Part 3: Selecting and Using a Stock Broker

In order to buy a stock, bond or any other type of security (see below), you need a stock broker. A stock broker has access into the stock exchanges where stocks are bought and sold and matches your order (as a buyer or seller) with another investor’s order (who is in turn selling or buying). Once you open up an account such as a Roth IRA, traditional IRA, 401k, etc. (see our previous article on account types) and deposit money into your account you can start investing your money by purchasing different securities.

A broker enables you to purchase an investment in many types of securities:

 

Stock –

Also known as shares of a company are certificates of ownership of a company. When an investor purchases a share of a company they are literally buying a percentage of the company. They will receive future profits of the company in the form of dividends and increases in the price of the stock, along with other perks such as voting rights in company shareholder meetings.

 

The price of a share of a specific company is determined based on demand from investors. A seller may want $22 per share (also known as the “Ask”) and a buyer may only want to spend $21.50 per share (also known as the “Bid”). The stock market functions no differently than a corner street market. People are constantly haggling to try to buy things as cheap as possible, or sell as high as possible.

 

Stock exchanges receive orders to buy shares (“Bids”) and orders to sell shares (“Asks”) constantly, and match up investors willing to buy and sell at the same price. When two investors agree upon a certain price, the trade is made. The price quoted by a broker is the last price that a share of the company’s stock was sold at. During the day, the price of the company’s stock is continuously changing. General Electric Company (GE) has about 51 million shares sold every day! If the company reports that they made more money than previously expected, the price of the company’s shares may go up due to increased demand. Likewise, prices may also go down based on bad news from the company.

 

For the rest of this article, you will notice certain terms may color coded. I have added these color codes along with pictures with similarly colored circles to more easily identify where that information is located on a website such as yahoo finance or a broker. If the images are too small, click on them to enlarge.

 

Shares of a company are identified by brokers and exchanges by the company’s “Symbol” or “Ticker Symbol”. This is a set of 2 to 5 letters used to identify the company’s shares on an exchange. If you do not know the company’s ticker, it can be found by typing in the company’s name into yahoo finance or your broker’s website.

 

For example searching for General Electric Company (GE):

 

From Yahoo Finance (click to enlarge):

 

From a Broker (Here Scottrade was used, we will get into all the different brokers later in this article.)

 

 

 

The value of the company is determined by the price of the company’s shares. Again using GE (General Electric) as an example:

 

Currently there are 10.6 Billion shares of GE outstanding. If each share of GE costs $21, the “market capitalization” of GE is then $222.6 Billion ($21 * 10.6 Billion). If an investor owns 100 shares of GE (which would cost $2100 in this case), they own about 1/106 millionth of the company (100/10.6 Billion).

 

As an investor in GE, you get paid dividends each year you own the stock. Currently GE pays $0.17 per share, every three months in dividends (or $0.68 per year, per share). For an investor that owns 100 shares, they will receive $68 per year (100* $0.68) while they own those shares.

 

 

Example from a broker:

 

 

 

 

 

Example picture from yahoo finance: (note – yahoo finance does not include shares outstanding on the company’s summary page, although it is available by clicking the “Key Statistics” link on the left sidebar.)

 

 

 

 

 

 

 

GE’s stock price may go up if business is growing and the company is making more money, and therefore the investor may sell their shares at an increased price giving them a profit. Of course, prices can also go down causing the investor to lose money when they sell. The ultimate reason for investing your money in the stock market is to buy shares of companies today and sell them at a later date for more money than what you paid for them.

 

 

However, stocks are just one of the many ways to invest your money.

 

 

 

 

 

Bonds

When an investor purchases bonds of a specific company they are buying the company’s debt in exchange for payouts over time.

 

For example, you go to the bank and take out a loan to buy a new car. The bank gives you money to fully purchase the car in exchange for payments from you every month until the loan is fully paid off. The bank also adds on interest of course to make money on the loan. When buying a company’s bond you are acting as the bank and will receive money (from interest) from the company paying back the loan.

 

Bonds also exist for municipalities such as cities, counties or states (these are known as Municipal Bonds or “Munis”) and for the federal government (known as treasury bonds or treasury bills)

 

Bonds are favored by some investors because they give investors structured payouts and are generally considered safer investments than stocks. When you buy a bond, you know that you will receive a certain amount of money every quarter (or however often the payments are made. It may be every month, or once per year etc.). Bonds also always have a higher priority to be paid back compared to dividends on its stock. If a company is running low on cash, they must make the payments to their bondholders before paying money to the stockholders.

