Coefficient of friction

What Are Friction Costs?

Friction costs represent the comprehensive calculation of all direct and indirect expenses associated with executing a financial transaction. Unlike the simple stated price, friction costs encompass a broader array of expenses and obstacles within the realm of financial economics and market microstructure that can hinder smooth market operations. These costs account for not only obvious charges like commissions but also less apparent expenses such as bid-ask spreads, taxes, and even the time and effort involved in completing a deal. By considering the full scope of these expenses, investors gain a more accurate understanding of the true cost of their endeavors.

History and Origin

The concept of "friction" in economics and finance draws an analogy from physics, where it describes resistance to motion. In financial markets, this resistance translates into various costs that impede the seamless flow of capital. While specific quantification and analysis of these costs have evolved with the complexity of financial markets, the underlying idea that transactions incur more than just their nominal price has long been implicit in economic thought. Early financial models often assumed a "frictionless market," an idealized state where trades occur instantly and without cost. However, real-world observations consistently revealed that such a perfect environment does not exist.

Academic research has progressively delved into the impact of these market imperfections. For instance, studies by the National Bureau of Economic Research (NBER) have explored how financial frictions can contribute to macroeconomic fluctuations, demonstrating their significant role in economic downturns by limiting firms' abilities to insure against shocks and affecting aggregate output and labor.⁷, ⁸, ⁹ This ongoing exploration underscores the historical recognition and increasing analytical focus on the real-world implications of friction in finance.

Key Takeaways

• Friction costs include all direct and indirect expenses, both monetary and non-monetary, incurred during a financial transaction.
• They provide a more holistic view of the total cost of an investment or financial activity beyond the stated price.
• These costs can significantly erode investment returns over time, particularly for long-term investments.
• Understanding friction costs is crucial for informed financial decision-making, enabling comparisons between different investment products and strategies.
• Factors such as commissions, fees, taxes, and illiquidity contribute to overall friction costs.

Formula and Calculation

While there isn't a single universal "formula" for friction costs akin to a physical coefficient, the calculation involves summing all identifiable direct and indirect expenses related to a financial transaction. The exact components will vary depending on the specific transaction.

A conceptual representation of total friction costs could be:

Where:

• Direct Costs: Explicit, visible charges like brokerage commissions and fixed fees.
• Indirect Costs: Less obvious costs such as the bid-ask spread, market impact costs (the effect of a large trade on the market price), and certain embedded fund expenses like the expense ratio.
• Non-Monetary Costs: Opportunity costs, the value of time spent on research, administrative effort, and psychological costs associated with a transaction.

For example, when investing in a mutual fund, the calculation of friction costs would incorporate the sales load (if any), annual operating expenses, and potentially redemption fees, alongside any trading costs incurred by the fund itself.

Interpreting Friction Costs

Interpreting friction costs involves understanding their impact on the net return of a financial activity or the true expense of a service. A higher friction cost implies a less efficient transaction or a more expensive product. For investors, minimizing friction costs is key to maximizing net returns on their investment portfolio.

For instance, two seemingly identical investment products might have vastly different total costs when friction costs are considered. An investment with a lower nominal price but higher hidden fees, such as significant sales loads or high annual asset management charges, could ultimately be more expensive than one with a higher initial price but fewer underlying frictional elements. Evaluating friction costs helps individuals and institutions make more informed decisions by providing a holistic view of financial obligations.

Hypothetical Example

Consider an investor, Sarah, who wants to purchase shares of a specific stock. The stock is priced at $100 per share.

Scenario 1: Low Friction Costs
Sarah uses a discount brokerage account that charges a flat $5 per trade in commissions. She buys 100 shares.

• Purchase Price: $100 x 100 = $10,000
• Commission: $5
• Total Friction Costs (purchase): $5

Scenario 2: High Friction Costs
Sarah uses a full-service broker who charges a 1% commission on the transaction value and an additional $20 administrative fee.

• Purchase Price: $100 x 100 = $10,000
• Commission: 1% of $10,000 = $100
• Administrative Fee: $20
• Total Friction Costs (purchase): $100 + $20 = $120

In this hypothetical example, while the stock price is the same, the friction costs vary significantly, directly impacting Sarah's net investment. The higher friction costs in Scenario 2 mean she effectively pays more for the same number of shares, reducing her potential returns from the outset.

