Transaction Costs

What it is:

Transaction costs are fees charged by financial companies in the sale and purchase of securities.

How it works/Example:

When investors purchase or sell securities via a broker or other financial intermediary, the intermediary charges a commission or fee for providing this service. These are costs to the client that generally contain two components:  1) the basic fee charged by the intermediary, and 2) the spread, or differential, between the price paid by the broker for the security and the price at which he is selling it.

To illustrate, suppose Bob purchases 100 shares of XYZ stock from his broker, Jack. He pays $200 for the shares at $2 per share. Jack originally purchased the shares for a total of $180, incurring a $20 spread charged to Bob. In addition, Jack charges a base $20 brokerage commission. Bob pays Jack a total of $220 even though the actual cost of the shares was $180.

Why it Matters:

For investors with a finite amount of money to spend on investment activities, transaction costs need to be carefully considered since they diminish the number of securities that may be purchased.

Best execution refers to the imperative that a broker, market maker, or other agent acting on behalf of an investor is obligated to execute the investor's order in a way that is most advantageous to the investor rather than the agent.