What you get when you pay for a full service broker

With a discount broker, you are simply paying to get your trades executed. For those with experience, the ability to analyze financial statements, and an understanding of businesses, this is an ideal arrangement. You just need someone to place the trades you order. For those without any financial experience or who want the comfort and security of handholding – and just as importantly, don’t mind paying for it – a full service broker can be worth the cost.

Although services and products are not fully uniform and costs will vary from firm to firm, typically you should want some or all of the following from your full service broker:

Perhaps the biggest benefit for someone without experience is the opportunity to have a reputable firm guide you through the process. Although it is highly probable that the fees will cut into your returns, you may be better off in the long run because a good broker can hold your hand through turbulent markets, helping you to avoid mistakes such as selling at market bottoms or buying during speculative bubbles.

That is, of course, if you can resist the temptation to bail. It’s amazing how many investors, who are the first to admit they don’t know hide nor hare about the market, will call their broker and complain about a few percentage points drop. Just last week, I was chatting with a financial representative from a major U.S. bank in his office and he confessed that when his client accounts were up more than 20% last year, no one called. Yet, a 4% drop in the broader markets caused, no joke, what he estimated were 250 calls to his office. That is madness. As long as you have a reputable firm with a proven history of good, long-term results, stay the course.

An alternative to full service brokerage firms

There is one alternative to full service brokers that is particularly attractive if you don’t have a lot of capital to invest or you are primarily interested in buying and holding stocks for the long term (ten years or more). You aren’t likely to hear about them because there really isn’t a motivation as they don’t produce profits for any brokerage house.

It’s called a direct stock purchase plan or a dividend reinvestment plan. Basically, these low-cost plans allow you to buy shares directly from a company, paying only $1 or $2 in commissions through optional cash payments or regular, recurring withdrawals from a checking or savings account. Every quarter, you’ll likely receive a statement detailing the reinvested dividends, purchases, sales, stock splits, or any other information that resulted in changes to your account.

Put together enough of these plans, and you have a simple, cheap way to build equity in some of the biggest names in the world – Coca-Cola, General Electric, Bank of America, Home Depot, Wal-Mart, etc.

Commissions and Fees

The most frequent frictional expense is brokerage commissions and fees. Thankfully, with the advent of the discount broker, the cost of buying and selling securities has been dramatically reduced over the past few decades. At Commerce Bancorp, for example, an investor that places a $2,500 or less trade of no more than 1,000 shares of stock will pay a commission of $29.95 if he places the order online. If, on the other hand, he opts to call the bank and have a broker execute the trade, he will pay $31 plus 1.50% of the principal value of the investment for a total of $68.50. If you had an established dollar cost averaging plan on a monthly basis, that additional commission expense of $38.55 would add up to more than $462.60 per year. Assuming the historical rate of long-term appreciation on equities remains twelve percent, over the course of forty years that would amount to $354,856 in foregone wealth!

Asset management fees can be an even greater impediment to long-term wealth building. Many firms focusing on high net-worth clients will charge fees of 1.5% of assets. A family with a $10 million net worth, under this type of arrangement, would pay $150,000 per year in fees even if they lost money on their investments. This sort of arrangement hardly seems fair. In certain situations, such as estate planning, trusts, and foundation management, however, the fee is justified by the services provided.

Spreads

When buying or selling an investment, a percentage of the investor’s principal is reallocated to the market maker. This reallocation is the spread (i.e., difference) between the bid price (what the buying is willing to pay) and the ask price (what the seller is willing to accept). Like the compounded future value of brokerage commissions, this can amount to significant foregone wealth.

Capital Gains Tax

The unique thing about the capital gains tax is that the investor is free to decide when the tax bill will come due by selling his appreciated securities. Each year that goes by without selling, the value of these deferred taxes becomes greater. To illustrate: assume Adam Smith owns 1,000 shares of Green Gables Industries which he purchased at $35 per share four years ago. Today, the stock is trading at $50 per share. The total value of his holdings is $35,000, of which $15,000 is a capital gain ($50 selling price – $35 cost = $15 per share capital gain x 1,000 shares = $15,000 capital gain). If he were to sell the stock, in addition to the money paid out as brokerage commissions and the spread taken by the market maker, he would have to pay $3,000 in capital gains tax.

This means that he now has $3,000 less in assets working for him, accruing to his benefit. Hence, it would only be intelligent to change investments if Adam believed that 1.) Green Gables Industries was overpriced, or 2.) he found a more attractive investment offering a higher rate of return. For this reason, Benjamin Graham recommended investors only change positions when they are fairly certain the alternative investment has a twenty or thirty percent advantage over their current holding. This rule, although necessarily arbitrary, should help ensure that frictional expenses are covered and the investor’s net worth increases enough to justify the time and effort required to discover the investment and to make the change.

