The 13 Steps to Investing Foolishly
Step 6: Open a Discount Brokerage Account
Top Five Things to Say While Breaking Up With Your Full-Service Broker
5.
I know you'll find somebody else.
4.
What about my needs?
3.
I feel that I've grown, and you haven't.
2.
I'm just not ready for a long-term commitment with a short-term trader.
1.
No, no -- it's not me -- it's you.
--The Motley Fool Calendar 2000
Full-Service Brokers
Full-service broker is the name given to those expensively dressed souls who work for Merrill Lynch, Salomon Smith Barney, Morgan Stanley Dean Witter Discover, etc. You've seen their oh-so-somber TV commercials too many times, particularly during sporting events and Sunday morning political commentary shows. These companies can afford to advertise during major TV broadcasts because they make a truly remarkable amount of money. A good deal of that lucre is made through "investment banking" (helping other corporations with their financing needs), but a very healthy percentage of their profits are made on the "retail side," through brokering.
Full-service (or full-price) brokers serve as the middlemen through which you can relay your trading orders to "the floor" of a stock exchange or to an electronic trading system. You send in an order, and they forward it on to their guys down in the trenches to fill for you.
Now, the phrase "full-service" indicates that these particular brokers are there to attend to ALL the needs of their account holders. That includes generating investment ideas for you, giving you stock quotes whenever you request them, managing your account (in many cases), providing investment research materials, helping you with tax information -- the works.
In return for these full services, the broker will charge you very high rates to trade stocks in your account. Where discount brokers (we'll get to them in a second) typically charge between $5 and $20 for an online trade, you'll probably pay around $150 for the average trade done through the typical full-service broker. Further, full-service firms often charge annual "maintenance" fees through which they grant themselves a generous slice of your assets, say about $150 a year or more. In other words, they provide an expensive "service."
OK, two problems here. (Actually, dozens of problems, but we'll keep it to a brief two right here.)
The first is that most brokers (or, more snootily, "Financial Consultants") who give advice are just glorified salesmen, shopping around their brokerage house's stock picks or pricey mutual funds. Brokers are getting paid a percentage (the commission) for every sale they make. While there are some knowledgeable brokers who do a knockout job for their clients, many aren't actually very good investors and lack impressive or even average performance histories. Certainly the performance of Wall Street brokerage "model portfolios," as reported from time to time in The Wall Street Journal, leaves virtually everything to be desired.
The second problem is that full-service brokers usually receive commissions on each trade, so their compensation is closely tied with how often their clients' accounts are traded. In other words, part of the commission YOU pay to the firm may wind up directly in your broker's pocket. So your full-service broker may be paid not for how well you do (which is in your best interest, obviously), but rather on how often you trade (often the opposite of your best interest). Highly distressing. This is why "full-service brokering" of the common variety is rapidly wasting away with the increasing use of online brokerages.
The full-service industry will save itself only when it bases its incentives on performance, not trading frequency. Your broker should be working to give you the best consistent long-term, market-beating return possible, and should receive bonuses based on a percentage of your long-term profits. Instead, he's getting paid slices of what he induces you to wheel and deal. Until this situation changes, you will continue to see full-service firms getting chopped at the knees by the increasing amount of do-it-yourself investing. Which brings us to the topic of...
Discount Brokers
Simply put, discount brokers provide a more affordable means for investors to execute their trades. Discount brokers are for do-it-yourself investors. The idea of managing your own money is a powerful one to the same sort of personality who wants to install the garbage disposal, change the oil filter, and patch the hole in the ceiling. (Managing one's own money also appeals to those with no carpentry skills at all, we've found.) The idea of paying exorbitant fees to some full-price broker for sub-par returns is anathema to this hardy, independent soul. But just as you need to go out and select tools and materials before you can begin to fix things around your house, you need to learn a little before you go out and pick a brokerage.
There are lots and lots -- seriously, lots -- of discount brokers. There are so many, in fact, that it can be quite bewildering to figure out which one to use if you're a newcomer. We've set up a little area on our site to help you figure out how to select a discount broker, and even more helpful is our Discount Broker message board which features the Foolish community providing the best answers anywhere on choosing the right discount broker for your needs. To provide an example, Foolish poster RheS took the time to post this helpful opinion (slightly edited) to one Fool's question on selecting the right discount broker:
"I think the first step is to get your mind in order. What kind of investor/trader do you intend to be? This matters because you don't want to pay extra for services from the brokerage that you don't need, but you don't want a broker that doesn't do what you do want. So consider yourself!
