The pitfalls of “full-service” brokerages are becoming more widely understood by younger investors. However, many investors still don’t understand the problem too well, so a word of warning about full-service brokers is in order.

They Make Money, Even if They Squander All of Yours

The largest problem with full-service brokers aside from the fees, which we’ll get back to, is the simple fact that their interests are not aligned with yours. They make money primarily by getting you to trade. For them, it doesn’t matter if your net worth increases or decreases. What matters is how often, and usually how much, they can get you to trade. Unfortunately, this runs contrary to your goal of increasing your net worth. Every time you trade, you have to pay a commission. And it’s a hefty commission, believe me, if it’s a full service broker. Worse still, each time you sell a stock that appreciated, you have to pay taxes. To top it off, the tax rate is higher if you hold your stock or fund for less than a year. Here’s an example from my own life:

in the go go days of the late 90’s when I was at a tech company, I decided it was time to start investing. Everybody else was making millions and I wanted in on it.

Unfortunately, I went about it in the worst possible way. I procured the services of a full-service broker. He told me to buy some 3COM, so I did. I put $2500 into it. Like many other stocks around that time, it tripled! I was making money! My broker then suggested that I “move out of that position to lock in my profits”, so I did. I bought two other tech companies. One tanked, but the other did pretty well. When he suggested that they were both “played out” and that I move my money again, I did. This time, one
stock stayed pretty steady and the other one increased in value.

With my three bagger from 3COM, I knew I was way up. But the thing is, I wasn’t. In a year when the NASDAQ went up by 37%, I only came out up
16%. Why? Trading costs. When I bought the 3COM, I paid a %3 commission, or $75. When I sold it, I paid another $200. It cost $200 more to buy my next two stocks. I had to pay nearly $200 more when it was time to sell them, though it was a bit less since the value of my portfolio had declined a bit. I had to pay another 3% in commissions to buy replacements for those stocks. Within one year, I spent over $800 in trading fees on what had started as a $2500 investment. No wonder I didn’t beat the market.

Full-Service Brokers Charge Way Too Much

Let’s put this into perspective. I was paying 3% per trade. That means 6% if I sell one stock and buy another. Over the past 100 years, the major stock market indexes have returned 10%-12% per year. With my previous broker, simply selling out of one stock per year and buying another would cut this rate in half. In other words, instead of $10,000 becoming $228,923 over 30 years, it would only become $41,161. If you were foolish enough to trade multiple times per year with such a broker, as I did, you’d lose money, even from market-beating investments. Admittedly, my broker was an exceptionally bad deal, and full-service brokerages have had to lower fees to compete with the ever growing number of discount brokers. However, make no mistake. You will pay dearly if you chose a traditional brokerage.

I know that many people feel they need a broker. It may seem that there’s no way you could possibly take care of your investments on your own. But do you really want to pay someone who’s financial interests are opposed to your own? Another consideration is that most of the money traded on Wall Street is traded by large, traditional institutions. They can’t all beat the market. What you pay for your broker doesn’t mean that you’ll enjoy superior returns. In fact, considering fees and taxes, you’ll almost certainly do worse than if you chose stocks at random, or better yet bought a low expense-ratio index fund.

Use Discount Brokers

After reviewing my finances and realizing how much my broker was costing me, I did some research online and learned about the then new discount brokerages. By not offering a traditional brick and mortar office, they save a great deal of money. They don’t tell you what to buy; you have to decide that for yourself. All orders are completed over the web or the phone. At that time, Scott was offering $7 trades, Ameritrade $8 trades, and E-trade charged $15 per trade. Each offered a friendly web interface, with a variety of features and research tools. In the end, I chose Ameritrade and I’ve saved a great deal as a result.

One of the most painful experiences I had upon coming back from Taiwan, was learning of my Grandmother’s financial situation. Nearly all of her money is at Merrill Lynch, and she’s paying both hefty fees after each transaction and she has money in funds which charge over 2% per year. Worse still, some of their funds even include 12b-1 fees. 12b-1 fees are basically how they make you pay their advertising costs. My grandmother already lost nearly half of her retirement due to the accounting scandal and ensuing crash of Qwest. It really, really pains me to see her paying more money than I made last year for “full-service” financial advice. Helping her get moved out of a full service brokerage, out of managed funds, and into index funds with a discount brokerage is a top priority for my current visit to Colorado. Here are links to some of the more popular services: Ameritrade, Sharebuilder, E-trade.