You can buy a given brand of toothpaste at any number of retailers, but the stock of a given company is only available at one place — the stock exchange where it's listed.
And although you can go to any retailer to buy that toothpaste, you cannot buy the stock directly. Instead, you must ask someone who holds a federal securities license to buy it for you (with one exception we'll cover later).
The first thing to understand is that all stocks have two prices, not just one. There's a price you pay to buy a stock, and a price you receive when you sell it. The difference is the "spread."
Understanding the spread and other fees
The spread, which all stock investors pay, is the fee charged by the trader who executes the order that your broker placed for you.
Say you ask a broker for the price of a stock and he replies, "Ten, ten and a quarter." He means that someone who buys the stock will pay $10.25, while someone who sells the stock will receive only $10. The difference — 25 cents — is pocketed by the trader.
Most brokerage firms also have annual account fees, transaction fees, and other costs. At least one national firm charges a $3 fee each time you trade, while another levies a $75 charge when you close your account.
Investors are willing to pay these fees because they believe their profits will outweigh the costs. If you pay fees totaling 3% of your investment, you must earn 3% just to break even. Thus, you must consider costs as you invest.
In defense of brokers everywhere, please observe this rule of etiquette: It's considered rude to ask for advice from full-service brokers, then buy their recommendations from discount brokers to save money.
A while back, I ran into an old friend of mine. He was one of the sharpest brokers I ever worked with — he once won the National Options Trading Championships — and he told me he had just created a new computer model for trading in options. Options are a (usually) speculative form of derivatives where huge trading costs usually require significant profits just to break even.
Anyway, my friend told me that mathematical tests of his model, using historical market data, showed he would have made incredible amounts of money. Thus, my friend was now looking for investors to help him finance the further development of his model.
"What do you need investors for?" I asked. "Why don't you just start trading for real?" And he replied, "Because my model doesn't take commissions into consideration. Once I do, the trading costs are so high that I can't figure out how to make money with this thing!"
Remember that when people brag about how much money they're making, they're often not calculating their performance after fees. Remember, it's not how much you make, but how much you keep that counts!
Method #1: Brokerage Firms
Brokers at the major national brokerage firms can help investors decide what stock to buy. They are paid commissions when you buy and sell shares — typically 1.5% of the investment amount. And that's each way, meaning you pay 1.5% when you buy a stock and another 1.5% when you sell it, for a total cost of about 3% (sometimes more, sometimes less, depending on how many shares you are buying, the price of each share, and how frequently you trade; prices vary from firm to firm). Unlike registered investment advisors who serve your best interests, commission-based stockbrokers need adhere only to the lower legal standard that their recommendations be "suitable" and "appropriate." Thus, brokers don't have to charge you the lowest commissions.
Method #2: Discount Brokers
If you know what you want to buy and all you need is someone to get it for you (execute the trade), you can save money by turning to a discount broker, whose commission fees will be less — maybe a lot less. Discount brokers do not provide investment advice, nor do they provide you with a specific representative. Instead, you'll get a toll-free phone number or a website for you to use when placing an order, like buying from a catalog.
Method #3: Buying Stocks Without a Broker
There's only one way to buy stocks without going through a licensed broker, and that's by buying your shares directly from the company that offers the stock.
It's called a Dividend Reinvestment Plan, and it's available from about 1,000 companies — typically large ones like IBM and Wal-Mart. There are two advantages to DRPs: Buying shares is usually free or very low cost (because no broker is involved) and the company will reinvest your dividends into more shares, usually for a small fee. (Brokers generally cannot reinvest stock dividends for you.)
But DRPs have their problems, too.
Five disadvantages of DRPs
If you know you want IBM stock, you can buy shares directly from IBM. There are disadvantages, however:
- Many DRPs still require you to execute transactions via U.S. mail, while others execute transactions only a few times each month. These delays can prove to be expensive;
- Restrictions usually apply, such as the amount you are permitted to invest;
- Not all companies offer DRPs;
- Many DRPs are beginning to charge fees, negating the primary benefit of using them; and
- You are forced to work individually with each company whose stock you buy, and the paperwork can become overwhelming. The same is true for the tax-reporting and record-keeping requirements, often making DRPs more trouble than they're worth compared to simply working with discount brokers.
There are many more problems with DRPs and DRP investing, which I cover more extensively in my second book, The New Rules of Money. Still, if you want to purchase DRPs, you can find information about the companies that offer them on the Internet and at your local library.