Practical Applications

Friction costs permeate various aspects of investing, markets, and financial planning. They are critical considerations for:

• Investment Product Selection: When choosing between different investment vehicles like mutual funds, exchange-traded funds, or individual stocks, analyzing their inherent friction costs (e.g., expense ratios, trading fees, sales loads) is paramount. Lower friction costs generally lead to higher net returns over time.
• Real Estate Transactions: Buying or selling property involves substantial friction costs, including legal fees, agent commissions, appraisal fees, and stamp duty. A KPMG report highlights that "round trip frictional investment costs" for UK property funds can average 6-8% of capital invested, emphasizing the need for a long-term investment horizon to absorb these costs.⁶
• Loan Assessment: For consumers, evaluating mortgage loans or other forms of credit should go beyond just the interest rate to include application fees, origination fees, broker fees, and other administrative charges, which are all components of friction costs.
• Regulatory Impact: Government regulations, while often aimed at protecting consumers or ensuring market stability, can inadvertently introduce new friction costs for businesses and individuals.
• Portfolio Management: Frequent trading can lead to higher cumulative friction costs due to repeated transaction fees and potential market impact, underscoring the benefits of a buy-and-hold strategy for certain investment portfolios. The U.S. Securities and Exchange Commission (SEC) consistently advises investors to understand how fees and expenses, which are significant components of friction costs, can impact their investment portfolios over time.⁴, ⁵

Limitations and Criticisms

While essential for a realistic view of financial transactions, the concept of friction costs has its limitations and faces certain criticisms:

• Difficulty in Quantification: Accurately quantifying all indirect and non-monetary friction costs can be challenging. Subjective factors, such as the value of an investor's time or the psychological effort involved, are difficult to measure objectively.
• Varying Definitions: In academic and industry literature, the precise definition and components of "friction costs" can sometimes overlap with or be distinguished from other terms like transaction costs. Some definitions are narrower, focusing only on explicit charges, while others adopt a broader perspective.
• Impact on Economic Models: Traditional economic models often assume frictionless markets for simplicity, which can lead to discrepancies between theoretical predictions and real-world outcomes. Integrating friction costs into these models adds complexity but offers greater realism.
• Dynamic Nature: Friction costs are not static; they can change over time due to technological advancements (e.g., automated trading platforms reducing brokerage fees), regulatory changes, or shifts in market efficiency. This dynamic nature makes long-term projections of their impact challenging.

Some criticisms also arise in fields like health economics, where "friction cost methods" are used to estimate productivity losses from illness. Critics argue that such methods may underestimate costs by assuming quick replacement of absent workers, thereby implying the value of lost leisure time is zero, which is generally not the case in economic evaluation.¹, ², ³

Friction Costs vs. Transaction Costs

While often used interchangeably, "friction costs" and "transaction costs" represent distinct, though related, concepts in finance.

Transaction costs are a subset of friction costs. All transaction costs are friction costs, but not all friction costs are transaction costs. Friction costs provide a more comprehensive picture by including elements that go beyond the direct execution of a trade, such as the inherent cost of a product's structure (like an expense ratio in a fund) or the costs associated with financial market liquidity.

FAQs

What are some common examples of friction costs in investing?

Common examples include brokerage commissions, advisory fees, mutual fund expense ratios, sales loads (front-end or back-end), bid-ask spreads, taxes on capital gains or dividends, and even the time and effort spent researching investments.

Why are friction costs important for individual investors?

For individual investors, friction costs directly reduce investment returns. Even seemingly small fees can compound over time to significantly diminish the value of an investment portfolio, making it crucial to understand and minimize them.

Can friction costs be entirely avoided?

No, friction costs cannot be entirely avoided in real-world financial transactions. Even in highly efficient markets, some form of cost, whether explicit or implicit, will be present. The goal is typically to minimize them where possible, for example, by choosing low-cost investment products or efficient brokerage account providers.

How do robo-advisors affect friction costs?

Robo-advisors generally aim to reduce friction costs by offering lower management fees compared to traditional financial advisors and by primarily investing in low-cost exchange-traded funds (ETFs) that have lower expense ratios. This technological approach streamlines the asset management process, lowering the overall cost for investors.