In the heady days of the late 1990s when returns were high, investors stopped paying attention to the little costs that sap returns. But disappointing returns bring the realization that successfully investing in markets is not as easy as you imagine. Here are some basic things that can help or hurt your portfolio.

Commissions

Commissions are a necessary evil in the investing game. However, because the amounts are small most investors don't realize what kind of performance they are sacrificing by trading. The investment industry is a nickel and dime business but the nickels and dimes add up to billions. Consider the typical investor with $25,000 in his online trading account.

If the investor trades once each day, they pay $25 for each buy and $25 for each sell for a total of $50. With 250 trading days a year, the active trader would pay $12,500 in commissions. This amount represents 50% of the investor's original capital. Even trading as little as once a week, the investor wipes out 10% of his capital in commission costs.

Since 1930 US equity markets have returned an average of 9% per year including dividends (more on dividends later). It is this secular gain in the equity market that investors are trying to capture. By trading as little as once a week, the commission costs wipe out that secular advantage. This leaves investors trying to pick stocks that will return greater than the market.

Reducing the number of times you trade in a portfolio reduces these costs and allows the growth in the economy to filter through to your portfolio holdings.

Bid/Offer Spreads

If an investor were to buy a stock and then sell it at the same instance, the investor realizes a loss. The loss represents the difference between the bid and the offer. This differential is what the market maker earns on the trade. The spread varies depending on how actively the stock trades. For instance on Nortel the spread is about 2 cents and on a less actively traded NASDAQ stock the spread is 7 cents. For a $25,000 trade in Nortel ($7 per share) the bid/offer spread amounts to about $71 ($25,000/7*.02).

If an investor were to make this trade daily, the annual cost in the bid/offer spread is about $17,750 (71*250 days) or 70% of his capital. Even trading once a week the investor forfeits about 14% of his capital in the bid offer spread.

Adding up just the bid/offer spread and the commissions, an investor trading once a week must make at least 25% on his capital to cover the transaction costs. The questions boil down to these: "Is your research better than the next guy’s?” and “Can you generate at least a 25% return?"

The picture doesn't get any better if you are an institution. Admittedly the commission costs are less but the bid/offer spread is wider for larger sized transactions. So the additional return must be just as great. It is no small wonder that low turnover funds tend to outperform high turnover funds.

The bottom line is that the more an investor trades, the greater the returns on capital required to breakeven, let alone make a profit.

Foreign Exchange Costs

Global investing has gained greater acceptance among investors because of the higher potential returns and lower correlation with domestic markets. Typically a great deal of effort is expended on research and analysis of different corporations and the selection of the final investment. Unfortunately, many investors ignore the friction imposed by foreign exchange costs.

Unlike commissions, foreign exchange costs are buried within the exchange rate. It is not uncommon for the exchange rate provided by the bank or the broker to be as high as 1% above the market. An investor might pick the right stock but will end up giving away part of the equity upside by paying too much for the foreign exchange conversion. In this case, the investor is subject to a charge of almost 1% -- that’s 1% of your capital that will not compound.

The situation gets worse in an RRSP account. Consider the case where an investor sells one $US stock and simultaneously buys another (not an uncommon occurrence). Most institutions require that RRSPs have no US cash balances. So, what happens? The bank/broker takes a spread on the exchange rate for the original purchase. Then on the sale, all the proceeds are converted into Canadian dollars earning the broker another spread. Then the Canadian dollars are converted to US dollars for the new investment. In total, a typical investor has as much as almost 3% of his original investment disappear in fees and exchange costs in the foreign exchange market.

Investors should fight for every nickel and dime in their investment portfolio. Additionally, they should try to avoid crossing the bid/offer spread every time they do a transaction by avoiding foreign exchange conversions.

Free Cash Flow

An investor calculates a company’s free cash flow by taking the cash flow from operations (CFO) and deducting cash outlays for the replacement of operating capacity. The remainder is the amount available to finance planned expansion, reduce debt, pay dividends or repurchase equity. The purchase of common shares represents a participation in this cash flow.

For an investor, dividends provide flexibility in their portfolios. Likewise a growing free cash flow provides a corporation with financial options. As long as the free cash flow continues to grow, a corporation can grow without any additional financing. For an equity investor, the cash flows start to compound.

By investing in companies that have free cash flow, time is on the investor's side. The longer an investor waits, the more cash the company has. By investing in companies with negative free cash flow, time works against an investor. This means that something must change within the company or the investor must trade out their position.

Dividends

At the end of the 1990s investors were not interested in dividends. The popular wisdom was that corporations should retain the cash they paid out in dividends and invest it in the company. Investors would be compensated by higher stock prices and their profits would be taxed at the lower capital gains rate.

What investors forgot was that the reinvestment of dividends into the equity market accounted for a full 60% of the return the equity markets have produced. Excluding dividends, equity markets have produced a compound annual return of 3.8% per year since 1930. Including dividends the return leaps to 9%.

Dividends are not subject to transaction costs and they allow investors to diversify or rebalance their holdings or average down on a particularly good stock. Most importantly, the investor makes the investment decision not the corporation. Dividends provide investors with flexibility.

Help yourself

You can help yourself cut out what hurts and focus on what helps by controlling as many factors as possible. For most investors this means invest with a long-term horizon, resist the temptation to trade to reduce all the costs associated with acquiring and disposing of an investment, and favour dividend paying companies with strong free cash flow. All these little changes add up to one big push for your investment performance.