In 2021, trading online through a discount broker, rather than with a full-service broker, is increasingly the preferred option for many investors. But risks remain.
The main advantage of switching to a discount broker is lower commissions. And commission rates can be even cheaper if you trade stocks with your discount broker online, as opposed to placing orders over the telephone.
Several years ago we asked our website visitors whether they trust the advice they get from their stock broker. Aside from a yes or no option, we gave visitors a third choice: “I trade online through a discount broker.” Seventy-five percent of the poll’s respondents selected this answer.
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Although lower commissions are a plus, there are several reasons to be cautious. Low commission rates sometimes lead investors to trade a great deal. They may assume they can’t lose because they can sell at the first sign of trouble.
Being quick to sell can cut your losses, of course, but that’s not the same thing as making money. And, if you stumble onto an investment that has a huge rise ahead of it, you may wind up selling just before the move begins.
On the other hand, a good stock broker or financial advisor (one who is experienced, knowledgeable, and oriented toward the long term) is worth the higher commissions that you are likely to pay. For instance, suppose your full-service stock broker charges an average commission of 2%, and you replace one-third of your portfolio every year (both figures are on the high side). In this case, you’d pay 1.34% of your portfolio’s value each year in commissions. That’s less than the 2% to 3% management fee on a typical mutual fund.
Know the risks of online trading with a discount broker
Online trading with discount brokers may look like a fairly quick and convenient way to build wealth, but there are many hidden dangers that may not be evident at first.
The main risk comes from the fact that it all may seem deceptively easy. The lower costs and higher speeds of online trading can lead otherwise conservative investors to trade too frequently. That can lead you to sell your best picks when they are just getting started.
The apparent ease of online trading may even prompt conservative investors to take up short-term trading or day trading. That’s just another danger of trading stocks online—there’s a large random element in short-term stock-price fluctuations that you just can’t get away from.
This random element can be profitable for short periods. But you can’t reliably profit from it over the long term. In fact, most short-term traders wind up losing money. By the time their beginners’ luck fades, many are trading in dangerously large quantities.
Frequent trading can also lead you to buy lower-quality, thinly traded stocks. The danger arises from the fact that the bid and ask spreads of many of these investments can be so wide that the share price will have to go up significantly before you’ll even begin to make money on a sale.
You can make trades quickly in online trading, and that cuts your commission costs. However, for successful investors, this is a bonus, not the object of trading stocks.
No one will warn you about potentially costly mistakes
Before you switch to a discount broker, or “no-fee” broker, remember that doing so gives you unlimited opportunity to go wrong on your own. The clerk who takes your order won’t warn you if they see you’re about to do something you’ll regret, even if they know this to be the case. As well, you’ll receive no guidance or investment advice while entering trades on a discount broker’s website.
So before you switch, 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.
In the long run, the best way to cut commissions is still the same in 2021 as it was in 2011: stick to high-quality investments and make fewer transactions. This 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 $18 or so to reinvest after paying capital-gains taxes and commissions.
It is far more important to focus on high-quality, well-established companies and how they fit in your portfolio for the long term. The longer you hold these stocks, the greater the chance that your profits will improve, as well. That’s something your discount broker won’t tell you.
If you have switched to trading with a discount broker online, was the prospect of cheaper commissions the main reason you did so? Or did you decide you simply didn’t need (or couldn’t trust) the advice of a full-service broker? Let us know what you think.
Note: This article was initially published in 2014 and is regularly updated.