Chapter 8

HOW TO BUY AND SELL STOCK

In the previous chapter, we have seen a small sampling of the staggering variety of information content and sources available to individual investors today. When it comes time to put this information to use, to actually buy and sell stocks and other securities, we are again faced with many choices.

This wasn’t always the case. Until 1975, the brokerage business operated under a system of fixed commissions. There were no discount brokers for the simple reason that no discounting was permitted. (In those days, going “online” meant waiting to pay for your groceries at the checkout counter.) Other financial services companies were prohibited by law from entering the brokerage business. Commercial banks, for instance, were barred from engaging in investment banking (primary market, underwriting) or brokerage (secondary market, broker /dealers). Neither insurance companies nor mutual fund or other money management organizations had a significant presence in brokerage.

With the advent of deregulation on May 1, 1975, everything began to change. Discount brokers sprang into existence. Merrill Lynch introduced the Cash Management Account, offering banklike check-writing privileges in a marginable securities account, albeit without FDIC insurance. The mutual fund business began its boom years. The stage was set for a historic bull market.

Today, more than 30 years into the era of deregulation and financial innovation, choice is ubiquitous. To help you make sense of your options, and to figure out which of the many ways of buying and selling securities is right for you, we have grouped your choices into four broad categories: full-service brokers, discount/online brokers, other financial intermediaries, and direct purchase. A brief description of each category is followed by some representative examples. Along the way, we will describe the essential mechanics of buying and selling stock.

What Is SIPC Insurance?

The Securities Investor Protection Corporation (SIPC, pronounced “sipick”) is a nonprofit organization set up by Congress in 1970. SIPC insurance covers the securities and cash in the customer accounts of SEC-registered broker/ dealers in the event that the firm fails. It offers no protection against a decline in the value of the securities themselves.

 

SIPC insures up to $500,000 in securities, including up to $100,000 in cash equivalents (e.g., Treasury bills or money market funds) per customer. For insurance purposes, a joint account is considered distinct from an individual account. A family can extend its amount of SIPC protection by allocating securities among several distinct customer accounts at the same brokerage firm. You may decide that this is unnecessary. Major brokerage firms offer supplemental private insurance for customers with portfolios that exceed SIPC’s coverage limits.

Full-Service Brokers

Full-service brokers are still important players in this business. Though their financial clout has been decimated by the credit crunch, they still possess powerful distribution networks and prodigious data-gathering and research capabilities. On the retail side, Merrill Lynch (www.ml.com), now a unit of Bank of America, remains by most measures the largest and most influential brand; it also retains a strong institutional presence. Smith Barney (www.smithbarney.com), another venerable brand, is slated to become part of Morgan Stanley Smith Barney, a joint venture between Citigroup and Morgan Stanley. The combination is a strong presence in both the institutional and retail arenas.

If you select a full-service broker, you are likely to pay more in commissions than a discount broker charges. There are, however, several points worth noting.

• Commissions are negotiable. Your broker may suggest otherwise, but if you are persistent and if he or she believes that you are a good customer for the long term, you should be able to get lower commissions than the standard rates. Think of the standard commission as their asking price, and shop around before you bid.

• Commissions are not the only way your broker makes money—far from it. This is true whether you use a full-service broker or a discount broker. There are six additional ways that brokers make money in the course of doing business with you:

1. You may be surprised to learn that your broker probably makes a lot more money from capturing the spread—the difference between bid and asked prices—than from commissions alone.

spread

The difference between bid and asked price.

2. Your broker is also a dealer, meaning that he may have the shares you want in inventory, and may have purchased them at a much lower price, in which case your broker would still make money, even if he sold those shares to you at the bid and charged no commission. A dealer in over the counter (OTC) stocks may also add a charge to the purchase price; this charge is sometimes called his markup.

3. If you buy stock on margin, your broker is effectively making you a secured loan, using the stock he sold you as the collateral. He charges you an interest rate above the rate he pays to borrow money from a bank. The difference between these interest rates is another spread—an interest rate spread. This represents additional profit to your broker, as long as the stock is margined.

4. Furthermore, if you look closely at your broker’s account agreement , it probably allows your broker under certain circumstances to engage in what is called a stock loan—using your securities. The counterparty, who is borrowing your stock, pays your broker for the privilege. Large institutional customers may receive some of the proceeds when their stock is loaned out. Individuals don’t see any of this money.

5. Your broker may be receiving payment for order flow. According to the SEC, this could be a penny per share—or more. This can also be done within the brokerage firm, a process called (what else?) internalization. More information about these types of payments can be found at www.sec.gov.

market maker

Broker responsible for maintaining a liquid, orderly market in a stock.

How can payment for order flow wind up costing you money? It may be a disincentive to your broker to get you the best price. It is to be hoped that your broker would put your interest in getting the best price ahead of his interest in receiving order flow money, but it would be better to know that your broker’s interests are aligned with yours.