 

It is generally very expensive for individual investors to purchase individual bonds from a specific company or municipality. Typical minimums are $10,000. However recently it has become much easier for individual investors to purchase bonds through Exchange Traded Funds (ETFs) or mutual funds. We will discuss each of these in detail below.

 

 

Bonds are identified by a CUSIP number, which acts just like a stock’s ticker symbol. Brokers will also offer also searches based on company name, payment options, the length of the bond (also known as “maturity”), etc.

When a bond is initially offered by a company it has a certain Coupon, or initial interest rate. This interest rate is based off of the face value (also known as “Par”) of the bond, which is typically $100. This is the payment that the company promises to pay until the bond reaches maturity.

However, just like stocks, the prices of bonds move up and down based on demand from investors and this will affect the actual interest rate (or yield) that an investor in the bond receives. As the price of a bond moves higher, the yield of a bond decreases.

 

For example consider this bond from GE shown below:

The Coupon is 6.875% and par value was $100. This means that the company will pay $6.875 per year for every $100 invested into the bonds. This corresponds to a yield of 6.875% [($6.875 / $100) *100%]. The $6.875 payment stays constant for the entire duration of the bond. So if, (as in the picture below) the price of the bond rises from $100 to $140, investors still only receive $6.875 meaning that the yield is now [($6.875 / $140) * 100%] or 4.9%.

 

In the example below, if an investor purchased this GE bond today, they would receive $6.875 per $100 (of par value) invested twice per year (“semi-annually” as noted below the maturity) until the year 2039.

 

 

 

 

Although it varies, most bonds are set up where the initial principal is paid back entirely at maturity. The payments you receive from the company are only interest payments, not any part of the initial principal invested. In the example above, the investor would not receive the $14,038 they paid in principal back until 2039 (or until they sold the bond to another investor), but they would receive an interest payment of [(4.89% * $14,038) /2] or about $340 every six months.

 

Although there can be tremendous opportunities investing in individual bonds, for the beginning investor purchasing bonds through a bond fund is much safer and more practicable. More on that below:

 

ETF – Exchange Traded Fund.

 

An ETF represents a pool of various securities (such as stocks or bonds of various companies) so that when an investor purchases shares of an ETF, their investment is actually purchasing shares (or bonds) of all the different companies that are included in the fund. These funds are ideal for investors looking to invest in many companies (known as “Diversifying”), without the hassle of buying each company’s shares separately.

The owners of the ETF typically charge a fee, known as an expense ratio. The fee is not paid separately by the investor, but is taken out of the ETF’s share price.

 

 

For example, if an investor is willing to bet that the banking industry is going to do well in the future, but is not sure what specific companies will do best, they have a couple of investment options:

They have the choice of either buying stock in many different banks (there are thousands to choose from), which would be expensive because your broker would charge you a fee for each stock you purchase, and it would take you a lot of time to set up all those orders. Or, an investor could otherwise purchase an ETF that tracks the banking industry, and with one click of a mouse buy many banks at one time.

 

There are several ETFs that track the banking sector, but let’s take a look at one. Vanguard’s Financials ETF – ticker VFH:

 

Many of these numbers you see below look just like our picture from GE, such as the price and dividend payment. However there are a few new numbers. The Expense Ratio, which tells you how much Vanguard charges each year to invest in the fund, in this case 0.23%. The fund strategy is listed, which gives a brief overview of the goal of the fund. And also you see the top holdings of the fund. In this case, VFH holds the stocks of 504 separate companies – Imagine the time and cost of putting in 504 separate orders at your broker!

 

 

 

 

 

There are ETFs for almost anything an investor could want. We discussed above in the “bonds” section that ETFs are a much better way for an individual investor to purchase bonds. This is because ETFs have no minimum investments, are cheaper to buy and sell and offer diversity for the investor (instead of owning 1 bond, you own hundreds or thousands). As just one example, Vanguard offers a bond fund (Total Bond Fund – ticker: BND) that holds 5248 separate bonds for an expense ratio of just 0.1%! By investing in that fund, investors immediately get a good mix of corporate, government, foreign and mortgage bonds in their portfolio.

 

I believe ETF index funds are some of the best investment opportunities for investors. BeginToInvest.com offers an “ETF spotlight series” where certain index funds will be highlighted. ETF index funds will save investors time, reduce risk and offer diversification at a better price than nearly any other investment.

