Summary: This section describes the work and services offered by a stockbroker or a brokerage firm. They can be thought of as the lubricant that makes various parts of the stock market work smoothly together. We also discuss how their services might be suitable - or not - for you, the individual as you contemplate how to buy stocks.
They have the role of being in between buyer and seller when a stock or share is traded. It is they that enable the trade to be completed smoothly.
If it were not for such a middleman / matching service, we would all need to spend months hoping that we somehow crossed paths with someone who was willing and able to trade stock in the same company as us and at a price we found acceptable.
Clearly, there is a need for these middlemen (and women) in order to enable the smooth running of a stock exchange, in the same way that virtually every other type of market needs middlemen to act as the lubricant that enables trade to occur.
Their role is different to most others we would think of in financial services because they simply act in between trades and (mostly) provide no advice. This is in contrast to the rest of the sector that survives by providing advice. The idea that an investment banker, lawyer or financial planner would not provide advice seems rather odd, but it the norm in most brokerages.
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With the recent advances of the internet and the impact that new technology is having on hundreds of industries, their traditional role has changed. New online only firms enable trades and information exchange at very low costs and with almost instantaneous precision.
It used to be that stockbroker jobs were well paid and something of a stipend for life, with long boozy lunches and well above average salaries, but things have changed. Many of the national chains that relied upon local offices to provide a personal service to the local investors have closed completely.
The flattening of the information structure on every modern stock exchange (information here) means that most private individuals can have almost identical knowledge of companies as any broker ought to.
In fact, a private investor or day trader can now have an actual advantage over a professional broker in terms of available information. In theory, at least, the pros are meant to be following a very wide range of companies and cannot really specialise in any one stock. In contrast, a private individual can use technology and extra time to really focus in on one or two firms if they need.
These changes have thrown the typical stockbroker career path out of the window and enabled the more tech-savvy firms to handle clients nationwide from a telephone call centre and website.
This also means that it is typically not necessary for the office to be located close to the stock market as used to be the situation. Big brokerage firms no longer need to be based on Wall Street to have better access to the NYSE. They simply need to have some of their computer servers located near to those of the exchange. Obviously, this has reduced the need for high ticket real estate in the financial district, very substantially.
Savings like these have enabled the bigger firms to invest heavily in trading platforms and technology and simultaneously expand their client bases and drive down the costs to the end user. This has revolutionised equity markets for the private investor.
These changes have also enabled firms to cut stockbroker pay substantially. When combined with the introduction of professional qualifications (known as the Series 7 exam in the United States (information here)) and enhanced stockbroker training, many of the older and established people have simply left the industry as it has morphed into something that resembles a production line. As the typical stockbroker job description changed, the new harsher and more process driven environment forced a changing of the guard.
The reality is that understanding what does a stockbroker do is now both more simple and much more complex. On one level, the level of professionalism is so much higher that the role is easier to grasp, but on another level, it is much more technical than used to be the situation, making it harder for outsiders to fully comprehend. Put bluntly, buying stocks is much more complicated than it used to be.
These changes are almost meaningless to some. The average investor - you and I - buy stocks and sell holdings now and again and it is fine for us to use a telephone operator or the company website to make the trade. However, for the more high-stakes day traders, the time it takes to call in a deal is already far too slow. They will be trading exclusively online via a complex platform (information here). And for the algorithmic funds (information here) that trade electronically and hold positions for a matter of seconds, the traditional process is just quaint.
Take this example from September 2013 where the possibility that information was shared automatically 2-3 milliseconds before a 2pm press embargo to see just how competitive the algorithmic trading world is.
However, most brokerages now have the capability to deal in a very wide range of assets, since the process is driven by computers. This means that for most private investors every stock in the S&P, NASDAQ and much more are available, as are corporate bonds, preference shares and on and on. This puts the level of service offered significantly beyond the ability of most types of financial adviser and wealth manager to compete against.
As you will see from the pages below, there are a number of different service and business models. However, to make money, they generally charge a fee in the transaction. In the case of stocks, the difference is called the 'bid/offer spread'. This means that the price quoted to you has a commission built in.
To remember which term is which, try this: 'bid to get rid'. This means that the 'bid price' is being offered to entice you to sell your holdings. The offer price is being 'offered' to you to make you want to purchase.
Service levels: Execution only
An execution only stockbroker offers a 'dealing only' service where no advice is given. This means that the investor bears all responsibility regarding investment decisions. The instructions to deal are usually made online or by telephone. The service is commission based and usually very low cost to the investor. This is now the mainstay of most stockbroking firms.
