WASHINGTON. In the previous article of our Investing 101 series, we discussed where to place your investible cash stash when you open a new brokerage account. That way, this money is instantly ready to invest when the opportunity arises. But with regard to all the available choices of brokerage houses, which type of firm might be best for you? A full service brokerage house or a discount brokerage house?
Good question. Let’s take a short break from exploring possible investments themselves. That’s because, first and foremost, investors must decide where they want to place their cash stash. Which means they need to decide where to do business, just like they do when choosing which bank they want to use for a checking account.
In the case of investing in stocks and bonds, investors generally need to choose brokerage house, of which there are two basic kinds. So let’s begin today’s Investing 101 installment by looking at those two brokerage house types — full service and discount. We’ll examine what they do for you, how much they cost, and which one might work best for you.
We’ll begin by discussing the difference between the two varieties of brokerage house. (For more detail on the distinction between the two, try this link.) Then we’ll examine more closely what you get (and what you don’t) by choosing a full service house. (Since nobody on the internet likes to read long articles, we’ll discuss discount houses in our next column.)
If you’re new to the investing world, read on. If you’re reasonably familiar with investing, you can probably skip the next section.
Brokerage houses vs. your friendly neighborhood bank
What I’ve been calling a brokerage, a brokerage house or a stock brokerage firm is formally known as an investment banking firm. In a general sense, these investment banking firms operate somewhat like a standard issue bank. But their primary business, at least until recently, hasn’t involved savings accounts, checking accounts, auto loans and the like. Their main focus is investing their clients’ money in stocks, bonds and related vehicles.
As opposed to your local bank (in most instances), in an investment banking firm, you deposit money with the firm and then invest it by purchasing securities. That’s essentially a catch-all term that includes stocks, bonds, mutual funds, ETFs and other more exotic forms of investment.
The idea of allocating a certain amount of your wealth in securities markets is that you stand a chance of making more money with these investments than you do with the near-zero or less-than-zero returns you get from your friendly neighborhood bank.
The main difference is that your investment bank account is considerably riskier than that old-fashioned bank account. Sure, you can, by dint of skill, scholarship and luck, become a malefactor of great wealth if you really work at it. But you can also lose every dime. It’s the old “risk-reward ratio” in action. Nothing in the investment world is “guaranteed.” Rule of thumb: Don’t do business with any broker or brokerage firm that tells you otherwise. Or, better yet: If it looks to good to be true, it probably isn’t.
Rich man, poor man
These days, the only firms that regard themselves as investment banking firms first and foremost are the big guys, like Goldman Sachs and Morgan Stanley. These are firms that pursue the investment accounts of individuals that a Las Vegas casino might regard as “whales.” Definition: The guys with the big bucks. The Warren Buffetts of their day. (Although Buffett himself would probably never get near a slot machine.) This distinction could potentially change in the future. But that’s the way the terminology tumbles currently. In other words, if you only have a few hundred dollars, it’s probably best not to call up someone at Goldman Sachs.
As for the rest of us, we work with a “stockbroker” (sometimes expressed in two words) at the investment banking firm or firms of our choice. Except that we usually call these firms our “broker,” our “brokerage,” our “stockbrokers,” or some similar derivative term. Which is why these firms are also known as “brokerage houses.”
Brokerage houses: What they offer
Wherever you are as an investor right now, most brokerages houses today offer more services than they used to. The entire banking industry in general has become more competitive over the past 3 decades. And, like many other businesses, each bank or brokerage house would ideally like allyour business. So, in addition to your one or more brokerage accounts, many firms now offer checking accounts, home loans, home equity loans, you name it.
Checking accounts are generally tied to your investment account(s), allowing deposits to flow back and forth for convenience’ sake. They generally pay (at the moment, at least) the same miniscule interest rates you get on your normal bank checking account. But if you’re an active investor, having that checking account link is another convenience. (It also handles the occasional overdraft in your checking account, by pulling the funds from your brokerage account to cover it.)
Some firms also offer their own versions of MasterCard and Visa cards. Each brokerage is a variable feast, but they all offer more services to the retail client(you and me) than they used to back in the 1980s when I was in the business.
If they’re all more or less the same, though, how are various brokerage houses different? Simple. The cost of commissions.
The full service brokerage house
In general, today a retail client has his or her choice of investing with a full service brokerage or a discount brokerage.
A full service brokerage house assigns to you a personal stockbroker (or account executive or advisor) who actively works with you to provide investment advice and execute trades. Your stockbroker, or broker, can also draw in in-house research to give you the firm’s latest tips on stocks that are likely to make you the most money, at least in the firm’s point of view.
This type of firm was the face of the industry back when I got into the biz in the late 1970s, and if you wanted to invest, this is where you generally had to do business.
One key characteristic distinguishing a full service house from a discount house was (and still is) that investors have to pay for that full service in the form of commissions. Yes, that means that your personal stockbroker is compensated via commissions, which is also the way the firm makes money. If you’ve ever bought a car, you know how this works.
Now, a commission sales model is neither good nor bad. But it does exist in the investment world. This means that your relationship with your full service broker involves at least a minimal conflict of interest. The brokerage firm wants each broker to generate plenty of business. Which means that he or she is going to call you with the house’s latest tips from time to time. As an investor, you don’t just get to sit there. You are going to be contacted. Sometimes often. (More on commissions in our next installment.)
Again, this is neither good nor bad. Brokerage firms must perform “due diligence” research when recommending investments or pitching the latest hot new issue. Due diligence is basically brokerage jargon for “thorough research.” When conducted by longtime, reliable firms, this research is usually pretty reliable. But, as with all such things, it’s also occasionally fallible. Yeah, Wall Street smart guys can make mistakes or get conned just like the rest of us, although it’s unlikely. But not impossible.
So caveat emptor – let the buyer beware – is still the best advice.
But what if you don’t want phone calls or advice? What if you’re a do-it-yourself investor, even if you’re new to the game? If this describes your situation, you have another choice. You may want to consider very different kind of retail brokerage house: the discount house.
— Headline image: The “thundering herd” of Bank of America / Merrill Lynch. (Image via Wikipedia entry on this topic, CC 3.0 license)