Frictional Expense in the Mutual Funds

Frictional expenses, including management fees and sales loads, are the primary reason actively managed funds as a whole have not outperformed their non-managed counterparts such as index funds over long periods of time. In order for an actively managed fund to merely break even with the market, it would have to earn higher returns by several percentage points to pay the frictional expenses. This is especially true thanks to capital gains taxes which are not applicable to index funds which, because they are a group of non-managed stock assumed to rarely change, do not require the frequent sale of securities.

Commissions and Fees

The most frequent frictional expense is brokerage commissions and fees. Thankfully, with the advent of the discount broker, the cost of buying and selling securities has been dramatically reduced over the past few decades. At Commerce Bancorp, for example, an investor that places a $2,500 or less trade of no more than 1,000 shares of stock will pay a commission of $29.95 if he places the order online. If, on the other hand, he opts to call the bank and have a broker execute the trade, he will pay $31 plus 1.50% of the principal value of the investment for a total of $68.50. If you had an established dollar cost averaging plan on a monthly basis, that additional commission expense of $38.55 would add up to more than $462.60 per year. Assuming the historical rate of long-term appreciation on equities remains twelve percent, over the course of forty years that would amount to $354,856 in foregone wealth!

Asset management fees can be an even greater impediment to long-term wealth building. Many firms focusing on high net-worth clients will charge fees of 1.5% of assets. A family with a $10 million net worth, under this type of arrangement, would pay $150,000 per year in fees even if they lost money on their investments. This sort of arrangement hardly seems fair. In certain situations, such as estate planning, trusts, and foundation management, however, the fee is justified by the services provided.
Spreads

When buying or selling an investment, a percentage of the investor’s principal is reallocated to the market maker. This reallocation is the spread (i.e., difference) between the bid price (what the buying is willing to pay) and the ask price (what the seller is willing to accept). Like the compounded future value of brokerage commissions, this can amount to significant foregone wealth.

Capital Gains Tax

The unique thing about the capital gains tax is that the investor is free to decide when the tax bill will come due by selling his appreciated securities. Each year that goes by without selling, the value of these deferred taxes becomes greater. To illustrate: assume Adam Smith owns 1,000 shares of Green Gables Industries which he purchased at $35 per share four years ago. Today, the stock is trading at $50 per share. The total value of his holdings is $35,000, of which $15,000 is a capital gain ($50 selling price – $35 cost = $15 per share capital gain x 1,000 shares = $15,000 capital gain). If he were to sell the stock, in addition to the money paid out as brokerage commissions and the spread taken by the market maker, he would have to pay $3,000 in capital gains tax.

This means that he now has $3,000 less in assets working for him, accruing to his benefit. Hence, it would only be intelligent to change investments if Adam believed that 1.) Green Gables Industries was overpriced, or 2.) he found a more attractive investment offering a higher rate of return. For this reason, Benjamin Graham recommended investors only change positions when they are fairly certain the alternative investment has a twenty or thirty percent advantage over their current holding. This rule, although necessarily arbitrary, should help ensure that frictional expenses are covered and the investor’s net worth increases enough to justify the time and effort required to discover the investment and to make the change.

Frictional Expense in the Mutual Funds

Frictional expenses, including management fees and sales loads, are the primary reason actively managed funds as a whole have not outperformed their non-managed counterparts such as index funds over long periods of time. In order for an actively managed fund to merely break even with the market, it would have to earn higher returns by several percentage points to pay the frictional expenses. This is especially true thanks to capital gains taxes which are not applicable to index funds which, because they are a group of non-managed stock assumed to rarely change, do not require the frequent sale of securities.

· Market orders guarantee execution but not price.

· Limit orders guarantee price but not execution.

· All-or-none orders are only executed if the broker has enough shares, as a block, to fill your order in a single transaction.

· A stop order automatically converts to a market order when a predetermined price (the stop price) is reached. A stop loss order, on the other hand, automatically converts to a limit order when the stop price is reached.

· When you sell short, your potential losses are theoretically unlimited.

· Day orders expire at the end of a trading day. Good-till-cancelled orders stay on the books until they are completely filled, cancelled, or sixty calendar days have passed.

· Due to the lower level of liquidity, extended hours orders are subject to far greater volatility than those placed during the regular market day.

· Trailing stop orders can be used to lock-in profits while potentially benefiting from the increased rise in stock price.

· Bracketed orders are the same as trailing stop orders, except that they require an upper limit trigger price which, when reached, results in the stock being sold.

Imagine you purchased 500 shares of Hershey Chocolate at $50 per share; the current price is $57. You want to lock-in at least $5 of the per share profit you’ve made but wish to continue holding the stock, hoping to benefit from any further increases. To meet your objective, you could place a trailing stop order with a stop value of $2 per share.

