Stocks and Shares

How do you choose a broker?

Would you let a stranger choose where you live for the next few months? Or to choose your next car or holiday? Of course not. Most people spend a lot of time on these kinds of big decisions. They want to make sure they get what they want at a good price. But when it comes investing their hard earned wealth, many people spend too little time on a really important decision. Which broker to use.

There’s something that any investor must always remember. It’s YOUR money at stake. No one else on the planet has nearly as much interest in protecting and growing your wealth as you do.

Despite appearances, that includes your broker. No amount of smooth talking, smart suits or slick web sites can make up for a basic fact. Brokers, like any service providers, exist to make money from you, not for you.

Now, of course it’s in any broker’s interest that things go well for you. The bigger your account the more money they are likely to make from it in future.

But the fact remains: if there are big losses then they are your losses, and not the broker’s. You must always remember this.

Notwithstanding that, all investors need a good broker if they want to be successful. “Equities” (stocks and shares) are by far the best financial investment if you want to beat inflation and taxes. That’s especially true if they’re approached the right way, and in the current climate of bubbly bonds and ultra-low interest bank deposits.

(For more see: “Turbocharge your stock profits”.)

What do we mean by a “broker” in the first place? He or she or it can actually be many things.

From a smartly dressed salesperson who will meet you personally and take your calls…through a web page for checking your account and placing trades, with a call centre as back up…to a computer algorithm that does everything for you once you’ve set some parameters.

When there are people involved they come with various titles. “Brokers”, “financial advisors”, “client advisors”, even “private bankers”…they’re all basically doing the same thing, albeit with different levels of service and cost.

And here’s a thing. I believe you should make your choice based primarily on the brokerage company, and not on an individual person who works as a broker.

People get moved to a new role, promoted, sacked or switch employer all the time. If you want to follow an individual around with your money you’ll be kept very busy indeed. In fact it’s probably not possible a lot of the time.

Choosing a broker is a bit like choosing a car. There are four basic types:

  1. Execution only, usually online. Also known as “discount” brokers. This is your basic, entry level, no frills model – with a price to match.
  2. Non-discretionary full-service broker. A more expensive luxury car, with added features, but where you remain at the wheel.
  3. Discretionary full-service broker. This is a chauffeur driven limo. You tell the driver where to go and sit in the back. But you’re never quite sure if the chauffeur knows where he’s going.
  4. Robo-advisor. This is a low-cost and automated system – the self-driving taxi of the broker world. It’s programmed to go somewhere. You have to trust that the designers knew what they were doing when they built it.

I won’t get into that last one today, the so-called robo-advisors. They’re pretty new things and haven’t been tested in crash scenario. But if you’re interested in the pros and cons you can read “Can robots invest?”.

Your first decision when choosing a broker is what level of service you want. The more service required, the higher the cost.

Execution only, or discount, brokers leave you to take all the decisions. You do your own research, go online (or sometimes send an email or call by phone), and place your trades.

Non-discretionary accounts give you a higher level of service but cost more. You get advice and suggestions on what to do, but all trading decisions have to be approved by you before there is a transaction placed.

Discretionary accounts do everything for you. The broker asks a load of questions about you such as how much “risk” you are prepared to take on, how old you are, and so on. Then, with your approval, a portfolio is set up.

Once it’s running the broker makes all the decisions about what to buy and sell. Often these discretionary accounts charge a flat annual fee of 0.5% to 1.5%, instead of charging commissions each time there is a trade.

In fact you should never, ever open a discretionary account that charges commissions on trades. Clearly that would make it in the interests of the broker to “churn” your account to make more money, meaning entering into unnecessary trades purely to generate commission.

To be honest I don’t think you should ever open a discretionary account even if it’s fee based. You’re handing complete control of your money to the broker. Individual brokers handle dozens, even hundreds of accounts. They won’t be paying much attention to yours.

Even if the brokerage company uses standard portfolios for the tick box that your profile falls into, these tend to be so conservative or unimaginative that you’ll just end up with very poor returns. Particularly once the fees are deducted.

So I recommend you have one of two things. Either a low-cost, execution only (usually online) account, or a more full-service account with advice, but where all trading decisions must be approved by you (non-discretionary).

Which you choose comes down to how much information and advice you want from your broker, your level of experience, how confident or otherwise you are about choosing investments, and what you want to pay.

Examples of execution-only services include outfits like Scottrade, E*trade, Vanguard and Fidelity (but it depends on the country). More full-service accounts come from firms like Merrill Lynch, Morgan Stanley, UBS. Many firms offer both kinds of account.

Then, once you know what kind of service you want, you need to shop around for the best pricing. The various costs of having and using a brokerage account are as follows:

  • Trading commissions
  • Trading spreads
  • Custody fees
  • Other account fees

Trading commissions are usually the biggest cost over time. They are either a fixed amount – say $9.99 per trade – or a percentage of the value of each trade, say 0.5%. Where they are a percentage, that percentage often falls for larger trades, meaning you get a volume discount.

So you need to consider how often you trade and how big your trades tend to be. Personally, I always recommend that private investors trade as little as possible. It’s less work, with the added advantage that it’s less expensive. But if you do a lot of small trades it’s even more important that the commissions are as low as possible.

Trading spreads are the difference between the price you can buy something for (the “offer” or “ask” price) and the slightly lower price you can sell the same thing for (the “bid” price).

Usually the bid-ask (or bid-offer) spread is quite small – as low as one thousandth of one percent for some stocks. But it can be substantial for low volume stocks, sometimes running to a few percent. Either way, brokers and investment banks make plenty of profit from the difference because they process huge volumes each day.

There’s not a lot you can do about spreads. They’re set in markets. In theory brokers are always supposed to provide “best execution” and get you the best price possible. In practice…hmm…not so clear.

Back in 2000 I was sent to New York to investigate whether my employer should buy a big wholesale brokerage company in the US. It’s a complicated business, but in short I discovered that the retail brokers that charge ultra-low commissions (those $9.99 flat rates) often end up giving their customers a slightly worse price to trade.

In other words, what they give up in commission – to attract customers –  they make up for in spread. There’s not a lot you can do about this – it’s buried deep inside the mechanics of the market.

It’s also illegal, but hard to prove and – at least back then – the market regulators didn’t seem to care. Just be aware that it could be going on, especially with brokers that offer services that look ultra cheap on the surface.

One thing all brokers have to do is provide custody for your securities. This is the record keeping of who owns what and where. It’s a huge volume, low margin business. The custody fees are usually fairly small, but nonetheless you should compare them between brokers before setting up an account.

Finally, there are sometimes additional account charges. Make sure you get any prospective brokerage company to disclose all the charges that could be loaded onto you.

There’s no right or wrong answer to choose a broker. A lot comes down to how much service you want, how often you plan to trade and how big your average trade will be. Something that looks cheap on the surface isn’t necessarily best for you.

Once you’ve worked that out it’s just a question of shopping around for the best deal. Focus on the commission rates, but don’t forget to compare the other charges as well.

That may seem like a tedious process. But it’s also an essential one. You wouldn’t make any other big purchase – like a house, car or holiday – without checking it out in detail.

So why place your investments with the wrong broker? Getting a good deal can make a huge difference in the long run. I strongly recommend you’ve taken care of this. After all, remember that it’s YOUR money at stake.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.