People who buy and sell stocks are aware of the brokerage commission they pay on those transactions. Many of them aren’t aware of another cost — a hidden one — called the spread. The spread can be insignificantly small, but it doesn’t have to be. This is one of the reasons frequent trading tends to produce inferior results.
If you aren’t aware of spreads, it’s probably because you think of stocks as having a single price at any given time. In reality they have three. The one you normally see is the price of the last reported transaction (often with a 15- or 20-minute delay built in). If you’re buying shares, the number that matters is the price you’ll pay, not what the last person paid. And if you’re selling, you’re interested in the price you’ll receive, not the price someone else received.
When you place an order to buy shares, your broker transmits it to the exchange to determine the lowest price available from investors who are willing to sell at that time. This is the current asking price, or the ask for short. Likewise, an order to sell goes over the wire to determine the highest price available from investors currently willing to buy, known as the bid. The ask is always higher than the bid, and the difference is called the bid-ask spread, or simply the spread.
If you’re wondering why the ask is always higher, it’s because the purpose of a stock exchange is to make transactions happen whenever there’s a buyer and seller who agree on the price. Matching buy and sell orders are like matter and antimatter, instantaneously cancelling each other out. So you’re faced with this reality as an investor: at any given time, the price at which you can sell a stock is lower than the price you would have to pay as a buyer. For an explanation of how this works as a hidden cost, here’s an excerpt from That Thing Rich People Do, my new book on investing:
Suppose you buy a stock when the best purchase price is $15.00 and the best selling price is $14.85. In this situation you have to pay $15.00 for your shares. You hold the stock for a while, and by coincidence the exact same prices are available when you decide to sell. That means you get $14.85 on the sale. Looking at your brokerage statement, you might think the stock went down 1% because you bought at $15.00 and sold at $14.85. In reality the stock’s price hasn’t budged. It had to go up 1% for you to break even.
In the bad old days (which aren’t that long ago), stock prices were quoted in fractions of a dollar, and spreads were normally no smaller than one-sixteenth of a dollar, or about six cents. The stock exchanges now quote in dollars and cents, so spreads can be as small as a penny. On a stock like Microsoft, with a huge volume of trading, that’s exactly what you’ll see most of the time. When you go off the beaten path, investing in smaller stocks that don’t trade as frequently, you can expect to encounter much higher spreads, often exceeding 1% of the stock price.
One of the key principles of investing is to keep expenses to a minimum. On every round trip, where you buy and sell shares of stock, you incur two commissions and a hidden expense called the spread. Even if your commissions appear to be trivial, or you’re able to trade with no commissions at all, the spread can be eating into your profits. That’s a major reason people who trade frequently tend to fall behind more patient investors.
