What’s A “Bro-Ker-Age?”

In this article, I want to focus on an extremely important, yet often overlooked topic: brokerages.

Today in America, approximately 1 out of 5 adults could tell you what type of account you need to buy and sell stocks (a brokerage account). Those are terrible odds, but chances are good that, if you’re already a member of FinClub, you’re a part of the informed 20%, and perhaps you’ve already done your homework on which one is best for your particular needs. I hope to still shed some light on often ignored aspects that differentiate one type of brokerage from another so there’s still something of value for you to take away from this, but this will primarily apply to those that haven’t gotten that far yet.

So, what does a brokerage do? A brokerage’s most important function is to act as the conduit between the investor’s intentions to buy or sell a security and the market in which those intentions may be fulfilled. Normally, the concept of a “middleman” implies a negative connotation – someone who stands between you and your objective for no reason other than to add a layer of cost – but this primary function is absolutely necessary for the actively trading community. Think of your cell phone: you pick it up, go to your contacts, and within seconds you are having a conversation with someone anywhere else in the world. In order to have that conversation, you DON’T have to connect the signal towers & relays, develop the software and maintain the hardware. Instead, you pay your phone bill. A broker is very similar to this. You don’t have to fly from wherever you are to the floor of the NYSE (or to a server farm in New Jersey, whatever). You just go onto your trading platform, place your order, and wait for your broker to find a buyer/seller… eh, there’s a bit more to it than that, but we’ll save the weeds for another day.

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Although there’s plenty of overlap as brokerages seek to enhance their capabilities through high and low tech solutions, I generally think of brokerages as falling into one of three main categories:

  1. Legacy Brokerages.
  2. Modernized Self-Service Brokerages.
  3. New Disruptive Brokerages.

Before we dive into the differences, my personal belief is each type offers a particular set of skills and tools that cater to a certain type of investor, and that none of the above classes of brokerages is inherently “better” than the others. That said, the culmination of specific strengths from one brokerage to another is crucial to the individual investor’s needs.

Legacy Brokerages:

These are what you might think of when watching an old movie about trading (the kind where you might see a landline phone), but much like the cellular communications industry, traditional brokers have adapted well over time, making up for technological deficiencies with research and financial wisdom.

Many in this category may offer “full service,” such as their clients being able to pick up the phone and speak with the same person they’ve spoken to dozens of times before and that professional being sufficiently licensed and educated to provide their expertise, insights, and should you decide to proceed with a trade, their experience in execution best practices (getting your order filled at the best price they can). However, as with most all things, full service typically comes at a price. Such transactions can cost around 1% of the value of your trade, sometimes with minimum and maximum dollar thresholds, as well. Also, if time is of the essence (as it generally is among active traders), making that full service stop can feel like an eternity compared to today’s online trading platforms.

It’s fair to say that traditional brokerages are best suited for passive, long term buy-and-hold investors and those seeking to structure purpose-driven accounts, such as college funds or retirement planning. If you’re paying 1% commissions, you don’t want to do it often, but if the investment you’re looking to make is intended to last for years, it doesn’t hurt to have an expert second opinion to make sure you do it right. Edward Jones, Raymond James, and most small independent offices are a few examples of legacy brokerages that readily come to mind.

Self-Service Brokerages:

This is what you probably think of first when the term brokerage is mentioned if you’re already actively trading securities, whether they’re the underlying stocks/equities or a derivate like option contracts. You don’t often rely on the professional advice or other full-services of a legacy firm, because you already spend several hours out of your day researching companies and reading charts a few minutes each morning before market open to log into your FinClub account to find the companies you’re interested in trading that day. For this reason, this is also the category with the most overlap, where legacy brokerages like Charles Schwab adapt to provide self-service tools to expand their market share, and disruptive brokerages seek to provide the same tools that so many are already familiar with.

Former disruptors who essentially created this space back in the days of AOL and dial-up connections, like E*Trade and TD Ameritrade, continue to hold a sizeable market share; however, low-commission alternatives such as Interactive Brokers, SpeedTrader, and Lightspeed have added significant competition to the self-service brokerage market.

While this is not always true, my general rule of thumb with online brokerages is that cost and service are directly correlated… the more expensive commission brokers may hold your hand a little longer, but if all you need is a pat on the back and a “go get’em tiger,” you might be more interested in saving money.

Disruptive Brokerages:

Given the nature of technology, today’s disruption is tomorrow’s tradition, so in a way, this category is sort of “everyone else.” It’s still important to highlight some of the features and benefits these new brokerages are providing, because each has its own unique gimmick (and I say that with the utmost neutrality… some of these gimmicks are pretty good). Likewise, in several cases it’s just as important to understand how these companies make money so that you as an individual trader can know where your interests are being best served.

Of course, there’s often more complexity to the business models of the companies mentioned here than I will dive into. Consider yourself encouraged to do your own research for any which catch your interest.

This is the category where you will find the predominance of “roboadvisors,” algorithmic applications which assess your current holdings and attempt to rebalance them so that your portfolio maintains an optimal diversification for your individual risk tolerance and investing inclinations. These generally adhere to variations of Modern Portfolio Theory, which has its own praises and criticisms. Companies like Betterment tout their tax-loss harvesting, which is basically a record keeping function that tracks your losing positions in order to offset capital gains, thus minimizing your tax obligation in exchange for an annual percentage of your account balance. Others, such as M1 Finance, offer the benefits of an advanced, automated roboadvisor in exchange for holding your deposits for a short period (albeit longer than others) to provide margin to others, and to collect interest on that sum. There are also new brokerages taking a social approach to investing. Of these, I personally find Nvstr especially fascinating. They offer a more interactive approach to market and equity research, leveraging the consensus of other traders you might follow. This is, in theory, very similar to the Dalio Dot Collector, which I think very highly of (when applied to a relatively controlled test group). On the other hand, there also exists credible reasons to fear the herd mentality in the markets, but we’ll save that for another day. Then there are “zero commission” brokerages like Robinhood that should appeal to traders who usually move a very small quantity of shares, rebalance partial positions frequently, and only engage in highly liquid securities with minimal spreads.

I hope I’ve helped demystify some of the lesser-known aspects of brokerages and that you’ll be able to use this information to make a more informed selection, but keep in mind that there are numerous other aspects (i.e., which brokers provide margin? At what rate? Are there account minimums? If you trade options or other securities, do they support them? What are the commissions or other fees on those other asset types? And so on…) that have frequently been covered by other sources, and you would be well served by a cursory search if these may apply to your style of trading.