In practical terms, here’s what happens: Your order will sit on your broker’s books and automatically adjust upwards as the price of Hershey’s common stock increases. At the time your trailing stop order was placed, your broker knows to sell HSY if the price falls below $55 ($57 current market price – $2 trailing stop loss = $55 sale price). Imagine Hershey increases steadily to $62 per share; now, your trailing stop order has automatically kept pace and will guarantee at least a $60 sale price ($62 current stock price – $2 trailing stop value = $60 per share sale price). In other words, the trailing stop order will increase in your favor and lock in any gains you’ve made in the interim. If Hershey were to fall to $60, your trailing stop order would convert to a market order for execution, your shares would be sold, and should result in a capital gain of $10 per share.

Good-till-Cancelled (GTC) orders, however, remain open until one of three things occurs:

1. They are completely filled
2. You cancel the order
3. Sixty calendar days pass

There risks in using Good-till-Cancelled orders:

· You may forget you placed the order; a lot can change in 60 days!

· If you place a large trade with Good-till-Cancelled status, you will pay a commission each day your order is partially filled. If, on the other hand, your order is filled by multiple transactions in a single day, your broker should only charge you a single commission.

Extended Hours Orders

The extended hours market allows you to place trades between 8 p.m. and 8 a.m.; times when the market is traditionally closed. This system permits investors to react to corporate announcements and news prior to the next session.

There are a number of risks associated with extended hours orders; primarily an increase in volatility as a result of decreased liquidity. Any time there are fewer shares trading hands, stock price movements larger because buy and sell orders have a disproportional influence upon the quoted value. As a result, the price you pay for an extended hours trade can differ substantially from what you would pay (or receive) during regular market hours.

A limit order allows you to limit either the maximum price you pay or the minimum price you are willing to accept when buying or selling a stock.

The primary difference between a market order and a limit order is that your broker cannot guarantee that the latter will be executed.
Imagine you want to buy 300 shares of U.S. Bank stock. The current price is $29 per share. You do not want to pay more than $27.50, so you place a limit order set to execute at $27.50 or less. If the stock falls to that price, your order should be executed.

There are three considerations you should take into account before placing a limit order:
1. The stock price may never fall (or rise) to the limit you’ve established. As a result, your order may never be executed.

2. Limit orders are executed by your broker in the order they are received. It is possible that the stock you are interested in buying (selling) will reach your limit price yet your trade will not be filled because the price fluctuated above (below) your limit before the broker could get to your order.

3. If there is a sudden drop in the stock price, your order will be executed at your limit price. In other words, imagine the stock you want is trading at $50 per share. You have a limit order placed at $48 per share. The CEO resigns, and in a single session, the stock plummets to $40 per share. As the security was falling in price, your order was executed. You are now sitting on a loss of $8 per share.

At times, however, you may want to place an order at a single price. This can be an efficient way to place your order while ensuring a minimum amount of bookkeeping; always a consideration if you are managing a larger portfolio with several hundreds of thousands, or millions, of dollars in equities. The solution is to place an all-or-none trade. All-or-none trades essentially tell your broker that you do not want your trade executed unless he can do so in a single transaction. The minimum qualification for an all-or-none trade is three round lots or more (300 shares).

Besides the usual caveats, there are some additional considerations before placing an all-or-none order:
· Your all-or-none order will not be executed if there are not enough shares available in a single transaction to cover it.
· All-or-none orders are not placed until all of the orders ahead of it with no special conditions are executed.
· All-or-none orders can only be applied in conjunction with a limit order; market orders are not eligible. (You can get the same result by simply placing a limit order 10 cents above or below the current market price.)

A stop order automatically converts into a market order when a predetermined price is reached (this is referred to as the “stop price”). At that point, the ordinary rules of market orders apply; the order is guaranteed to be executed, you simply don’t know the price – it may be higher or lower than the current price reported on the ticker symbol.

Contrast that to a stop limit order, which automatically converts into a limit order (not a market order) when the stop price is reached. As discussed earlier in this tutorial, your order may or may not be executed depending upon the price movement of the underlying security.

Sell Short and Buy to Cover Orders

As you learnt in The Basics of Shorting Stock, selling short is an extremely speculative practice that can, theoretically, lead to unlimited losses.

Here’s how it works: You think that Company ABC is grossly overvalued. Management is terrible, financial condition is deteriorating, the sales outlook is pitiful, and, you believe, the stock price does not fully reflect these apparent realities. You are convinced the stock is going to fall substantially from its current price of $10 per share.

These orders are often subject to the lowest commission since they are the easiest to execute.
Imagine you want to buy 100 shares of Apple Computer, Inc. (Symbol: AAPL). The current market price is $53.95. You log into your brokerage account or call your broker directly on the phone and tell him, “Place a market order for 100 shares of Apple Computer, ticker symbol AAPL”.

By the time the order is actually executed a few seconds later, the market price may be higher or lower; $54.10 or $53.75 for example. Your cost before commissions will vary accordingly; in our example, the difference between $5,410 for the round lot and $5,375, or $35.

That may not seem like much, but thanks to the time value of money, those savings can result in a substantially larger nest egg.