Brokerage Firms

On 02/08/2010, in Investment Concepts, Investment Strategies, by Jordan Wilson

With few exceptions, if you wish to buy or sell publicly traded investments, you will need an agent to do so on your behalf.

That agent is a brokerage firm.

Brokerage houses fall into two broad categories; full service or discount. In both cases, you will pay a service charge, known as a commission, to the agent when buying or selling investments.

Which is right for you?

Full Service Brokerage Firms

As the name states, you receive a complete range of investment related service in this category. Providers include Morgan Stanley, Merrill Lynch, Smith Barney, UBS, Edward Jones, Raymond James.

When you create an account, you are assigned an individual representative. You will interact with this person, or team, for all your investment needs.

When you wish to buy or sell an investment, you contact this person who then places the order on your behalf.

A full service firm also provides other services, including: comprehensive investment research and (often unsolicited) advice; detailed portfolio reports and tax information; a live person with investment experience to bounce ideas off; potential access to investments that may not be available to the public as whole; internal departments that can assist in retirement planning, wealth management strategies and tax related matters.

For services like retirement planning, tax advice, etc. you pay incremental fees. But much of the offering is free, indirectly paid for through the commissions that you pay on transactions. As a result, full service broker charges the highest commissions of any brokerage category.

Discount Brokerage Firms

Again, the name gives it away. These firms charge commissions that are discounted (i.e. less than) as compared to the same transaction with a full service broker.

Examples include E*Trade, TD Ameritade, Scottrade. Many full service firms, retail banks, and some mutual fund companies offer discount brokerage services as well.

With less commissions received, these firms cannot provide the same service level as a full service broker.

Discount brokers do not provide a specific individual or team to communicate with. You have no individual to discuss investment strategies with, to bounce specific ideas off of, or to get contacted with recommendations. All the decision-making rests with you, the investor.

With some discount firms, you may telephone in orders via a 1-800 number. With others, you trade completely on-line.

Discount firms tend not to provide services normally found in a full service brokerage house. Reports tend not to be as detailed. Advisory services for financial, tax, or retirement planning are not typically offered directly by a discount house.

Some discount firms do offer good research tools that you can use. Often on par with what you can receive from a full service firm. But the quality can differ significantly between discount firms.

Which Should You Choose?

A full service firm will let you speak to someone that understands the investment process. That can greatly assist as you begin to learn the terminology and mechanics of the investing process. Also, in dealing consistently with one advisor, you develop a relationship with the advisor which should improve the communication and information flow.

At times, I find that trade execution is better with a full service broker. Both in speed and in pricing. But this involves investments that are not heavily traded, so may not be an issue for you right now.

A discount broker will save you money on commissions. In Minimizing Investment Transaction Costs, we looked at the importance of controlling investment commissions. This is a big plus for using a discount broker.

At this stage in your investment life, you probably will not need all the other extras that a full service firm provides. Also, access to certain perks (e.g. being able to buy prized new share issues) usually goes to customers with large investment accounts who trade a lot. You will not be able to enjoy these perks at this time.

So it comes down to whether access to a knowledgeable person is worth paying significantly higher commissions.

My Advice

I realize that your understanding of the investment process is likely limited. I was once in your shoes.

Unless you have a friend or family member with knowledge on investing, you may have no idea how to research and select investments. You may think that the extra returns you can make on advice from a full service investment advisor will more than offset the higher commissions.

If you truly believe that there is value in dealing with a full service firm, feel free to do so. There are many excellent investment advisors out there.

But for the vast majority of readers, I would recommend a discount brokerage account. Building an investment portfolio is easier than it may appear at the moment.

Good investors, both novice and sophisticated, concentrate on building a base of diversified, high quality investments. These include mutual funds, exchange traded funds, and blue chip (i.e. top quality) individual investments. Investments are held for the long term, with minimal portfolio turnover (i.e. selling one investment and buying another).

The fancy techniques (small capitalized over the counter stocks, distressed bonds, options, venture capital, etc.) are not used at all, or in very small amounts, by investors. Most stick with the basic, proven, investment strategies.

Why this should be the case, we will discuss at a slightly later date.

Researching investments in these base categories is not that difficult. For example, companies such as Morningstar provide comprehensive ratings on most mutual funds.

Over the next few months, I will provide guidance on how to research core investments. Much of it involves simple common sense and does not require an MBA in Finance.

Post Script

Another investment account option involves dealing directly with a mutual fund company. If you plan to invest only through mutual funds, this may be an option. If so, you do not need to establish an account with either a full or discount broker.

However, I will save a discussion of investing through mutual fund companies until later.

Plus, when we look at investment transactions, I will give some consideration on selecting selecting a discount brokerage firm.

3 Responses to “Brokerage Firms”

  1. Anonymous says:

    You indicate what “good investors” do. Are those “good investors” in your opinion or is that a generally held view of good investment practises? Also, for clarification, is it “good investors” who avoid “fancy techniques” or just “investors”?

    Given the most recent financial meltdown (~2008), is it still considered prudent to buy and hold or should the small, individual investor pursue a more active trading strategy?

  2. JMW says:

    I would say “good investors” in my opinion. But that my opinion would be based on personal experience and empirical data. So my opinion is probably common in the investment community. Over the next few months, I shall attempt to demonstrate why “good”, perhaps prudent is a better word, investors should focus on a diversified portfolio of core investment products with a proven track record of performance. Also, why prudent investors avoid or minimally invest in more exotic instruments such as options, venture capital, distressed bonds, and the like.

    Also, when I speak of good or prudent investors, I am referring to normal investors. That is, those without significant assets to invest, specialized training or serious experience as investors. For example, the average payback period on venture capital (vc) investments is usually between 10-14 years. Without large asset reserves to cover potential liquidity needs (vc is very illiquid), an understanding of vc mechanics and being able to properly assess various vc opportunities, I would not recommend vc as an investment for investors.

    Good question on the possible impact for investment strategy due to the meltdown. I advocate a dollar cost averaging strategy that builds up positions over time. In the event of a meltdown you would buy more when the prices have fallen and less when they are high. I also firmly believe in performing portfolio reviews and rebalancing back to your target asset allocation on a consistent, periodic basis. So when the stock market is overinflated, it is likely that you will rebalance your portfolio and (hopefully) avoid disaster. These are important concepts and strategies that we will look at over time. For now, please review my post, Investment Strategies to Avoid Bubbles, for a few points on the subject.

    I hope that helps. If not, let me know.

  3. Anonymous says:

    @JMW – Thanks for your reply. I also found some good investment strategy answers in your older posts (and the linked articles): Simplify Your Investment Life; Avoid Basic Investing Mistakes; and Three Common Investment Mistakes.

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