How much should you spend on brokerage fees?

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My rule of thumb is up to 0.5% of the transaction amount in a given year, which roughly annualizes to 0.025% p.a..

Was this information useful? I don’t think so. Because I didn’t provide any context. The actual numbers I use are not as important as how I came up with them.

In order to become confident with investing, you have to understand why/how instead of just reading about the what.

The goal of this article is to explain how you can estimate the impact of brokerage fees on your investment returns.

Free-commission is all the rage these days. You can see it in the excitement over commission-free ETFs in Degiro and the popularity of zero-commission brokers like Trade Republic or Trading 212.

You can also see evidence of that in statements like this: “Interactive Brokers charges a monthly maintenance fee of $12 on accounts with balance lower than $100k. Therefore, I will wait for my portfolio to reach that value before changing brokers”.

Investors really care about minimizing brokerage fees. And you can compare broker commissions using a tool developed by Curvo.

This left me wondering: How much do brokerage fees really matter? I concluded that brokerage fees have a small impact on investment returns for any reasonably priced broker. And most importantly, brokerage fees matter less as the size of your portfolio increases.

Method 1: Comparing growth of investments

The simplest way to estimate the impact of brokerage fees is to compare the growth of an investment without fees to an investment with fees.

For example:

  • Imagine you pay €120 per year in fees
  • Imagine your contribute an additional €500 per year to your portfolio
  • Imagine your average annual return is 5%
  • If we assume an investment period of 30 years we get the final values
    • Without fees: €35,380.39
    • With fees: €27,407.73 (-22% than without fees)

For the example above, the investment with fees reduced the final portfolio value by 22%(!). That is awful! Let’s see another example:

  • Imagine you pay €120 per year in fees
  • Imagine your contribute an additional €24,000 per year to your portfolio
  • Imagine your average annual return is 5%
  • If we assume an investment period of 30 years we get the final valuesWithout fees: €1,698,258.957
  • With fees: €1,690,286.295 (-0.47% than without fees)

In this example fees only reduced the final portfolio value by 0.47%. This looks more reasonable than the first example. These examples are evidence that:

  • Minimum fees have a meaningful impact on small investment amounts;
  • Fees have a negligible impact on performance for large investment amounts;

Method 2: Annualizing brokerage fees

The previous method is great but I had to use Excel for that. There is a simpler method I learned from Robert Carver’s Smart Portfolios. It helps you get a rough and quick estimate of the results from the previous method.

When you have an ETF with a TER of 0.25% p.a., you know that you are going to reduce your yearly investment returns by 0.25%. This TER can easily be compared to your estimated average annual returns (e.g. 5% p.a. ) because they both have the same unit of measurement – they are annualized (i.e. they have the per annum, p.a., bit at the end).

The issue with brokerage fees is that they are initial costs. They are one-time fees you pay for buying/selling shares. You don’t pay them based on your yearly investment returns. They are not per annum. We need a method to estimate the impact of all the brokerage fees paid during the investment period. Therefore, you need to annualize them before you can compare them with the average annual returns.

Let’s imagine the following scenario:

  • You pay €120 per year in fees
  • You contribute €24,000 per year to your portfolio

To annualize the brokerage fees you take the following steps:

  • You calculate the percentage spent in fees in a year: €120 / €24,000 => 0.5%
  • You annualize by dividing by 20: 0.5% / 20 => 0.025% p.a. Robert Carver calls this the rule of 20. I like to call it annualizing. We divide by 20 because we are assuming an investment period of 30 years. We would divide by a different number for a different investment period (e.g. divide by 15 for a period of 20 years).

The rule of 20 is a rough approximation of the discounted cash flow method.

For annualized brokerage costs of 0.025% p.a., you can conclude the following:

  • If you are spending 0.25% p.a. in TER for an ETF, the brokerage costs are 10 (!) times lower.
  • If your estimated average returns before brokerage fees are 5% p.a., after brokerage fees you will get 4.975% p.a.
  • You can then use the average return after brokerage fees to calculate the final value of your portfolio

We can also annualize brokerage costs for our “small portfolio” example:

  • Percentage spend in fees in a year: €120 / €500 => 24%
  • Annualized brokerage fees: 24% / 20 => 1.2% p.a..
  • If you are spending 0.25% p.a. in TER for an ETF, the brokerage costs are almost 5 times higher.
  • If your estimated average returns before brokerage fees are 5% p.a., after brokerage fees you will get 3.8% p.a. (ouch!)
  • You can then use the average return after brokerage fees to calculate the final value of your portfolio

My rule of thumb

I came up with my rule of thumb after playing around with numbers in Excel. Instead of using Excel you can also use a tool like Backtest to assess the impact of fees on your portfolio.
I realized that spending up to 0.025% p.a. in fees for a -0.47% in reduction in final value of the portfolio sounded like a reasonable trade off to me. That is the threshold below which I consider a broker very cheap. I probably could live with up to a -1% reduction if needed.
This is just a guesstimate. You are free to come up with your own rule of thumb. What matters is:

  • That you are aware of how much brokerage fees affect your bottom line.
  • That you realize that when your investment amounts grow, brokerage fees have a lower impact.
  • That choosing ETFs with high TERs in order to save on brokerage fees is usually a bad deal. ETF annual fees tend to have a higher impact on your investment returns.
  • That you realize that commission-free is amazing but it should not be your only criteria for evaluating a broker.
  • The threshold for reasonably priced investing using Interactive Brokers may be lower than $100k in portfolio value.

This post is an early draft of one of the improvements I am making to my “Guide to brokers for index investors”. This guide is an in-depth video where you will learn how to use and choose a broker as well as how brokers work. This guide is one of the add-on materials of my book “Introduction in index funds and ETFs”.

Subscribe below to get the first chapter of the book.

Disclaimer: This information is for educational and entertainment purposes only. This does not represent, in any case, specific investment, legal nor tax advice nor recommendations to purchase a particular financial product. Learn more at https://indexfundinvestor.eu/disclaimers/