Not offering advice means that you, the
investor, need to know in advance, what company stock is to be purchased
(or sold), in what amount and any and all analysis will have been
completed without the broker being involved. You need to know everything except how to buy before you pick up the telephone (or login).
This change in responsibility is very important. In the age of online brokers, investors are much more responsible for their financial actions than has ever been the case previously. This shift in responsibility may be beneficial for some investors, but for those that do not fully understand the markets, this may be a problem.
However, it should be noted that both advisory and discretionary management stockbrokers are unlikely to be willing to advise smaller scale investors. In other words, they are in the 'relationship' business and the relationships that they encourage and build are with wealthier investors with money, assets or a portfolio to manage.
Commission rates vary (as noted above) depending upon what sort of security is being bought or sold. The largest fees generally relate to foreign stocks and convertibles. Government securities (gilts, T-Bills etc), loan stocks (a type of bond or debt instrument) are usually the cheapest.
Whilst it is obvious that there needs to be and must be some fee to buy and sell, it is important as a private investor to try and minimise these costs. When annual returns are only a few percentage points per year, paying an extra one percent, for example, can be a very heavy drag on potential returns.
Service levels: Advisory management
An advisory management stockbroker offers a service where an adviser discusses or reviews the investments of a client on a regular basis or as required. This could relate to formal portfolio management or trading in individual shares.
The client will make the final decision to buy or sell. The adviser will normally supply research materials relating to markets, sectors and individual firms. The stockbroker will also make a specific recommendation for action.
As might be imagined, if the client makes the final decision and the portfolio is invested directly in the market (as opposed to via collective investment funds), many problems can occur. If the situation changes suddenly against a company being held, and the adviser cannot sell without agreement from the client, any delay can prove very costly.
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Equally, good opportunities can be missed because a client has not been able to fully appraise him or herself of the facts quickly enough.
The broker / client relationship will grow close over time. It is vital that both sides have clear guidelines as to how to work, and laying these principles down should be the role of the advisory management stockbroker. The client will almost certainly need a reasonable understanding of strategic asset allocation (information here) and portfolio management techniques (information here). Therefore, this is a service which requires skills and cooperation from both parties.
From the perspective of a finance professional, services such as these can be highly frustrating to work in. As investment research services have advanced with the use of powerful computer analysis software, the level of knowledge required to understand the results has increased massively.
It is also worth mentioning that if an advisory management stockbroker or investment manager makes a recommendation, it is up to the client to say yes on the majority of occasions! Without agreement there will be no stock buying. Clearly, any client paying for advice but always refusing it is going to be very difficult to deal with and as such will not be able to retain good help for long...
Service levels: Discretionary management
Discretionary management is the name given for to an advisor who manages a clients money under pre-arranged criteria. These criteria would include the clients thoughts and requirements relating to risk levels, tax position and income or growth requirements.
In terms of service levels for private investors, this is the top of the pile - direct management of an individual portfolio by a professional. In theory, such a service should be tailored to the client and priced as such.
Clients will not be involved in the day to day running of their investments but will be kept informed with regular portfolio valuations.
As one might imagine, this style of service is reserved for those clients with significant assets to manage. Depending upon your location and the company involved, these services can be aimed at clients with a minimum to invest of anywhere from 50,000 to 250,000.
Essentially, this would mean that if you had a 'liquid' lump sum to invest of perhaps, 80,000, many firms would not offer such a service to you.
Of course, in such circumstances it might be advisable that a client uses a traditional wealth manager who will invest in collective funds rather than increasing risks with direct investments into the market.
Services like those of a discretionary management stockbroker can be fee or commission based. It is quite common for the manager to charge a fee based on the value of funds being managed. This fee will often be a percentage (eg. 1% pa). Commissions may also then be charged on each transaction.
For an indepth discussion of the role of a client in such a relationship, we recommend reading the excellent investment book, Winning The Loser's Game by Charles D. Ellis. The role of the investor in investment management is the main subject of the book and it will help almost every investor significantly.
Stock investments form part of estate assets and must be specified in your Last Will and Testament. I have found an excellent external resource that offers information about how to write a will as well as providing a range of free will templates that visitors can use and personalise.
How does the SEC describe stockbroker fraud?
In the USA, the SEC has laid down guidelines to define what is and what is not stockbroker fraud. These rules also offer guidelines for investment advisers to follow that ensure investment advice is being given fairly and consistently and stockbrokers are not engaging in securities fraud.
Investment advisors and stockbrokers are responsible for providing information that is accurate and complete to investors. Stockbroker fraud occurs when an advisor, stockbroker, or brokerage firm offers inaccurate, incomplete, or biased information in an effort to control a market.
