Definition and example of friction costs

How friction costs work

Types of friction costs

What does this mean for individual investors

Definition and example of friction costs

Friction cost is the cost that an individual pays as part of completing a financial transaction. Friction costs can be financial or non-financial. In brief, they encompass anything that hinders trade or the completion of transactions.

Friction costs are named so because they slow down financial processes just as friction slows down the movement of objects. An example of friction costs is the fees you may pay a robo-advisor to manage your portfolio.

How friction costs work

Friction costs work by interfering with free and easy financial transactions, making them more difficult to complete and forcing at least one party to bear a cost to finalize the transaction.

Friction costs are common for investors. In a perfectly efficient market, for example, an individual wanting to sell a stock can simply find someone willing to pay the asking price and exchange that stock for cash. In reality, most transactions involve some form of frictional costs. The seller may have to pay a commission to a broker to complete the transaction.

They may also find that there’s a spread between the bid and ask prices of the stock, forcing them to accept a slightly lower price to complete the sale immediately. Alternatively, they can incur a cost in time, waiting to find a buyer willing to pay the asking price.

Nevertheless, the investor pays the friction cost, which results in the transaction taking longer or the investor receiving less money after the sale.

Types of friction costs

There are two main types of friction costs: direct costs and indirect costs. However, some costs may fall under multiple categories, making it difficult to pinpoint certain types of costs.

Transaction costs: Transaction costs are the simplest type of friction cost to understand. They are usually like commissions you have to pay to complete the transaction, or asset management fees charged by the broker to maintain your portfolio throughout the year. However, they can also include things like the opportunity cost of the time spent searching for a better deal on a product or finding the best product to buy.

Taxes: Taxes are a common friction cost. Sales taxes or capital gains taxes add additional costs to transactions such as purchasing a product or selling investments.

Regulation: Government or industry regulations can create friction costs by forcing transaction participants to spend time completing necessary paperwork or other required processes before they can complete the transaction.

Information: Information is essential to complete the transaction. If you are interested in buying shares of a company, you will likely spend time researching the company’s leadership, what their financial statements look like, and metrics such as the price-to-earnings ratio and past performance. The time spent gathering information is a cost.

What does this mean for individual investors

Individual investors should pay attention to various friction costs when designing their portfolios. In particular, investors should consider the commissions charged by the broker they choose and the taxes.

Taxes are imposed on the profits that investors make from selling securities. An investor looking to rebalance their portfolio should consider the tax implications when selling some of their investments. They may be willing to accept slightly more risk or potentially lower returns to avoid those costs.

Over time, friction costs, especially management fees for things like mutual funds and ETFs, can accumulate to significant amounts, so investors should take steps to minimize friction costs as much as possible.

Summary

Main:

• Friction costs are additional costs involved in transactions.
• Friction costs can be financial or non-financial, such as the opportunity cost of using time to complete the transaction.
• Investors should seek to reduce friction costs to enhance the performance of their portfolio.

Sources:

• The Federal Reserve Bank of Atlanta. “Friction in Financial Markets”.

Source: https://www.thebalancemoney.com/what-are-friction-costs-5223461