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202-Using Financial Services Wisely--Choose Broker
  Course 202:
  Using Financial Services Wisely
  Once you consider taxes and decide what type of investment account you'd like
  to open, the next nuts-and-bolts decision involves actually choosing a broker.
  

  When thinking about a stockbroker, a picture of Charlie Sheen from the movie
  "Wall Street" often comes to mind. Thoughts of cold calls interrupting your
  dinner and pushy salesmen trying to sell the latest "hot stock" can scare
  investors away from buying stocks. In reality, however, it isn't so bad, and
  there are many options to choose from. In this lesson, we'll aim to provide
  the information you need to pick a broker that will help you reach your
  financial goals.
  

  Think of a broker as the middleman between you and the person you are buying
  your stock from or selling your stock to. When you place an order to either
  buy or sell a stock, your broker will find a party that is willing to take the
  other side of your transaction. Of course, the broker will charge a fee
  (commission) for this service. There are hundreds of brokers and other
  financial advisors, and they provide varying levels of service. For the
  purpose of this book, however, we'll focus on three types of service
  providers: full-service brokers, fee-based financial planners, and discount
  brokers.
  

  Full-Service Brokers
  Full-service brokers provide handholding through the investment process that
  often gives investors reassurance that they are not going it alone. They
  provide personalized service, as well as advice on what to buy and sell. This
  is the greatest benefit to full-service brokers, but the benefits can be
  outweighed by the costs--literally. This handholding does not come cheap, and
  the commissions charged by a full-service provider can quickly eat away at any
  investment gains your portfolio makes. It is difficult enough to achieve
  success at investing; we don't need another obstacle. We think investors would
  be well served to avoid these high fees if possible.
  

  Another concern with full-service brokers is the inherent conflict of interest
  that drives many of the recommendations they give clients. Many brokers are
  compensated by trading activity, not performance. For example, most
  full-service brokers are paid based on a commission they receive for executing
  sales and purchases. So the more you trade, the more your broker will make.
  One of the reasons frequent trading is generally a bad idea is that it leads
  to higher commissions that will eat into your returns. It can also cause you
  to pay higher taxes on realized short-term capital gains.
  

  So while it is against your best interest to trade often, a full-service
  broker has an incentive to encourage frequent trading, just to rake in the
  fees. At the end of the day, even the well-intentioned commission-based
  brokers face a conflict with your interests. If you decide to use a
  full-service broker, make sure to seek out those upstanding professionals who
  are willing to look beyond this conflict and put your interests ahead of their
  own.
  

  Fee-Based Planners
  If you still find the need for personalized, professional investment advice
  but want to avoid the conflicts of interest at full-service brokers, fee-based
  planners can be a worthy consideration. Fee-based planners usually charge
  their clients based on a variety of factors, and the way they get paid does
  not have a large inherent conflict of interest.
  

  In general, planners and advisors get paid in one of three ways. First, they
  may charge you a percentage of your assets on an ongoing basis (say, 1% a
  year, not including brokerage costs or any expenses associated with mutual
  funds). Other planners charge a dollar rate on a per-job or hourly basis.
  Finally, others earn commissions on any products they sell you. Some planners
  may use a combination of these fee structures--for example, a planner might
  charge you an hourly rate to set up your plan and also put you in funds on
  which he or she earns a commission. The upshot is that most planners do not
  have the incentive to encourage frequent trading, but they can be just as (if
  not more) expensive as full-service brokers.
  

  Discount Brokers
  To avoid the pitfalls of full-service brokers and the costs of fee-based
  planners, using a discount broker is often the best option. Discount brokers
  differ from their full-service counterparts in that they offer bare-bones
  brokerage services, and typically do not offer advice. Investors with discount
  brokers don't have to worry about aggressive sales tactics or the conflicts of
  interest we discussed above. Instead, discount brokers such as Charles Schwab
  SCH, E*Trade ET, and Ameritrade AMTD allow investors to make their own
  decisions regarding what to invest in.
  

  Most importantly, the commissions that investors pay to discount brokers are
  significantly cheaper than the commissions charged by full-service brokers.
  Whereas a full-service brokerage may charge a commission in the hundreds of
  dollars per trade, a discount broker's commissions are often a fraction of
  this. And with the advent of the Internet, Web-based discount brokers make it
  easier than ever for individuals to maintain their own stock portfolios.
  Although discount brokers make investing easier, picking which broker to use
  can be difficult. In the following sections, we'll tell you what to look for
  when choosing a discount broker.
  

  Costs
  When looking for a discount broker, cost should be a major focal point. We've
  already established that discount brokers are significantly less expensive
  than full-service brokers, but there is a wide range of price options within
  the discount broker arena as well. For example, commissions can range anywhere
  from $30 to less than $10, depending on the broker. Obviously, the less you
  have to pay in commissions, the better. But there are also many other factors
  you should consider. Many brokers charge lower per-trade commissions for
  "active traders." For example, a brokerage house can require that investors
  make more than 20 or 30 trades a quarter or month before they qualify for the
  lower commissions. We've said it before and we'll say it again: All else
  equal, frequent trading will eat away at your returns over the long run.
  

  Peripheral Services
  Brokers sometimes charge higher commissions because they offer investors a
  variety of other useful services. For example, many brokerages offer
  third-party research for stocks. (With a subscription to Morningstar.com's
  Premium Membership, you wouldn't need to worry about paying up for research.
  We have insightful independent Analyst Reports for more than 1,500 stocks.)
  