6. In order to encourage such an alignment, some full-service brokerage firms have moved away from commission-based payments, instead introducing compensation schemes that reward brokers for asset retention. By charging you and paying the broker on the basis of how large your account becomes, the brokerage firm is taking away the economic incentive for the illegal practice of churning a client’s account, thus encouraging a true partnership between client and broker. Nonetheless, these fees can also add up. And some of them are less obvious than others, particularly if you are purchasing money management services.

Many firms have wrap accounts that dispense with brokerage commissions entirely, replacing them with an annual money management fee similar to what would be charged by a mutual fund. This is yet another example of the broad convergence of financial businesses.

Discount Brokers

Discount brokers offer much lower commissions to customers willing to forgo services such as research reports and other traditional perks offered by full-service brokers. Commissions, however, represent only a small part of the money that brokers make from your business, as we have seen. Full-service brokers frequently defend their higher commissions by claiming that they achieve better execution for their customers, leading to a lower cost overall. Let’s look at an example to see how this might be true.

Say you issue a buy order for 5,000 shares of IJK Corporation at the current market price (a market order) and IJK last traded at $144 per share, bid $143^3/4, ask $144^1/4. FSB, your full-service broker, fills your order at $144, the midpoint of the bid and asked price. They charge you $500 commission.

On the same trade ZCB, your zero-commission (superdiscount!) broker would have filled your order “for free,” but at the asking price. You could have “saved” $500 on commissions, but you would have paid an additional $1,250 for the shares.

There might be a strong argument in favor of full-service brokers if there were credible evidence that the quality of execution at these brokers was much higher than at the discount houses. We know of no such evidence presented by independent third parties, but would be very pleased if brokers began to disclose more information about the true costs of trading to their customers. Such pressure for greater disclosure comes, at present, mainly from brokers’ institutional clients. They are (for the most part) savvy enough to ask for the information and big enough to get it. We suspect that full-service customers do not get consistently better execution, but in reality are paying for the higher cost structure of full-service firms. This would tally with the other justification usually offered by brokers at the full-service firms: “You’re paying for the research.” Maybe so, but you need to decide if it’s worth the money.

With the emergence of the Internet, online investing has created a new generation of superdeep discount online brokers, whose commissions may be less than 10 percent of traditional brokerage commissions.

Financial Intermediaries

Other financial intermediaries from banks to fund groups to insurance companies have established brokerage business. Fidelity (www.fidelity.com) and other major fund groups offer cash management accounts. Comparable to Merrill’s original CMA, they combine check-writing privileges with brokerage services, including, of course, the ability to purchase shares in the group’s funds.

Large commercial banks such as Chase (www.chase.com) also have brokerage (and insurance) subsidiaries, allowing you to engage in one-stop shopping. And insurance companies are another point of entry to the system. With all this choice, there’s bound to be some great deals out there. There will also be a continuation of the consolidation trend that has seen a decrease in the number of banks, insurance companies, and major brokerage firms. In sum, a smaller number of bigger firms offering a wider menu of financial products and services is the way things are headed. How far dare we extrapolate?

Direct Purchase

Financial services firms face fierce competition to survive. Not only must they compete against firms crossing over from related areas, but the very technological innovation that makes their businesses thrive can hurt them as well. For example, for many years it has been possible to bypass brokers entirely, buying stock directly from the issuer. Such direct investing programs are sometimes referred to as dividend reinvestment programs (DRIPs), because that is how they got started—as a way for existing stockholders to reinvest their cash dividends to buy more stock without a broker’s involvement. That same technology has made it easier for a growing number of corporations to offer their shares directly to the public, without brokers or exchanges as intermediaries. Some of these programs charge no fees at all, justifying the new term no-load stocks. Others are beginning to charge small administrative fees that still compare favorably to the online brokers. One nice feature of many DRIPs is the extremely low minimums necessary to open an account. For a list of available no-load stocks, see www.investorguide.com/links-dir-dripslist.html.

no-load (fund, stock)

A fund or stock that is sold without a commission or sales charge.

Dividend reinvestment and payroll deduction programs make it easy to accumulate shares using dollar cost averaging. Further information on DRIPs is available from many sources, including www.dripinvestor.com.

dollar cost averaging

Technique for accumulating securities at lower risk by periodically purchasing equal dollar amounts of a security.

If It Sounds Too Good to Be True . . . Protecting Yourself from Stock Scams

A broker calls you out of the blue with a compelling pitch about a can’t-miss investment. The broker will promise you the moon, or better, the next Microsoft—but only if you act quickly. Shares are cheap at $10 each. They’re certain to go up 1,000 percent in no time at all . . .

