What is a Discount Broker and Why You Should Care

More and more people are talking about discount brokers and how you have to be a dummy not to use them exclusively.

Well, discount brokers are important to understand.  I agree with that completely.

It used to cost an arm and a leg to buy and sell stocks. As a result, it was almost impossible for people with limited means to invest their money.

But in 1975 discount brokers came along and rocked the investment world. They changed everything about investing for everyone. But exactly what is a discount broker ?

What is a discount broker?

A discount broker buys and sells stocks and other investments for you at a fraction of the cost of full-service brokers.  That’s the good news.

They are able to deliver these services because they only do what you tell them to do. Nothing more and nothing less. They do not give you any advice. Even popular discount brokers won’t provide advice. These firms just execute your trades.

Regular stock brokers (also known as full-service brokers) do provide investment advice. They make direct suggestions to you on what you should do with your money but they can also be very expensive.

The commissions they charge each time you buy or sell a stock could be as high as 2%.

Even if you only trade a few times during the year you can see how expensive these full-service brokers can be. On top of this, they often try to sell investments to you based on which products pay them the highest commissions.

These are known as “proprietary funds.”  My big beef with this is that when brokers do that, they are worrying more about how much money they are making rather than finding the best investment for you.  (This can be a huge problem and it is the main reason why more and more investors are leaving full-service brokerage firms in favor of discount brokers.)

What are the benefits of using a discount broker?

Besides saving you a lot of cabbage, I love the fact that discount brokers do what they do best and don’t muddy the waters by giving you any investment advice.

So for the right investor, the discount brokerage can be a great fit.  (If you do need investment advice, there are 2 great ways to get that advice and still take advantage of discount brokers. More on this in a bit.)

So, assuming you are interested in signing up with a discount broker, the question is, how do you find the right one.  Glad you asked…..

How to pick a discount broker

1. Cost

Compare how much each trade is going to cost you at a variety of firms. You also should consider if the discount broker charges for data (most provide 20 minute delayed quotes for free and many provide free streaming data).

Cost is important to large and small investors.

If you are a large investor and you trade often, an extra dollar or two per trade adds up fast.

And if you are an investor with a small portfolio, trading costs can become a very high percentage of your investment. Let’s consider an example.

If your discount broker charges you $7 for a trade and you only invest $100, you just paid 7% of your investment in fees. That’s outrageous. But if you invest $10,000 that $7 becomes almost inconsequential.

This illustrates why commissions are a bigger concern for people with smaller sized accounts. I’ll give you a solution to this problem in a minute. Don’t worry. Be happy.

Each online discount broker has a schedule of fees on their websites. Simply compare a few to get a sense of what you’ll pay.

Many discount brokers actually show you what they charge and compare their fees with the those of other discount brokers. This makes it even easier to compare apples to apples.

Cost is important of course but don’t be fooled into thinking this is the only criteria by which to pick a discount broker. This is especially true when you think about where to park your IRA.

2. Minimums

Some discount brokers will allow you to open your account with as little as $500 and some will require much more. Don’t waste your time opening up an account unless you know what the minimums are and that you can meet them.

Also, remember that many discount brokers have a minimum number of trades you must make during the year. If the minimum number of trades is much higher than the number of trades you plan on making, that “discount broker” might become very expensive for you.

People often overlook this requirement and it comes back to bite them. That’s not funny.
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3. Support

Discount brokers are cheap because they don’t hire a big staff to take your trade orders. It’s all automated. Please only consider using a discount broker if you are comfortable transacting business online.

Even so, you are going to need to talk to a human being from time to time. And my experience tells me that the time you will most need to talk to a person will be during high-stress situations.

In those occurrences, you’re going to need professional help that solves whatever your problem is quickly.

Once you whittle down your list of discount brokers, call each one. See how long it takes them to answer your call. Formulate a few questions and evaluate how good they are at answering them.

Excellent service can be worth quite a bit when it’s show time. Don’t be penny wise and pound foolish by ignoring this all important aspect when you pick your discount broker.

While we’re on the subject of support, if you trade options or futures rather than stocks and funds, only use a broker that specializes in this field.

This is a fast-moving market and you only want to work with experts who know what they are talking about. If you are interested in that kind of trading, this OptionsHouse review can help you get a sense of what you should be looking for.

4. Menu

Most discount brokers offer the same menu of available investments. What differentiates them however is the number of funds and ETFs that can be traded commission free.

Ask your candidates for a list of commission-free funds and ETFs. This could become one of the most important questions you ask because it could save you a boat-load of cash.

5. Trading and Research Tools

Most online discount brokers offer easy-to-use trading and research software. But take a look at these programs.

Most companies will allow you to take their systems for “test ride” before actually opening an account.  Take them up on the offer.

Are the systems intuitive? Are they simple to understand and use? Does the brokerage firm have tutorials that walk through how to use these tools?

Go through the tools you are most likely to use and evaluate how user friendly they are.

6. Proprietary Funds

Proprietary funds and products stink as I suggested above. They are put together by the brokerage firm themselves to earn more fees. In my experience, the performance of proprietary funds is rarely good and can often lead to significant investment losses.

I don’t like it when brokers push this “dreck” on you. I feel it’s a breach of their duty when they put their interests above yours.

Unfortunately, many discount brokers do offer proprietary funds. While I dislike this, it’s not going to be a big problem for you. That’s because nobody there is going to try to ram these lousy investments down your throat. (Full-service brokers often focus entirely on selling you proprietary funds. Another reason they are on my poo-poo list.)

Remember, a discount broker doesn’t provide advice so they shouldn’t be peddling you proprietary funds. Still, be aware of this and make sure nobody does try to sell you these funds – even from a discount broker.

7. Execution

Often overlooked, execution is really one of the most important criteria you can consider in selecting a discount broker.

You want your trades to be executed quickly and you want them executed at good prices. Some brokers are notorious for poor execution.

If that describes your firm, it can easily cost you more per trade than even a full-service broker would charge you.
Ask your candidates how well the firm does compared to the National Best Bid and Offer (NBBO).

Many firms have statistics that track their performance against this yardstick. Never deal with any firm that does not.

Who should use a discount broker?

If you are a do-it-yourself investor, it could be wise to open an account with a discount broker. Since you make all your investment decisions yourself, why pay for advice you don’t need or use?

What if you need financial advice?

If you work with an independent financial advisor, you could also be covered.

The truly independent advisors only do business with discount brokers. That means when you open an account with an independent advisor, she’ll open your account at a discount brokerage house. Smile.

(HINT- if the advisor you are talking with wants to open your account at an expensive full-service broker that’s a good way to know that they aren’t independent and may not have your best interests at heart.

Do you have a discount broker? Which firm? Why? Are you happy with the relationship? Why or why not?