  Although we think most investors are capable of making their own investment
  decisions, even the most experienced investors will eventually have a question
  or two about their accounts. This is why it's important to look for a broker
  that provides good customer service. Some companies have satellite offices in
  neighborhood strip malls, while others may provide 24-hour phone support. It's
  certainly worthwhile to look into a broker's customer service before making a
  decision.
  

  A more recent trend is for brokers to also provide other financial services,
  such as retail banking (checking and savings accounts) and loans. These
  services may be attractive for those looking for a "one-stop shop" for all
  their financial needs. The range of these services can vary, but they are also
  worth looking into.
  

  After you've opened an account with your broker of choice, you have a variety
  of investing options and strategies at your fingertips. At Morningstar, we
  believe that a long-term investing strategy is the best way to achieve
  financial success, but it is important to understand some of the mechanics and
  options involved in trading and investing in stocks.
  
  
  Market and Limit Orders
  Investors can trade stocks through a broker using several methods, some of
  which offer them more control or the opportunity to juice their returns--with
  added risk, of course.
  
  Placing an order to buy or sell shares of a company is relatively
  straightforward. There are various methods you can use, however, if you want
  to execute a trade at a specific price.
  
  A market order is the most straightforward method of placing a trade. A market
  order tells the broker to buy or sell at the best price he or she can get in
  the market, and the trades are usually executed immediately. Since we
  recommend a long-term investing philosophy, fretting over a few pennies here
  and there doesn't make sense to us, and a market order is best in most cases.
  
  A limit order means you can set the maximum price you are willing to pay for a
  stock, or a minimum price you'd be willing to sell a stock for. If the stock
  is trading anywhere below your maximum purchase price, or above the minimum
  selling price, the trade will be executed. However, because there are
  limitations when a limit order is placed, the trade might not be executed
  immediately. Also, some brokers charge extra when a limit order is requested.
  
  
  Buying on Margin
  Buying on margin is a risky way to pump up the potential return on your
  investment. Margin trades involve borrowing money from your broker to purchase
  an investment. Let's run through an example of how buying on margin can be
  profitable and also how it can be a risky game:
  
  Let's say you want to buy 100 shares of fictional company Illini Basketballs
  Inc. Each share costs $10, so your total cost would be $1,000 (we'll ignore
  commissions for now). If those shares go up to $12 after you buy, your return
  would be 20%, or $200 (100 shares x $2 per share profit).
  
  Now let's say you bought those 100 shares on margin. Instead of using $1,000
  of your own money, you borrow $500 and use only $500 of your own money. Now if
  the stock goes up to $12, your return jumps to 40% ($200 profit/$500 initial
  investment).
  
  Of course nothing is free, so you'd have to pay interest on the $500 you
  borrowed. Nevertheless, it's easy to see how buying shares of a company on
  margin can really juice your returns. But below is an example of how buying on
  margin can turn ugly. We'll use the same example as above, but with a twist:
  
  You've borrowed $500 and used $500 of your own money to buy 100 shares of
  Illini Basketballs Inc. at $10. If Illini's shares drop to $8, you've suddenly
  lost 40% of your investment, and you still owe your broker the $500 it lent
  you.
  
  If stock bought on margin keeps going down, you might even eventually get a
  dreaded "margin call." This means your broker is getting nervous that you
  might not have enough money to pay back the loan. If you get a margin call,
  you'd have to contribute more cash to your account, or sell some of your
  stocks to reduce your loan. Typically, these sales happen at precisely the
  wrong time--when stocks are down and at bargain-basement prices. Brokerage
  houses usually have set requirements that dictate how much of your own cash
  you need to have in your portfolio when trading on margin. Buying on margin is
  not for beginners, so tread carefully.
  
  
  Shorting
  It may sound funny, but investors can actually profit when a stock goes down
  in price. Shorting stocks involves selling borrowed shares with the intent of
  repurchasing them at a lower price. Instead of trying to buy low and sell
  high, you are simply reversing the order. Once again, let's go through an
  example:
  
  You've been tracking fictional company Badgers Bricks Corp. and think its
  newest products are going to flop. The company is already on the ropes
  financially, and you think that this may be the last straw. You decide to
  short 100 shares of the company. After an order to short Badgers Bricks
  Corp.'s stock is placed, your broker will find 100 shares that it can lend to
  you. You immediately sell those shares on the marketplace for $10 and receive
  proceeds of $1,000. If the stock drops to $8, you can buy the shares for $800
  and return them to your broker. Your profit is $200 ($1,000 minus $800).
  
  This sounds easy enough, but no investment is foolproof. If you make the wrong
  bet when shorting a stock, your downside is potentially unlimited. In a
  best-case scenario, the stock you short will go down to $0 and your profit
  equals all the cash you received from selling the borrowed shares. On the
  downside, the stock you short could increase in price, and there is no limit
  on how high it may go. Remember, those shares are borrowed and eventually will
  have to be returned. If the price keeps going up, you'll be stuck paying a lot
  more to buy the stock back, perhaps much more than you could have made if the
  stock went to zero. The important thing to remember is that the potential
  downside in shorting stocks is unlimited. As with buying on margin, be
careful.
  
  
  The Bottom Line
  The mechanics of trading are really not very difficult to grasp. But to be a
  successful investor, it is certainly worthwhile to use financial services
  wisely by paying attention to fees and commissions, which will inevitably eat
  into your returns. Minimizing your fees, like minimizing your taxes, is an
  extremely worthwhile endeavor.