"But, don't limit yourself too much. Think beyond the first $2000 that you have and consider what you're going to want to do for a year or two. Because you probably don't want to change brokers every few months, so you'll want to choose one to last a bit.
"Take a look at the FAQ for this group, and the Fool's Discount Broker Center. Both have a bunch of pointers to various broker comparisons, which will give you some ideas about what other people thought were important in a broker. Since every chart puts a different broker at the top, you can see that it depends on your own priorities. Build your own chart.
"Read a bunch of this board. I suggest going back about six weeks! Yes, I know this is a lot of articles and many are repeats of the same old question, "Which one is the best broker?" or the same old answer. But between all of that, you will find a bunch of different people's comments, which, if they're smart (and we mostly are, here, really), include their reasoning, so you can see if it fits in with yours. And, if you're lucky, you'll come across a few questions that you ought to be asking but haven't thought of yet. This alone makes the reading worth it.
"Look at the broker sites themselves. Most have trading demos of some sort and most have their fees and commission statements online. Call their new accounts desk, and see whether they're managing to answer their phones. Or stop in at a local office, if that's a feature that matters to you.
"And read those, long, sleep-inducing account agreements, too, at least when you get to a short list. You will sign a form that says you agree to your broker's agreement, so you'd better be sure that you do (or at least that nothing in it surprises you too much).
"As you narrow your list, remember that there are probably several brokers who would do just fine. So, if you end up making the last choice between two because one sounded nicer on the phone, or you liked one's web site a tiny bit better, don't worry. The other is probably nearly as good for you -- and you're likely to be perfectly satisfied with either."
Many thanks, RheS, for taking the time to distill your thoughts. Foolish readers should check out the message board, ask questions, and determine which brokers are providing the best service out there.
Keep this list of ten Foolish considerations in mind as you embark on your search:
Read the fine print. Some brokers "forget" to mention their minimum charge, while others print out-of-date claims. Keep in mind that there are virtually always going to be hidden costs, from account minimum balances, to fees for late payments or bounced checks, to transaction and postage and handling fees.
- Commission schedules can vary considerably within the same brokerage, depending on the trade. If you most typically buy 1000 shares of stock below $10 a share, use this trade as a test of your prospective brokers. See how much of a commission you'd pay for your typical trade with each prospective brokerage.
- If you want to trade foreign stocks or options or penny stocks, none of which we generally counsel doing, make sure your discounter is set up to trade them.
- Check out the margin interest rate, if you plan on ever borrowing money from your broker for purchases. Margin rates vary substantially from broker to broker. If you're Foolish, you won't want to even think about using margin until you've been buying and selling your own stocks for a couple of years. (For more on margin, see Step 12, Advanced Investing Issues.)
- The availability of checking accounts or bill paying may be very attractive to some. Discount brokers are expanding their banking services in an attempt to make the most from each customer. Do you really still need a checking account from a separate bank? A lot of Fools don't.
- Mutual funds: You probably know already that we're not big fans of the world of underperforming mutual funds, but, heck, maybe you disagree with us. If so, and you're looking to buy mutual funds, learn which funds are offered from any prospective discount brokers.
- Research and investing tools: There's plenty of free research and heaps of investing tools available right here at fool.com, and at plenty of other sites on the Internet, but one of the perks of a brokerage account is (or should be) getting access to additional screening tools, analyst research reports, stock charts, and more.
- Money market sweeps, or other interest paid on cash in your account. Does your prospective brokerage sweep any unused funds into a money market account at the end of the day? Check into it.
- Touch-tone (phone) trading and/or a local office. For those still too frequent times when there are problems getting a trade placed online, you might want to place a trade the old-fashioned way -- through automated touch-tone dialing or by phoning a human broker. Additionally, some people aren't going to be fully comfortable without having a real bricks and mortar office locally available. Compare and contrast the choices out there to find something that makes you the most comfortable.
- Free perks are free perks. Some are even worth having. Whether you're talking frequent flyer miles, free trades on your birthday, or even cold hard cash placed right into your account, there are some things out there that could tip the balance in favor of choosing one discounter over another. Don't sacrifice good customer service for some perk you don't really need, but see what the offers are out there and factor that into your ultimate choice.
What do you do once you've chosen a discount broker and are ready to pick your first stocks? Move on to Step 7 to consider some Dow heavyweights.
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