it over four times a year pays 640: 3.2% a year in explicit commissions, before a single decision has turned out right or wrong.

Set that 3.2% against the 0.15% a year a cheap index fund costs and you have the true size of the problem. This is not a difference of nuance: it is a full order of magnitude and then some. Charles Ellis described investing as a game you win not by getting more things right but by committing fewer unforced errors, and paying twenty times what you need to for the same market exposure is the cleanest unforced error there is.

A practical rule for minimum order size

Out of all of the above comes an operating rule you can apply today. Set a ceiling on the round-trip cost per trade (0.5% is a demanding and reasonable bar) and solve for the minimum order size that respects it. At 8 euros a side that is 16 for the round trip, and for that to be 0.5% the order has to be 3,200 euros. If you cannot get there, the conclusion is not that you are investing badly: it is that you need a different tariff, or a vehicle that diversifies on your behalf without charging you ten separate minimums.

One final warning: the commission you are billed is not the total cost of your trade. There are others charged inside the execution price that appear on no line of any statement. That is the business of the levels that follow.