The cold-calling broker is probably part of a multibillion dollar per year business in chop stocks. Chop stocks are stocks sold by crooked brokers colluding with equally crooked stock promoters associated with the sham companies. These promoters take “buy low, sell high” to an absurd—and illegal—extreme. Taking advantage of loopholes in SEC regulations, the promoters are able to acquire large blocks of stock for pennies a share. These shares are then sold to the chop house for a much higher price, say $12 per share. The chop house employs the cold caller who catches you in the middle of dinner with the “opportunity of a lifetime” (neglecting to mention that the only opportunity being offered is the wallet-emptying kind). Taken in, you buy 1,000 shares at $12.50 per share. Fifty cents isn’t such a bad markup, you reason, for a thinly traded stock. Besides, you got a discount on the brokerage commission.

Chop stocks are characterized by enormous but cleverly disguised mark-ups. They are the bad apples scattered among legitimate, thinly traded microcap companies (i.e., companies whose total market value is under $300 million). The low turnover (rate at which the stock is traded, a measure of its liquidity) makes it easier for the scamsters to manipulate the stock’s price. In the case of chop stocks, the true value of the stock may be a big fat zero.

How can you protect yourself? The SEC, whose regulatory role includes protecting the investor against unscrupulous financial scamsters, has a very simple rule for investors to keep in mind: Ask questions. By asking the right questions before you invest, you can protect yourself against financial loss, bypassing products that are either inappropriate for you as an investor or products that serve no one’s interest except the crook at the other end of the phone line.

Here’s the SEC’s list of questions you should ask about financial products before investing:

• Is this investment product registered with the SEC and my state securities agency?

• Does this investment match my investment goals? Why is this investment suitable for me?

• How will this investment make money? (Dividends? Interest? Capital gains?) Specifically, what must happen for this investment to increase in value? (For example, an increase in interest rates, real estate values, or market share?)

• What are the total fees to purchase, maintain, and sell this investment? After all the fees are paid, how much does this investment have to increase in value before I break even?

• How liquid is this investment? How easy would it be to sell if I needed my money right away?

• What are the specific risks associated with this investment? What is the maximum I could lose? (For example, what will be the effect of changing interest rates, economic recession, high competition, or stock market ups and downs?)

• How long has this company been in business? Is its management experienced? Has management been successful in the past? Have they ever made money for investors before?

• Is the company making money? How are they doing compared to their competitors?

• Where can I get more information about this investment? Can I get the latest reports filed by the company with the SEC: a prospectus, offering circular, or the latest annual report and financial statements?

Additional information is available from the National Fraud Information Center, a service of the National Consumer’s League, at www.fraud.org.

A Note on Financial Planners

In their search for unbiased advice, many investors are turning to financial planners to occupy the void created when they dropped their full-service broker and got online with a discount firm. Ideally, a financial planner creates a well-thought-out, comprehensive financial plan customized for you or your family’s unique circumstances. In actual practice, some plans may be geared more to selling you products that earn the planner a commission or other monetary or nonmonetary compensation.

Financial planners can be categorized as commission-based, fee-based, and fee-only. The unsuspecting investor could easily confuse fee-based planners with the less common fee-only variety. The fee-based planner can make commissions on top of the fees he or she charges for investment advice. The result? A potential conflict of interest between the planner, who would like to make a buck, and the customer, who would like to be sold a quality product at the lowest possible price.

fee-based

Euphemism used by financial planners who earn commissions on the products they sell.

fee-only

Financial planners who promise not to accept any commissions from third parties.

The term financial planner has no legal standing, nor is there any licensing requirement. Anyone who wants to call him- or herself a financial planner can do so. There are self-regulatory groups that set standards and offer certification programs. The best known of these certification programs is for the Certified Financial Planner (CFP) designation. If the planner has been certified by the National Association of Certified Financial Planners, www.cfp.net, he or she has promised to put the client’s interest first.

Unfortunately, however, the potential for conflict of interest remains. The vast majority of planners, certified or not, get most of their compensation by selling products. Fee-only planners are few and far between; the vast majority of financial planners still receive compensation for selling products about which they also provide advice. Even some fee-only planners might get a commission here or there from a mutual fund distributor for selling you one of their no-load mutual funds. Please don’t call it a commission, though. Instead, refer to it as an administrative fee or a distribution fee. It remains a reason for caveat emptor.

The National Association of Personal Financial Advisors (NAPFA), a 15-year-old organization of fee-only planners, has acknowledged the problem. To raise investor awareness, the organization has introduced a fiduciary oath for financial planners to sign, pledging them to put their clients’ interests ahead of their own. You can contact the Association at 847-483- 5400, info@napfa.org, www.napfa.org, or by mail: 3250 North Arlington Heights Road, Suite 109, Arlington Heights, IL 60004.

fiduciary

Someone who has the obligation to look after an investor’s financial interests.