Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

Part II. Before You Start Buying

Chapter 7. Going for Brokers


Finding out what brokers do

Comparing full-service and discount brokers

Selecting a broker

Exploring the types of brokerage accounts

Evaluating the recommendations of brokers

When you’re ready to dive in and start investing in stocks, you first have to choose a broker. It’s kind of like buying a car: You can do all the research in the world and know exactly what kind of car you want, but you still need a venue to conduct the actual transaction. Similarly, when you want to buy stock, your task is to do all the research you can to select the company you want to invest in. Still, you need a broker to actually buy the stock, whether you buy over the phone or online. In this chapter, I introduce you to the intricacies of the investor/broker relationship.

For information on various types of orders you can place with a broker, such as market orders, stop-loss orders, and so on, flip to Chapter 17. To see how the latest technology (such as trade triggers) offers some cool possibilities for today’s investor, check out Chapter 18.

Defining the Broker’s Role

The broker’s primary role is to serve as the vehicle through which you either buy or sell stock. When I talk about brokers, I’m referring to companies such as Charles Schwab, TD Ameritrade, E*TRADE, and many other organizations that can buy stock on your behalf. Brokers can also be individuals who work for such firms. Although you can buy some stocks directly from the company that issues them (I discuss direct purchase plans in Chapter 19), to purchase most stocks, you still need a brokerage account with a stockbroker.

remember The distinction between institutional stockbrokers and personal stockbrokers is important:

·        Institutional stockbrokers make money from institutions and companies through investment banking and securities placement fees (such as initial public offerings and secondary offerings), advisory services, and other broker services.

·        Personal stockbrokers generally offer the same services to individuals and small businesses.

Although the primary task of brokers is the buying and selling of securities (the word securities refers to the world of financial or paper investments, and stocks are only a small part of that world), they can perform other tasks for you, including the following:

·        Providing advisory services: Investors pay brokers a fee for investment advice. Customers also get access to the firm’s research.

·        Offering limited banking services: Brokers can offer features such as interest-bearing accounts, check-writing, electronic deposits and withdrawals, and credit/debit cards.

·        Brokering other securities: In addition to stocks, brokers can buy bonds, mutual funds, options, exchange-traded funds (ETFs), and other investments on your behalf.

Personal stockbrokers make their money from individual investors like you and me through various fees, including the following:

·        Brokerage commissions: This fee is for buying and/or selling stocks and other securities.

·        Margin interest charges: This interest is charged to investors for borrowing against their brokerage account for investment purposes. (I discuss margin accounts in more detail later in this chapter.)

·        Service charges: These charges are for performing administrative tasks and other functions. Brokers charge fees to investors for Individual Retirement Accounts (IRAs) and for mailing stocks in certificate form.

remember Any broker (some brokers are now called financial advisors) you deal with should be registered with the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC). In addition, to protect your money after you deposit it into a brokerage account, that broker should be a member of the Securities Investor Protection Corporation (SIPC). SIPC doesn’t protect you from market losses; it protects your money in case the brokerage firm goes out of business or if your losses are due to brokerage fraud. To find out whether the broker is registered with these organizations, contact FINRA (, SEC (, or SIPC ( See Appendix A for more information on these organizations.

Distinguishing between Full-Service and Discount Brokers

Stockbrokers fall into two basic categories, which I discuss in the following sections: full-service and discount. The type you choose really depends on what type of investor you are. Here are the differences in a nutshell:

·        Full-service brokers are suitable for investors who need some guidance and personal attention.

·        Discount brokers are better for those investors who are sufficiently confident and knowledgeable about stock investing to manage with minimal help (usually through the broker’s website).

tip Before you deal with any broker (either full-service or discount), get a free report on the broker from FINRA by calling 800-289-9999 or through its website at Through its service called BrokerCheck, you can get a report on either a brokerage firm or an individual broker. You can find more details on this and other services (such as investor education and so forth) at FINRA can tell you in its report whether any complaints or penalties have been filed against a brokerage firm or an individual rep.

At your disposal: Full-service brokers

Full-service brokers are just what the name indicates. They try to provide as many services as possible for investors who open accounts with them. When you open an account at a brokerage firm, a representative is assigned to your account. This representative is usually called an account executive, a registered rep, or a financial advisor by the brokerage firm. This person usually has a securities license (meaning that she’s registered with the FINRA and the SEC) and is knowledgeable about stocks in particular and investing in general.

