Types of stock brokers

Types of stock brokers

Why you might want to hold some individual stocks

Although I believe that most beginning investors should invest in stocks through mutual funds, some investors also may want to hold a few individual stocks.

Cost is one reason why you might want to own a few individual stocks. There are good mutual funds with annual expenses of only 0.2 percent of assets under management, but this is still a cost to you. If you buy and hold your own stocks for a long time, your annual holding expense is essentially zero.

In this case, you might want to limit your individual stock investments to large, diversified companies like GE or Proctor and Gamble. These companies have sufficient diversification that it's unlikely that they would go bankrupt because of a problem with a single product.

When buying individual stocks, you can buy from a so-called full-service broker, a discount broker, or a deep-discount broker.

Full service brokers

Full-service brokers include Merrill Lynch, PaineWeber and Dean Witter. These firms offer advice on stock selection and other financial services like retirement or estate planning.

Full service also means full price. Buying 100 shares through a full-service broker can easily cost $120 dollars or more. Full-service brokers usually are compensated through commissions, so brokers may encourage you to trade in and out of volatile stocks just to generate commissions.

This may be fun and a wild ride, but it's unlikely that you'll be able to beat market averages without assuming higher risk -- especially after paying the high brokerage commissions and capital gains taxes.

Discounters

In the bad old days, brokerage commissions on Wall Street were fixed. Every brokerage house charged the same fee for trading stocks.

The Securities and Exchange Commission, however, thought that the industry would benefit from more competition, so commissions were deregulated in 1975. Almost immediately so-called discount brokers started to charge less than their full-price brethren like Merrill Lynch.

There are now a number of discount brokerages, including Charles Schwab, Fidelity, Jack White and Muriel Siebert. Fees at these brokerages vary, but you typically can trade 100 shares for $70 dollars.

Discount brokers cost less, but they won't tell you what stock to buy. Most employees at discount brokerages earn straight salaries, so they don't have an incentive to make you buy stocks.

The discount brokers are beginning to offer more services to their clients, but for the most part they expect that you'll do your own research and determine what investments you want to buy.

Deep discounters

Finally there are the so-called deep discounters. Trading shares of stock with these brokerages can cost $29 or less if you trade through their electronic systems.

Like the discount brokerages, the deep discounters won't tell you what stock to buy. In fact, the deep discounter's employees, if you can ever get through to them, are basically order takers.

Although the deep discounters have the lowest costs, you should look out for other fees. You may have to pay additional handling fees on top of the advertised price.

Commissionless trading

In addition to commissions, you should be aware that your broker can make money from your trades in other ways. Stocks that are traded on NASDAQ or over the counter have market makers.

Market makers are brokers who hold inventories of stocks that they make a market in. Like any business that holds inventories, market makers make money by buying low and selling high. They also make money through payments for order flow or through the bid-ask spread on prices.

In fact, the ability to make profits through large bid-ask spreads has attracted the attention of the US Department of Justice's Antitrust Division. Buying and selling stocks on the NASDAQ or the over-the-counter market may limit your profitability unless you can reduce these bid-ask spreads.

To reduce these spreads, you might want to think about using limit orders when you buy or sell a stock. Limit orders mean that you'll only buy or sell at a specified price, instead of the current market price. Just set your limit price inside of the current bid-ask spread.