 

 

 

Mutual Funds –

Mutual funds work in much the same way as ETFs. Investor’s money purchases a pool of securities held by the fund. Mutual funds are run by large asset managers who, like ETF managers, charge a fee for investing in their fund. Typically, investments in mutual funds are more expensive, with expense ratios ranging from 0.2% up to 2% or more. There may also be other fees associated with mutual funds such as load fees (extra one time fee when buying or selling typically a certain percentage of your initial investment – in the case below, the fund has a initial sales load of 4%!) or increased transaction costs from your broker (these costs, among others are compared below where we discuss individual brokers). Mutual funds typically have relatively high minimum initial investments, which can be avoided by investing in ETFs. Mutual funds with load fees should almost always be avoided today – there is simply no reason to pay load fees anymore.

 

 

 

 

 

 

Because of the increase in expenses, mutual funds can typically be replaced by ETFs in portfolios today, however there is a scenario where investing in mutual funds makes sense.

 

Companies like Vanguard and Fidelity are not only brokers, but also fund managers. If you open a brokerage account with, for example Vanguard, many times Vanguard will let you buy and sell their funds for free. In this case, all an investor would pay to invest in these mutual funds would be the expense ratio. But read carefully, not all brokers do this and not all funds apply.

 

There are many other types of securities to buy from a broker. They may offer Certificates of Deposits (CDs), stock options or even precious metals like gold or silver. In general these are best done outside your broker or avoided all together. We will cover a few other security types in future articles.

Now that you have a better idea of the types of investments available, it is time for you to select a broker and open an account.

 

Brokers

 

 

 

Before selecting a broker there are several factors to consider. You want a broker that charges low fees, offers retirement accounts such as Roth IRAs and is easy to use.

 

There are several big names that I have used personally and feel qualified to talk about, though there are many more I have not used. I am not going to get too detailed on the specific brokers as I believe any of the few listed below, along with several others, will suite the beginning investor just fine.

 

I have also included other notable broker reviews from big name finance websites below.

 

Motif Investing

content_motif-logo_new

 

I am a huge fan of Motif Investing (Named one of CNBC’s most disruptive companies). Motif Investing allows investors to create their own “motifs” (effectively an ETF or Mutual Fund) containing up to 30 U.S. listed stocks – all for a one time $10 commission. (That’s $10 for purchasing up to 30 stocks – or as low as $0.33 per stock!)

You can see our full review of Motif Investing here: Motif Investing Review

and some of the cool things we have done with Motif Investing, like creating our own Property Rental “ETF” and Copying a Successful Active Managers, While Eliminating Their Fees.

 

Some screenshots of Motif’s platform:

Mimicking the investment portfolio of a very successful mutual fund that charges a 1% expense ratio. (Recreating that portfolio in Motif Investing costs $10, and no annual expense ratio):

SOR_motif_holdings

motif building SOR


Scottrade

 

  • $7 online trades.
  • $500 minimum to open an account.
  • Commission free ETFs available with the lowest expense ratios in the industry. Complete list here.

These funds have been liquidated as of August 2012.

  • Offers over 14,500 mutual funds, 3,100 of which are free to trade under most circumstances.
  • Offers online checking, savings and money market accounts.
  • Has over 500 local branches

 

 

I have had a Scottrade account since the day I turned 18. They offer a low minimum of $500 to open an account and charge no annual fees of any kind. I have personally never had a problem with Scottrade and have found their local branches useful on several occasions.

 

Scottrade offers a great variety of educational resources (You will see the “Knowledge Center” tab in the screenshot below), an online community and message board, and research tools which will be very useful for the beginning investor.

 

 

 

Scottrade also offers a free iPhone app (as shown below – nothing for the iPad yet).

 

 

The app will allow you to place a trade if you need to, but is a far stretch from being at your computer. Hopefully this is improved soon because it is one place Scottrade is falling behind from other brokers.

 

 

Fidelity

 

  • $7.95 online trades
  • $2,500 minimum to open an account, or $200 per month recurring deposit set up.
  • Numerous “No Transaction Fee” mutual funds. But $75 to purchases non-fidelity mutual funds!
  • Users pay no commissions on 30 iShares ETFs. Full list of free ETF are Here.

 

Fidelity is known for its top of the line research and retirement planning tools.

 

Fidelity does not charge any standard annual fees, however there are some that apply for balances below $2,000 on “non-core” Fidelity mutual funds. There is a 5 page document to describe Fidelity’s fees here, most will not apply to the average investor.