Examples of full-service brokers are Merrill Lynch and Morgan Stanley. Of course, all brokers now have full-featured websites to give you further information about their services. Get as informed as possible before you open your account. A full-service broker is there to help you build wealth, not make you … uh … broker.

What they can do for you

Your account executive is responsible for assisting you, answering questions about your account and the securities in your portfolio, and transacting your buy and sell orders. Here are some things that full-service brokers can do for you:

·        Offer guidance and advice: The greatest distinction between full-service brokers and discount brokers is the personal attention you receive from your account rep. You get to be on a first-name basis with a full-service broker, and you disclose much information about your finances and financial goals. The rep is there to make recommendations about stocks and funds that are hopefully suitable for you.

·        Provide access to research: Full-service brokers can give you access to their investment research department, which can give you in-depth information and analysis on a particular company. This information can be very valuable, but be aware of the pitfalls. (See the section “Judging Brokers’ Recommendations,” later in this chapter.)

·        Help you achieve your investment objectives: A good rep gets to know you and your investment goals and then offers advice and answers your questions about how specific investments and strategies can help you accomplish your wealth-building goals.

·        Make investment decisions on your behalf: Many investors don’t want to be bothered when it comes to investment decisions. Full-service brokers can actually make decisions for your account with your authorization (this is also referred to as a discretionary account, although many brokers have scaled back the use of discretion for ordinary brokerage accounts). This service is fine, but be sure to require brokers to explain their choices to you.

What to watch out for

Although full-service brokers, with their seemingly limitless assistance, can make life easy for an investor, you need to remember some important points to avoid problems:

·        Brokers and account reps are salespeople. No matter how well they treat you, they’re still compensated based on their ability to produce revenue for the brokerage firm. They generate commissions and fees from you on behalf of the company. (In other words, they’re paid to sell you things.)

·        remember Whenever your rep makes a suggestion or recommendation, be sure to ask why and request a complete answer that includes the reasoning behind the recommendation. A good advisor is able to clearly explain the reasoning behind every suggestion. If you don’t fully understand and agree with the advice, don’t take it.

·        Working with a full-service broker costs more than working with a discount broker. Discount brokers are paid for simply buying or selling stocks for you. Full-service brokers do that and much more, like provide advice and guidance. Because of that, full-service brokers are more expensive (through higher brokerage commissions and advisory fees). Also, most full-service brokers expect you to invest at least $5,000 to $10,000 just to open an account, although many require higher minimums.

·        Handing over decision-making authority to your rep can be a possible negative because letting others make financial decisions for you is always dicey — especially when they’re using your money. If they make poor investment choices that lose you money, you may not have any recourse because you authorized them to act on your behalf.

·        warning Some brokers engage in an activity called churning. Churning is basically buying and selling stocks for the sole purpose of generating commissions. Churning is great for brokers but bad for customers. If your account shows a lot of activity, ask for justification. Commissions, especially by full-service brokers, can take a big bite out of your wealth, so don’t tolerate churning or other suspicious activity.

Just the basics: Discount brokers

Perhaps you don’t need any hand-holding from a broker (that’d be kinda weird anyway). You know what you want, and you can make your own investment decisions. All you need is a convenient way to transact your buy/sell orders. In that case, go with a discount broker. They don’t offer advice or premium services — just the basics required to perform your stock transactions.

Discount brokers, as the name implies, are cheaper to engage than full-service brokers. Because you’re advising yourself (or getting advice and information from third parties such as newsletters, hotlines, or independent advisors), you can save on costs that you’d incur if you used a full-service broker.

remember If you choose to work with a discount broker, you must know as much as possible about your personal goals and needs. You have a greater responsibility for conducting adequate research to make good stock selections, and you must be prepared to accept the outcome, whatever that may be. (See Part 2 for information you need before you get started and Part 3 for details on researching stock selections.)

For a while, the regular investor had two types of discount brokers to choose from: conventional discount brokers and Internet discount brokers. But the two are basically synonymous now, so the differences are hardly worth mentioning. Through industry consolidation, most of the conventional discount brokers today have full-featured websites, while Internet discount brokers have adapted by adding more telephone and face-to-face services.

