Frictionless Market

See: Weightless Economy.

One of the worst things about winter is zapping ourselves on a doorknob after shuffling across the carpet in our socks. The electricity generated by the carpet-sock friction is even more annoying because we know it’s probably going to zap us, but we reach out for the doorknob anyway.

In the financial world, friction can still zap us, but in a different way. Friction costs are all of the direct and indirect costs that come with financial transactions, from fees to commissions to taxes to interest charges, and boy howdy, they can really add up. In fact, if friction costs are high enough, they can lead people to shy away from particular transactions.

But in the theoretical financial universe, analysts will oftentimes consider a frictionless market: one where all of those associated costs don’t exist, and securities can be evaluated solely on their merit. Is this kind of analysis helpful? Sure it is, because it can give investors a nice picture of an investment opportunity without any of the noise of friction costs skewing it.

But a frictionless picture might not be a truly accurate picture, which is why it shouldn’t be the only analysis we’re looking at. For example, let’s say we want to buy a house. We’ve got $200,000 in our savings account and the house we want costs $200,000. In a frictionless market, we’re good to go; we just hand over the $200k and the house is ours. But in the real world, that’s just not how it goes. We’ve got broker fees, inspection costs, taxes, transfer fees, and everything else that goes along with buying a house. And if we decide to finance any of the payment amount, we can add interest, transaction fees, underwriting fees, and a bunch of other fun costs to our bottom line. We might find out that, when all is said and done, that frictionless $200,000 is actually going to end up being more like $230,000…or more.

So long story short, frictionless market analysis is a helpful tool, but it shouldn’t be the only one thing we hang on our financial belt. Because, in the real world, even though we’re edging closer to frictionless markets with stuff like free trades and closing-cost-free homebuying, we’re probably never going to be 100% there.