 

Fidelity is one of the best in the business, and frequently ranks towards the top of brokerage reviews.

 

I also believe Fidelity has one of the better mobile apps in the business.  The Fidelity app for the iPad looks stunning and more importantly is nearly as functional as logging in on a regular computer.

 

 

Fidelity is a great broker, but make sure you are happy with their selection of Mutual Funds and the iShares ETFs that they offer for free. If you choose to trade outside those funds or common stocks, Fidelity will end up being very expensive.

 

Vanguard

 

  • $7 online trades for first 25 trades, then $20 per trade. Prices get cheaper with greater than $50,000 in account and cheaper still with more than $500,000 in account.
  • $3000 minimum to open
  • Large selection of commission free ETFs and No Transaction Fee mutual funds
  • $20 per year annual fee if account is below $50,000
  • $10 per month fee if account is below $2,500

 

 

Vanguard is the “Grandfather” of smart passive index investing. Their founder, Jack Bogle set up Vanguard to cater to investors who primarily stick to ETFs and mutual funds and do not actively trade. Vanguard can get expensive if you have an account less than $50,000 and/or trade non-Vanguard ETFs or mutual funds. But because of their large selection of funds, that should rarely be necessary. You won’t find flashy research tools or web pages on vanguard, just the basics.

 

Screen Shot of the Vanguard iPad app:

 

Vanguard’s website:

 

Here is how a few other notable sites have rated these and other brokers:

 

Kiplinger Barrons SmartMoney Magazine

1

Fidelity Fidelity Fidelity

2

TD Ameritrade TD Ameritrade Scottrade

3

E Trade Charles Schwab TD Ameritrade

4

Vanguard E Trade E Trade

5

Charles Schwab Trade King Charles Schwab

6

Options Xpress

7

Scottrade

8

Trade King

 

Personally, I don’t think you could go wrong with any of the brokers I mentioned above. They all have their pros and cons. I have not used TD Ameritrade, but they consistently rank up toward the top wherever you look. Make sure you do a little research before ultimately choosing your broker to make sure it fits your needs. If I was picking a broker today, it would be a tough choice between Vanguard and Fidelity. However, the industry is changing every day. Before deciding, be sure to check broker’s websites to see the latest news, product offerings and prices/fees.

 

As one final comment, I want to discuss a recent trend among discount brokers. Many discount brokers will initially appear cheaper than the three I listed above. For example – TradeKing advertises $4.95 per trade, some offer even cheaper rates.

 

I feel that this figure is given too much attention by retail investors who trade responsibly.

In many articles I talk about how important it is to keep costs down. That means not buying and selling too many times during the year. A responsible investor has at most a couple trades to rebalance during the year and a couple more when adding in new money. I see very few reasons for an investor to need more than 10 trades a year. When put into this context $5, $7 or $9 per trade really doesn’t become the “make or break point” for investors when you have that few of trades.

 

So sure, at face value it appears TradeKing could save you maybe $40 a year on commissions. However, consider trading with other brokers such as Scottrade, Fidelity or Vanguard where if you have a brokerage account with them, you can purchase their ETFs or Mutual Funds for free! A company like Vanguard or Fidelity has ETFs or Mutual Funds for nearly everything. It would be very easy for an investor to set up a well balanced diversified portfolio for free (as far as commissions) at Vanguard or Fidelity.

 

Remember, for many of those discount brokerages, their goal is to get you to trade more, that is how they make their money. Don’t fall into the trap of their low commission fees, because in the end I believe the average responsible investor would pay more investing through a random discount broker than Vanguard or Fidelity.

 

Now I am losing the chance at some great commissions by not promoting some of these discount brokers. Many other financial websites you read will be touting them because they offer great affiliate programs. Discount brokers offer $40+ in compensation for each account sent their way via sites like BeginToInvest! But I can not in all honesty send you to one of those discount brokers and say that it is the best thing for you. If I do promote a product here on BeginToInvest, you can be sure that I believe it is worth you time. But if I were to sell out and just promote any product that offers a good commission, I wouldn’t be able to say with a straight face that I am doing my best to educate you and get you investing responsibly.

I hope you understand why at first glace my “brokerage review” may seem lacking compared to other sites simply because mine is not filled up with “reviews” and affiliate links from all the sub-par discount brokers available.

 

 

There is one more part left in our getting started series, part 4 found here, which deals with asset allocation. We will get into the specifics of investing your money. How much money should I put in bonds? How much money in stocks? These questions and more will be answered in our next article.

 

 

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