Charles Schwab and TD Ameritrade are examples of conventional discount brokers that have adapted well to the Internet era. Internet brokers such as E*TRADE (, TradeKing (, Scottrade (, and thinkorswim ( have added more conventional services.

What they can do for you

Discount brokers offer some significant advantages over full-service brokers, such as:

·        Lower cost: This lower cost is usually the result of lower commissions, and it’s the primary benefit of using discount brokers.

·        Unbiased service: Because they don’t offer advice, discount brokers have no vested interest in trying to sell you any particular stock.

·        Access to information: Established discount brokers offer extensive educational materials at their offices or on their websites.

What to watch out for

Of course, doing business with discount brokers also has its downsides, including the following:

·        No guidance: Because you’ve chosen a discount broker, you know not to expect guidance, but the broker should make this fact clear to you anyway. If you’re a knowledgeable investor, the lack of advice is considered a positive thing — no interference.

·        warning Hidden fees: Discount brokers may shout about their lower commissions, but commissions aren’t their only way of making money. Many discount brokers charge extra for services that you may think are included, such as issuing a stock certificate or mailing a statement. Ask whether they assess fees for maintaining IRAs or for transferring stocks and other securities (like bonds) in or out of your account, and find out what interest rates they charge for borrowing through brokerage accounts.

·        Minimal customer service: If you deal with an Internet brokerage firm, find out about its customer service capability. If you can’t transact business on its website, find out where you can call for assistance with your order.

Choosing a Broker

Before you choose a broker, you need to analyze your personal investing style (as I explain in Chapter 3), and then you can proceed to finding the kind of broker that fits your needs. It’s almost like choosing shoes; if you don’t know your size, you can’t get a proper fit (and you can be in for a really uncomfortable future).

remember When it’s time to choose a broker, keep the following points in mind:

·        Match your investment style with a brokerage firm that charges the least amount of money for the services you’re likely to use most frequently.

·        Compare all the costs of buying, selling, and holding stocks and other securities through a broker. Don’t compare only commissions; compare other costs, too, like margin interest and other service charges (see the earlier section “Defining the Broker’s Role” for more about these costs).

·        Use broker comparison services available in financial publications such as Kiplinger’s Personal Finance and Barron’s (and, of course, their websites) as well as online sources.

tip Finding brokers is easy. They’re listed in the Yellow Pages (or on directory sites like, in many investment publications, and on many financial websites. Start your search by using the sources in Appendix A, which includes a list of the major brokerage firms.

Discovering Various Types of Brokerage Accounts

When you start investing in the stock market, you have to somehow actually pay for the stocks you buy. Most brokerage firms offer investors several types of accounts, each serving a different purpose. I present three of the most common types in the following sections. The basic difference boils down to how particular brokers view your creditworthiness when it comes to buying and selling securities. If your credit isn’t great, your only choice is a cash account. If your credit is good, you can open either a cash account or a margin account. After you qualify for a margin account, you can (with additional approval) upgrade it to do options trades.

remember To open an account, you have to fill out an application and submit a check or money order for at least the minimum amount required to establish an account.

Cash accounts

cash account (also referred to as a Type 1 account) means just what you’d think. You must deposit a sum of money along with the new account application to begin trading. The amount of your initial deposit varies from broker to broker. Some brokers have a minimum of $10,000; others let you open an account for as little as $500. Once in a while you may see a broker offering cash accounts with no minimum deposit, usually as part of a promotion. Use the resources in Appendix A to help you shop around. Qualifying for a cash account is usually easy, as long as you have cash and a pulse.

With a cash account, your money has to be deposited in the account before the closing (or settlement) date for any trade you make. The closing occurs three business days after the date you make the trade (the date of execution). You may be required to have the money in the account even before the date of execution. See Chapter 6 for details on these and other important dates.

In other words, if you call your broker on Monday, October 10, and order 50 shares of CashLess Corp. at $20 per share, then on Thursday, October 13, you better have $1,000 in cash sitting in your account (plus commission). Otherwise, the purchase doesn’t go through.

warning In addition, ask the broker how long it takes deposited cash (such as a check) to be available for investing. Some brokers put a hold on checks for up to ten business days (or longer), regardless of how soon that check clears your account (that would drive me crazy!).

tip See whether your broker will pay you interest on the uninvested cash in your brokerage account. Some brokers offer a service in which uninvested money earns money market rates, and you can even choose between a regular money market account and a tax-free municipal money market account.

