Minimizing investment friction

Over the years, I have started to pay more attention to friction in my portfolio, which I define as any charges, fees, or penalties, which ultimately deter from my earning potential. When I am making decisions to buy/hold/sell investments, there are three primary types of friction I pay attention to, and try to avoid: Tax Friction, Rounding Friction, and Commission Friction.

1. Tax Friction

Taxes are a reality, and ultimately the tax man (or woman!) always gets his (her) due. In Canada, there are three key types of taxes to pay attention to with your investments. The first, is the capital gains tax, which is applied on any capital gains (i.e. profits) from your investments when you sell them. Following this, is taxes on dividend income; and finally, there are taxes on interest income.

There are a number of ways to reduce tax friction with your investments. The most obvious one, is to keep your investments in a tax free account; in Canada, this would be your TFSA, otherwise known as a tax free savings account. Any capital gains, dividends, or interest, you receive in the TFSA are received tax free. The reason for this is that any contributions you make to a TFSA (i.e. money or investments transferred into the TFSA) are made from after tax dollars, so you have already been taxed on the inflows to the account. The one downside to using a TFSA is that you cannot use capital losses incurred in the TFSA to offset capital gains outside of your TFSA.

The second vehicle at your disposal is to keep your investments in a tax deferred account, e.g. your RRSP. Similar to your TFSA, any gains, dividends, or interest, or not taxed in the account (well, not immediately; see the second key difference below). Moreover, any losses cannot be used to offset gains outside of the RRSP. That being said, there are two key differences between a TFSA and an RRSP. The first difference is that contributions to your RRSP lower your taxable income in the year in which you make the contribution1. As an example, say your salary in 2016 is $45,000, and you contribute $5,000 to your RRSP. This lowers your taxable income to $40,000, which means that your income tax for the year is on $40,000, not $45,000. Taking this even further, if you review the marginal tax rates for your province, you may actually move yourself into a lower tax bracket. In the example we just cited, in the province of Ontario, at $45,000 your marginal tax rate is 9.15%, but at $40,000 your marginal tax rate is 4.05%!

The second difference is that you are taxed when you take money out of the RRSP. The theory is that when you take the money out however, you will already be in a lower tax bracket. So while you may be in a $45,000 tax bracket today, when you take the money out when you retire, you will likely be in a lower tax bracket. Again, by forcing yourself into a lower bracket, you are ultimately paying less tax (and keeping more money in your pocket!).

The third way to reduce taxes is to leverage your capital losses against your capital gains. This option is only available to you in a non-registered account (e.g. not a TFSA and not an RRSP). With this reduction, you reduce the amount of tax you pay on your gains by your losses in that year. For example, if you sell a stock for a profit of $10,000, and you sell another stock at a loss of $4,000, you will only pay tax on $10,000 -$4,000 = $6,000. In general this applies provided you claim the gain and loss in the same reporting period (or carry forward any losses and/or gains to future years); seek advise from a tax professional for details.

2. Rounding friction

Rounding friction is exactly what it sounds like: losses due to rounding. As an example, assume we are able to trade stocks with no commissions, and with no tax friction (e.g. in our TFSA). For our example, say there are two companies, A and B, and we wish to sell company A and purchase company B, because the yield on B is higher:

Line # Company A Company B Notes
A # shares 100 20
B share price $12.34 $59.80
C total value $1,234.00 $1,196.00
D dividend yield 5.00% 5.10%
E dividend $ $61.70 $61.00

After we have completed all of our trades, our absolute dollar return is less even though Company B is the higher yielding stock. The reason for this is that we cannot trade fractional shares. When we sold Company A and took the proceeds of $1,234.00, the proceeds divided by the price of Company B would have had fractional shares: $1,234.00 รท $59.80 = 20.635 shares. But, since we can only trade in whole shares, we lost out on 0.635 shares. Even if we take into account the residual cash from selling Company A (i.e. the cash leftover from the trade), our net value is still less. Note that this is only in Year 1, however in subsequent years your net dividend income would still be lower as well with Company B due to the loss of 0.635 shares.

Line # Company A Company B Notes
A # shares 100 20
B share price $12.34 $59.80
C total value $1,234.00 $1,196.00
D dividend yield 5.00% 5.10%
E dividend $ $61.70 $61.00
F Cash in Lieu n/a $38.00
G Net Value $1,295.70 $1,295.00

The only way to get around this is to either luck out and fund companies where the net proceeds of the first will exactly pay for the net cost of the second, or to purchase fractional shares. Luckily, there are ways to perform the latter. If one uses Optional Cash Purchases for companies that allow it, you can purchase any number of shares, and the the total shares purchased will be exactly equal to the amount of capital divided by the going price for the shares.

3. Commission Friction

The most common type of friction, and often one of the hardest to avoid, is friction caused by commissions on your trades. As investors we are all familiar with commissions, and they are a cost of doing business when investing.

Other than choosing a (discount) brokerage which has very low commissions (Personally I use BMO InvestorLine, which charges $9.95/trade), to my knowledge there are really only two ways to get around commission friction.

The first, is to use Optional Cash Purchases for those companies that allow it, and that do not charge commissions on OCPs. Not all companies that offer OCPs do so commission free. For example, the McDonald’s OCP program charges $6.00 per share, whereas the Emera OCP program does not.

The only other way to reduce commission friction is to trade in larger quantities of stock, thereby reducing the average commission. For example, if you purchases 100 shares of a stock at $9.95 commission, your average commission per share is only $0.0995. But if you were to purchase only 50 shares, your average commission would be $0.1990. While you are not completely eliminating the commission, you are reducing it on an average basis.

Onward and Upward!
-pmp
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1 This isn’t exactly true. See a tax professional, but you can may be able to defer your contributions to a later year, hence reducing taxes in a later year.