There's little question among financial experts that short of buying your own home, stocks are the single best long-term investment an individual can make (one reason homes make better investments: you can live in them while they make money for you). Over most of this century, the stocks of well-run companies have produced some of the best returns of any investments.
But before plunging straight into stocks, it's important to understand one potential stock market obstacle: getting into the market. Buying stocks is not as simple as dropping into the neighborhood market to pick up a quart of milk. A group of intermediaries, called brokers, handle the actual transaction of buying and selling the stock, and their services are not free. Virtually everyone who buys and sells stocks on the market has to do so through a broker, except in special cases.
In general, there are two kinds of brokers that one can employ to handle trades: full-service brokers and discount brokers. Full-service brokers work at some of the marquis name firms of Wall Street, such as Merrill Lynch or Goldman Sachs. These brokers tend to charge investors a premium for transaction services because along with traders, they provide research, analysis, and predictions from the in-house group of stock-trackers.
Some investors prefer paying extra for this service. These brokers can also be a good reality-check barrier for new investors who may hear a "hot tip" on a stock and rush to buy it without understanding the ramifications of doing so.
The second kind of brokers were born on May 1, 1975, when two major stock exchanges lifted their rules about how minimum commissions had to be charged. That "May Day," as it is known, ushered in a new kind of broker called the discount broker. As the name implies, discount brokers generally charge less (sometimes up to 70 percent less) for their services compared to a full-service broker. But as the saying goes, you get what you pay for.
When using a discount broker like Charles Schwab or Quick & Reilly, the investor receives little or nothing in the way of analysis, advice, or predictions from the broker (upon request, some houses may provide third-party information about a particular stock). This, of course, is what some self-directed and independent investors want.
When the market is doing well, more investors may turn toward discount brokers with the understanding that they can make money without the need of professional advice or analysis. (It's when the market drops that advice from a broker is sought for a premium.) For smaller investors, discount brokers can also be popular in that the commission rates don't eat into the entire would-be investment.
Although actual dollar amounts may vary, brokers commission rates generally follow a pattern. Brokers, for instance, all charge a minimum price for a trade, maybe $15 or $29 for a discount broker (an amount that seems to be dropping daily with the burgeoning online trading industry). That means that whether an investor buys 10 shares or 100 shares of a stock such as, say, McDonalds, she or he would pay the same dollar amount of commission on the trade.
What this translates into is that smaller transactions end up costing more in commissions on a percentage basis. Ironically, those who receive a single share of a company as a "gift" may find that selling that one share later often costs more than the value of the share itself. Nice present.
Consider the following chart taken from discount brokers Quick & Reilly (800-837-7220). The transaction amount refers to the total value of the stock purchased. Remember: All transactions are subject to a minimum charge of $37.50.
| Transaction Amount | Commission Rate |
| $0-2,500 | .014 x principal + $22 |
| $2,501-6,000 | .0045 x principal + $38 |
| $6,001-22,000 | .0025 x principal + $59 |
| $22,001-50,000 | .0017 x principal + $77 |
| $50,001-500,000 | .00085 x principal + $120 |
| $500,001+ | .00068 x principal + $205 |
| Source: Quick & Reilly |
The purchase of one share of McDonalds trading at $40 would cost $37.50 because of the commission minimum. Fifty shares of McDonalds trading at $40 a share would be calculated as follows: .014 x $2000 (50 x $40 = $2000 principal) + $22 = $28 + $22, for a total of $50 in commission fees.
Opening an account (which you are required to do) with a brokerage house is similar to opening an account at a bank. Brokerage firms will ask for basic info--name, address, phone--as well as information about your employer. They will also ask for a deposit, often between $500 and $2000, to establish an account before you begin buying and selling.
You can often mail in the form and check or electronically transfer this amount from your bank account to the brokerage house. The firm will then hold this money in a cash account (actually, a money market account which gains some interest credited to your account) while they wait for your orders. When you call them to buy a certain stock, they pull from this account the total cost of the stock plus the cost of the commission.
Likewise, when you call to sell a stock or a stock declares a dividend that is not reinvested, they put these earnings into your account. You can withdraw from this account on demand after subtracting the commission costs. At all times this money is very accessible, but most brokers require that you maintain a minimum dollar balance either in stock value or in the cash account.
It's important to note that even as commission rates fall with discount brokers and online trading, frequent buying and selling can really eat into any returns, particularly for beginning investors. Consider the case of first-time investor Michael.
After doing some research on various software company stocks, Michael decided to buy 100 shares of IntraWeb stock trading at $10 a share. In January, Michael opened an account with a discount brokerage (he had to establish a $2000 account before he could buy or sell any stocks). He instructed the brokerage to purchase 100 shares of IntraWeb at the "market price," or the price that the stock was trading for on that particular day.
The brokerage was able to purchase the 100 shares for him at $10 a share. Since the total portfolio value was $1000, the commission Michael was charged was the brokerage's minimum of $30, and his total cost for the transaction was $1030 for the stock. Ten months later, after a promising earnings report from IntraWeb drove the stock price up, Michael sold his 100 shares of the stock at $12 a share, hoping to end up with a 20 percent return in less than a year.
The total value of this portfolio at that time was $1200 (100 shares @ $12 a share), which again the brokerage charged $30 to sell. A total of $1170 was put back into his personal brokerage account.
After the stock was sold, Michael did some math to verify his 20 percent investment return. His investment of $1030 had yielded $1170. However, upon closer inspection, Michael realized that the $140 dollars he had actually made was a return of only 14 percent, before taxes. Since he earned that profit on a stock he held less than one year, he would owe short-term capital gains tax, which might be higher than a long-term tax had he kept his money invested longer.
That means that while Michael had actually made a 20 percent return on this stock, the brokerage commissions ate away 6 percent of his return before taxes. This is one reason why small investors who buy and sell frequently to capture short-term growth end up squandering decent returns on commission charges.
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