Margin accounts

margin account (also called a Type 2 account) allows you to borrow money against the securities in the account to buy more stock. Because you can borrow in a margin account, you have to be qualified and approved by the broker. After you’re approved, this newfound credit gives you more leverage so you can buy more stock or do short selling. (You can read more about buying on margin and short selling in Chapter 17.)

For stock trading, the margin limit is 50 percent. For example, if you plan to buy $10,000 worth of stock on margin, you need at least $5,000 in cash (or securities owned) sitting in your account. The interest rate you pay varies depending on the broker, but most brokers generally charge a rate that’s several points higher than their own borrowing rate.

Why use margin? Margin is to stocks what mortgage is to buying real estate. You can buy real estate with all cash, but using borrowed funds often makes sense because you may not have enough money to make a 100-percent cash purchase, or you may just prefer not to pay all cash. With margin, you can, for example, buy $10,000 worth of stock with as little as $5,000. The balance of the stock purchase is acquired using a loan (margin) from the brokerage firm.

warning Personally, I’m not a big fan of margin, and I use it sparingly. Margin is a form of leverage that can work out fine if you’re correct but can be very dangerous if the market moves against you. It’s best applied with stocks that are generally stable and dividend-paying. That way, the dividends help pay off the margin interest.

Options accounts

An options account (also referred to as a Type 3 account) gives you all the capabilities of a margin account (which in turn also gives you the capabilities of a cash account) plus the ability to trade options on stocks and stock indexes. To upgrade your margin account to an options account, the broker usually asks you to sign a statement that you’re knowledgeable about options and familiar with the risks associated with them.

tip Options can be a very effective addition to a stock investor’s array of wealth-building investment tools. A more comprehensive review of options is available in the book Trading Options For Dummies, 2nd Edition, by Joe Duarte (Wiley). I personally love to use options (as do my clients and students), and I think they can be a great tool in your wealth-building arsenal.

Judging Brokers’ Recommendations

In recent years, Americans have become enamored with a new sport: the rating of stocks by brokers on TV financial shows. Frequently, these shows feature a dapper market strategist talking up a particular stock. Some stocks have been known to jump significantly right after an influential analyst issues a buy recommendation. Analysts’ speculation and opinions make for great fun, and many people take their views very seriously. However, most investors should be very wary when analysts, especially the glib ones on TV, make a recommendation. It’s often just showbiz. In the following sections, I define basic broker recommendations and list a few important considerations for evaluating them.

Understanding basic recommendations

Brokers issue their recommendations (advice) as a general idea of how much regard they have for a particular stock. The following list presents the basic recommendations (or ratings) and what they mean to you:

·        Strong buy and buy: Hot diggity dog! These ratings are the ones to get. The analyst loves this pick, and you would be very wise to get a bunch of shares. The thing to keep in mind, however, is that buy recommendations are probably the most common because (let’s face it) brokers sell stocks.

·        Accumulate and market perform: An analyst who issues these types of recommendations is positive, yet unexcited, about the pick. This rating is akin to asking a friend whether he likes your new suit and getting the response “It’s nice” in a monotone voice. It’s a polite reply, but you wish his opinion had been more definitive. For some brokers, accumulate is considered a buy recommendation.

·        Hold or neutral: Analysts use this language when their backs are to the wall, but they still don’t want to say, “Sell that loser!” This recommendation reminds me of my mother telling me to be nice and either say something positive or keep my mouth shut. In this case, the rating is the analyst’s way of keeping his mouth shut.

·        Sell: Many analysts should have issued this recommendation during the bear markets of 2000–2002 and 2008 but didn’t. What a shame. So many investors lost money because some analysts were too nice (or biased?) or just afraid to be honest, sound the alarm, and urge people to sell.

·        Avoid like the plague: I’m just kidding about this one, but I wish this recommendation was available. I’ve seen plenty of stocks that I thought were dreadful investments — stocks of companies that made no money, were in terrible financial condition, and should never have been considered at all. Yet investors gobble up billions of dollars’ worth of stocks that eventually become worthless.

