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Switching to a discount brokerage firm has its risks

discount brokerage firm

Saving money with a discount brokerage firm is a good thing, but investors should be aware of some of the pitfalls that exist.

Switching to a discount brokerage firm from a full-service broker makes sense for many investors. It’s sure to cut your per-trade commission costs. But low per-trade brokerage commissions are rarely if ever the sole reason for better investment results.

While there may be good reasons to switch to a discount brokerage firm, low commission fees will not help you choose good investments and can often lead to crucial mistakes like selling too soon.

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If you are unhappy with your investment results, you should check to see if you are making one or more of these four main investing mistakes:

  1. Buying and selling too often
  2. Buying too many low-quality investments
  3. Failing to diversify, or
  4. Buying too many stocks in the broker/media limelight.

Low commissions are better than high commissions, of course. But low commissions can warp your investing decisions. You may decide that low commissions give you the freedom to sell at the first sign of trouble. However, all stocks go through troubled periods from time to time. High-quality stocks manage to overcome their troubles. Low-quality stocks go from bad to worse.

Some of your investments may be headed for a huge rise in the long term. If you always sell at the first hint of trouble, you can wind up selling your best stocks at a temporary low, just before a big rise.

Diversification works best with high-quality stocks

If you delve into low-quality stuff like penny stocks or stock options, it takes more than low commissions to turn the inevitable losses into profits. Getting out at the first hint of trouble can limit your losses, but that’s not the same as making money.

Diversification can expand your profits in the long term, if you focus on high-quality investments. But it’s much less help with low-quality stuff. That is why we advise you to put strict limits on your holdings of speculative stocks (10% for conservative investors and perhaps up to 30% for more aggressive investors are the guidelines we set out for our advisory on more aggressive investing, Stock Pickers Digest). It’s why we advise you to stay out of stock options altogether.

Finding a good full-service stock broker is hard but not impossible. Some successful investors view their brokers as a valuable source of investment research, information and advice. But they keep in mind that brokers operate under the potential for enormous conflicts of interest. That’s why they carefully assess a broker’s advice before acting on it.

In the long run, the best way to cut commissions is by sticking to high-quality investments and making fewer transactions. If you do that, and diversify across most if not all of the five main economic sectors, and downplay or avoid stocks in the broker/media limelight, you are following our Successful Investor approach—and we feel that’s by far the best way to invest. Fewer trades also improves your tax deferral. For instance, suppose you buy an investment at $10 and it goes to $20. As long as you hold on, the entire $20 keeps on producing dividends and capital gains for you. If you sell, you’ll have only $16 or so to reinvest after paying capital-gains taxes and commissions.

If your broker can help you invest successfully in high quality stocks, and do it consistently, the extra commission cost per trade is probably worth it.

So before you switch to a discount brokerage firm, put yourself through a brutal self-assessment. Are you able to single out a selection of investments that’s right for you, keeping investment quality and diversification in mind? If not, you may be better off with a full-service stock broker, provided you can find one who values your business and puts your needs first.

Here are two other dangers to avoid when dealing with an online discount brokerage firm. Both can seriously hurt your long-term returns

Practice accounts can breed false confidence: Some investors are nervous about trading stocks online. So, instead of jumping right in, they start off by using the “practice accounts” or “demo accounts” that online discount brokerage firms initiated several years ago.

Practice accounts are supposed to be identical to real accounts in all but one respect: you buy stocks in them with imaginary or “play” money, rather than the real thing. The brokerage industry says this gives would-be traders a free opportunity to learn how to trade online without risking any money.

Using a discount brokerage firm’s practice account, you can learn online trading essentials, such as how to enter an order to sell or buy stocks; how to double-check your order before submitting it, so you avoid obvious but common mistakes, like buying 10,000 shares when you only meant to buy 1,000; and so on.

But the big risk with practice accounts is that you’ll try out a risky and ultimately unwinnable investment approach, like day trading or options trading, and hit a lucky streak. This could embolden you to put serious money at risk just when your results are about to regress to the mean. This will deliver losses instead of profits.

Automated stock-picking systems: Some investors who trade through discount brokerage firms online use automated stock-picking systems to help them make investment decisions. These systems are typically marketed with impressive-looking performance records designed to make investors think they are sure to make guaranteed profits.

However, those records are typically derived by “back-testing” the program against past data. In other words, the promoters go back through old trading records and see what would have worked in the past.

Automated stock-picking systems essentially do two things: First, they narrow down the data you use when you make investment decisions. Second, they apply a fixed rule, or rules, to draw a conclusion or an investment decision from that selection of data.

Unfortunately, the market’s key concerns continually change. Today’s good investments can turn into tomorrow’s dead ends.

Have you had positive or negative experience with your discount brokerage firm? Share your experiences with us in the comments.


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