Loading the player...

What are 'Transaction Costs'

Transaction costs are expenses incurred when buying or selling a good or service. Transaction costs represent the labor required to bring a good or service to market, giving rise to entire industries dedicated to facilitating exchanges. In a financial sense, transaction costs include brokers' commissions and spreads, which are the differences between the price the dealer paid for a security and the price the buyer pays.

BREAKING DOWN 'Transaction Costs'

The transaction costs to buyers and sellers are the payments that banks and brokers receive for their roles. There are also transaction costs in buying and selling real estate, which include the agent's commission and closing costs, such as title search fees, appraisal fees and government fees. Another type of transaction cost is the time and labor associated with transporting goods or commodities across long distances.

Transaction costs are important to investors because they are one of the key determinants of net returns. Transaction costs diminish returns, and over time, high transaction costs can mean thousands of dollars lost from not just the costs themselves but because the costs reduce the amount of capital available to invest. Fees, such as mutual fund expense ratios, have the same effect. Different asset classes have different ranges of standard transaction costs and fees. All else being equal, investors should select assets whose costs are at the low end of the range for their types.

Elimination of Transaction Costs

When transaction costs diminish, an economy becomes more efficient, and more capital and labor are freed to produce wealth. A shift of this nature does not come without growing pains, as the labor market must adjust to its new environment.

One type of transaction cost is a barrier to communication. When an otherwise perfectly-matched seller and buyer have absolutely zero means of communication, the transaction costs of a deal are too high to be overcome. A bank serves the role of middleman by connecting savings with investments and a prosperous economy justifies the income of the bank for the transaction cost of compiling information and linking parties.

However, the Age of Information, specifically the influx of the internet and telecommunications, has greatly reduced barriers to communication. Consumers no longer need large institutions and their agents to make educated purchases. For this reason, the survival of the insurance agent is being jeopardized by a wide range of technology start-ups that run websites either selling or promoting insurance policies. The easy access to information and communication that the internet provides has also threatened the livelihood of jobs, such as the real estate agent, stock broker and car salesman.

In essence, the prices of many goods and services have lowered due to a reduction in barriers to communication between everyday men and women. Retailers and merchandisers serve the role of middlemen as well, by pairing consumers with manufacturers. The retailing industry has also been shaken up in recent years, with e-commerce company Amazon.com passing traditional giants such as Kohl's and Macy's in a composite score based on assets, revenues and market value.

Mutual Fund Transaction Costs

The average annual transaction cost for a mutual fund in the U.S. was 1.44%, according to a study by Edelen, Evans and Kadlec. The first of these costs is brokerage commissions from when a fund manager buys or sells a stock. Lower-turnover funds will pay less brokers' fees, though they may pay more than individual investor. A large mutual fund may also incur market impact costs, where the fund's sizable purchase of stock artificially drives the price higher. Some managers diminish these costs by spreading their purchases over longer periods of time. Last, the mutual fund will encounter spread costs, which can be greater when the manager trades stocks across global exchanges or those with less liquidity. 

RELATED TERMS
  1. Five Percent Rule

    The five percent rule requires brokers to use fair and ethical ...
  2. Authorization Only

    Authorization only is a type of transaction that creates a pending ...
  3. For Sale By Owner - FSBO

    A method of selling property without the use of an agent or broker. ...
  4. Flat Dollar

    A flat dollar is a fixed dollar amount charged for transactions, ...
  5. Precedent Transaction Analysis

    Precedent transaction analysis is a valuation method in which ...
  6. Third-Party Transaction

    A third-party transaction is a business deal with a buyer, a ...
Related Articles
  1. Investing

    How Do Real Estate Agents Get Paid?

    Most real estate agents are paid a commission based on the sale price of a property and split between the agents and brokers involved.
  2. Investing

    Would You Make A Good Real Estate Broker?

    How to tell if you'd be good in this field. It is a common second career for many people, but isn't a good match for everyone.
  3. Tech

    Bitcoin Transactions Vs. Credit Card Transactions

    We provide an overview of the differences between bitcoin and credit card transactions, and the advantages of using one over the other.
  4. Investing

    4 Expensive Mutual Fund Mistakes to Avoid

    Mutual funds are a good way to balance your asset allocation but there some potentially expensive pitfalls investors need to be aware of.
  5. Trading

    Fund Costs and Expenses

    How much a fund charges for its services is the most important indicator of how well it will perform.
  6. Financial Advisor

    How Mutual Fund Companies Make Money

    Read about the many different kinds of fees and sales charges mutual fund companies can use to generate revenue from those who invest in their shares.
  7. Investing

    Mutual funds: Management fees versus MER

    Having a clear understanding of the fees charged by a mutual fund is a significant component to making an informed investment decision.
  8. Investing

    Start investing with only $1,000

    You can get started as an investor with as little as $1,000. Here's how to maximize your returns by minimizing your costs.
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center