Asking a few important questions

Don’t get me wrong. An analyst’s recommendation is certainly a better tip than what you’d get from your barber or your sister-in-law’s neighbor, but you want to view recommendations from analysts with a healthy dose of reality. Analysts have biases because their employment depends on the very companies that are being presented. What investors need to listen to when a broker talks up a stock is the reasoning behind the recommendation. In other words, why is the broker making this recommendation?

Keep in mind that analysts’ recommendations can play a useful role in your personal stock investing research. If you find a great stock and then you hear analysts give glowing reports on the same stock, you’re on the right track! Here are some questions and points to keep in mind:

·        How does the analyst arrive at a rating? The analyst’s approach to evaluating a stock can help you round out your research as you consult other sources such as newsletters and independent advisory services.

·        What analytical approach is the analyst using? Some analysts use fundamental analysis (see Chapters 8 and 11) — looking at the company’s financial condition and factors related to its success, such as its standing within the industry and the overall market. Other analysts use technical analysis — looking at the company’s stock price history and judging past stock price movements to derive some insight regarding the stock’s future price movement (see Chapter 10 for more about technical analysis). Many analysts use a combination of the two. Is this analyst’s approach similar to your approach or to those of sources that you respect or admire?

·        What is the analyst’s track record? Has the analyst had a consistently good record through both bull and bear markets? Major financial publications, such as Barron’s and Hulbert Financial Digest, and websites, such as, regularly track recommendations from well-known analysts and stock pickers. You can find some resources for getting this type of info in Appendix A.

·        How does the analyst treat important aspects of the company’s performance, such as sales and earnings? How about the company’s balance sheet? The essence of a healthy company is growing sales and earnings coupled with strong assets and low debt. (See Chapter 11 for more details on these topics.)

·        Is the industry that the company’s in doing well? Do the analysts give you insight on this important information? A strong company in a weak industry can’t stay strong for long. The right industry is a critical part of the stock selection process (for more information, see Chapter 13).

·        What research sources does the analyst cite? Does the analyst quote the federal government or industry trade groups to support her thesis? These sources are important because they help give a more complete picture regarding the company’s prospects for success. Imagine that you decide on the stock of a strong company. What if the federal government (through agencies like the SEC) is penalizing the company for fraudulent activity? Or what if the company’s industry is shrinking or has ceased to grow (making it tougher for the company to continue growing)? The astute investor looks at a variety of sources before buying stock.

·        Is the analyst rational when citing a target price for a stock? When he says, “We think the stock will hit $100 per share within 12 months,” is he presenting a rational model, such as basing the share price on a projected price/earnings ratio (see Chapter 11)? The analyst must be able to provide a logical scenario explaining why the stock has a good chance of achieving the cited target price within the time frame mentioned. You may not necessarily agree with the analyst’s conclusion, but the explanation can help you decide whether the stock choice is well thought out.

·        warning Does the company that’s being recommended have any ties to the analyst or the analyst’s firm? During 2000–2002, the financial industry got bad publicity because many analysts gave positive recommendations on stocks of companies that were doing business with the very firms that employed those analysts. This conflict of interest is probably the biggest reason that analysts were so wrong in their recommendations during that period. Ask your broker to disclose any conflict of interest. Additionally, brokers are required to disclose whether their firm is involved with a particular stock as a “market maker” or in another capacity (such as being its investment banker).

·        What school of economic thought does the analyst adhere to? This may sound like an odd question, and it may not be readily answered, but it’s a good thing to know. If I had to choose between two analysts that were very similar except that Analyst A adhered to the Keynesian school of economic thought and Analyst B adhered to the Austrian school, guess what? I’d choose Analyst B because those who embrace the Austrian school have a much better grasp of real-world economics (which means better stock investment choices).

remember The bottom line with brokerage recommendations is that you shouldn’t use them to buy or sell a stock. Instead, use them to confirm your own research. I know that if I buy a stock based on my own research and later discover the same stock being talked up on the financial shows, that’s just the icing on the cake. The experts may be great to listen to, and their recommendations can augment your own opinions, but they’re no substitute for your own careful research. I devote Part 3 to researching and picking winning stocks. But for starters, Part 2 helps you lay the groundwork for your stock investing strategy.