We all know that you want to buy low and sell high, I presume. So let’s examine what that may mean for the individual investor.
Using the buy low and sell high strategy, you have to offset 1 or more of the following items:
- transaction fees
- income taxes – if it is contained within a brokerage account and contains short term gains
- capital gains taxes – in a brokerage account and if it is long term capital gains, which is holding an investment for 366 days or more (here’s a more thorough explanation of capital gains taxes
Now let’s say your transaction fees are $8 for a lot of shares as is the case with most brokerage firms currently. If you buy 1 share, that stock/fund has to go up $8 in order for you to be at a break even point since it cost you $8 to purchase that share. If you buy 10 shares, your transaction fee amounts to $0.80/share. However if you buy 100 shares, your transaction fee goes down to $0.08/share. Yes, obviously 100 shares cost 10 times as much as 10 shares, but you’re trying to lower your cost per share as low as possible. If the stock/fund normally trades up or down more than $0.80/day, you can easily make up your cost per share, however if the stock doesn’t change that drastically, you’ll want to get a larger number of shares so that you can ensure that you’re not just throwing money out for transaction fees.
As a real world example, let’s say you wanted to buy McDonald’s stock. As of Aug 20, 2013, the stock is selling for $95.50/share. If you only bought 1 share, then you would have to wait until the stock went up by $8 before you recouped the transaction fee. But if you’ve saved up $1,000 to put into it, you could buy 10 shares that would cost $955.00 + $8 transaction fee, and the stock would only have to go up $0.80/share. That’s a significant difference and the reason that you should try to fund your IRA or brokerage account as much as possible. Some wise people such as the Financial Samurai would suggest that you max out your 401k and IRA, and after all that still put away 20% of your take-home pay, in order to achieve wealthy status.
If it is not held in a pretax retirement account such as a 401K, 403B, or Traditional IRA, you will have to pay taxes on any increase of a stock when you sell it, along with any dividends in the year when they are received in a tax year.
Everybody’s income taxes are different since we have a tiered income tax system in the U.S., not to mention the various write-offs that are also available. For the sake of simplicity, we’ll say that you have to pay 15% income taxes since that is the middle income quintile of the bell curve according to the CBO (source: http://www.cbo.gov/sites/default/files/cbofiles/attachments/43373-06-11-HouseholdIncomeandFedTaxes.pdf) for 2009, although I rounded it up from 14.7% to be conservative. If you sell a stock after it has gone up $1.00/share, you’ll have to pay income tax of $0.15/share.
Continuing with our real world example above, if you bought 1 share, the stock would have to go up $8.15 (or $103.65/share) before it makes sense to buy it, or you are just giving money away. If you bought 10 shares, the stock would have to go up $0.95/share (or $96.45/share) before you break even. But if you bought 100 shares, the stock would only have to go up $0.23/share (or $95.73/share) to break even. If you invested in a very low cost stock like RENN on Aug 20, 2013 which ended at a price of $3.36/share, you might be able to purchase 1,000 shares which would cost $3,360 + $8, however if it goes up by $0.10 (10 cents), you’ve just managed to gain $100 – $15 (tax) = $85, and the transaction fee is almost inconsequential since it amounts to $0.008 – yes that’s 8/10 of 1 penny.
Capital Gains taxes
These are similar to the Income Taxes above, however they have been limited to no more than a certain percentage since 1997 due to the “Taxpayer Relief Act of 1997″. But since 2008, it can now be as low as 0% if you are in the 10% tax bracket, with the maximum being 23.8% if you are in the 39.6% tax bracket. This information is relative to 2013 as noted by this link to TaxFoundation.Org.
Hopefully it is clear that you want to maximize the number of shares that you purchase after having put away for savings and investments as much as possible. Along with taking advantage of tax breaks that may be available if you are eligible due to capital gains taxes.