There are several types of these crimes and they include:
Biased investment advice: brokers or brokerages may have a bias for or against investments for reasons that are not disclosed
Unfounded advice: advice may be provided based on unqualified or unfounded opinions of the broker made without the benefit of due diligence
Contradictory investment advice: a stockbroker may be giving contradictory advice to different clients
Continuing a risk: stockbrokers may not advise clients to hold securities based on speculation when the risk is apparent and the potential for gains is unlikely
Conflict of interest: brokerage firms that have outside ties to a business may not sell that stock
A reading of The Wolf of Wall Street by Jordan Belfort, suggests that much of this legislation has been written over relatively recent years. Much of the finer detail - it appears - was to actually combat him and the actions of his former firm.
In his book, Belfort describes how he and his staff aggressively sold stock to the public in new IPOs to the NASDAQ in which they held undisclosed interests! He describes the silent third-parties through which he held his interests as 'rat holes'.
Much of the book describes the working environment at his brokerage as a little like a zoo - where only the lions get to survive! The films Boiler Room and The Wolf of Wall Street both show quite graphically just what this environment was like for the brokers and how they treated clients - which is ultimately their profession and responsibility.
He also goes on to describe other issues such as trying to hide deals profits and money from regulators by using accounts located in Switzerland, using transfer pricing techniques to repatriate his funds tax free and the life of mass excess that huge (ultimately illegal) profits can produce. This lifestyle included drugs, super cars, travel by private jet, prostitutes and eventually rehab and prison.
Needless to say, it is an eye opening read for anyone wondering what might be possible for a stockbroker to 'get away with'. The majority of his actions were illegal - or are now - but it still took many years for the FBI to finally gather enough evidence to shut down his operations - something that he had largely done himself by then anyway!
Obviously, it is worth mentioning that these guys were the worst extremes of the most rotten parts of the financial services sector, but sadly they do exist, so it is important for a private investor to know enough to make sound decisions and not fall prey to their tricks.
Misconduct or fraud?
It is worth pointing out that stockbroker misconduct is generally considered to be different to fraud. Fraud usually signifies an intent to harm or profit, whereas misconduct could often be better described as incompetence.
Towards the end of the last century, many investors suffered at the hands of poor quality investment advice. Their stockbrokers over invested their portfolio into high-tech and internet stocks. As we all know, these stocks were trading at very high market valuations and when the market crashed, huge amounts were lost.
We have personally met individuals who in 2001/2 had portfolios which were down by 80% or more from the time of their investment in 1998/9. Of course, no person can tell the future, but any rational observer could have seen that this was a very high risk part of the market.
Another way that stockbroker misconduct can harm clients relates to the investment and construction of portfolios for those on a limited or fixed income. Every so often, stories reach the daily papers of clients, often retired, who have had their life savings invested into a very high risk venture which they did not understand.
For almost everyone, the correct approach is that of a portfolio containing a number of different asset classes. This might involve corporate and government bonds, property, cash, commodities and stocks. Such a portfolio will usually contain far less risk than one that simply contains stocks (or equities).
A problem however, is that stockbrokers are not usually paid or targetted to sell assets other than stocks and shares. This means that the hard work of portfolio construction can be left to the client.
Churning is a term given to excessive trading. The trading is a way to generate commissions for the broker and his firm. As you may imagine, trading an account on a very frequest basis makes it almost impossible for any investment to show a profit and as such, the fees and charges will quickly reduce an account to almost zero.
In fact, there
have been a number of court cases in past years (when the legislation
was a little less severe than it is now) where clients accounts were
reduced from hundreds of thousands to zero - through a combination of
poor investment choice and daily trading. As odd as it may sound, these long-term investors portfolios were buying stocks and selling them virtually every day. Needless to say, they were not all good stocks to buy...
Since most members of the stockbroking world earn a basic salary and a bonus which is directly linked to the trade commissions earned, temptation has never been far away.
Churning an account is not viewed well by regulatory authorities. Depending upon the jurisdiction, it is either frowned upon or actually illegal. As legislation is implemented and enforced, convictions always follow.
Obviously, there is a point until which a stockbroker is making justifiable trades and is genuinely attempting to maximise performance.
As a rule, the bad brokers that make these excessive trades are very noticable. The account will be traded not a few, but dozens (or hundreds) of times during the course of a year. Very few technical analysts and even less stockbrokers have the time and skill to do this successfully.
Being able to draw a line between incompetence and fraud is not always easy. After all, some people really are incompetent! But either way, the reputation of the brokerage would often be damaged enough that many potential new investors were scared away.
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