Should You Use an Online Discount Brokerage?

If you're just getting started in the investing world or are trying to decide whether to take a more hands-off or hands-on approach to your finances, one of the most important decisions you need to make is choosing a broker. There are two main choices here: You could go with either an online discount brokerage or a full-service broker.

While the full-service option does have a few benefits, an online discount brokerage is the way to go for most investors. Here are a few of the differences between the two options -- and the reasons why going it alone is probably the better choice.

The obvious difference: the cost
Perhaps the most compelling reason to go with an online discount brokerage is that it's much cheaper. With most online brokerages, you can execute stock trades for less than $10, and options trades for a small additional charge.

A full-service brokerage will generally charge much more to place a trade and can work on a flat-rate basis, a percentage commission, or a combination of both.

For example, one Florida-based full-service brokerage charges a flat rate of $40 plus 0.8% of the dollar amount of any trade of up to $5,000 and has a declining percentage scale for larger trades, with a $75 minimum commission. So, on a $5,000 trade, your commission would be $80. On a $50,000 trade, the commission would be $240, as the percentage component falls to 0.4%. However, with an online discount brokerage, the commission for either trade would be the same low rate of about $10.

For buy-and-hold investors, this is bad enough, but the commissions could really add up if you sell your positions and buy new ones every few years. Online discount brokerages are the clear choice for "active" investors who don't simply want to buy stocks and forget about them for years and years.

Full service: what you get for your money
A full-service broker does come with a few perks for your money. You'll get professional advice and recommendations on stocks and bonds, which can be tricky to navigate. With a full-service broker, there is no need to do your own research, understand financial reports, or get acquainted with the underlying businesses.

Basically, a full-service broker is for investors who don't want to do their homework. However, there are better ways to invest your money easily without paying those high commissions. There are exchange-traded index funds for pretty much any level of risk tolerance that completely take the guesswork out of investing and have historically provided some pretty compelling returns. Plus, they can be traded for just a small commission at a discount brokerage.

Are you a do-it-yourselfer?
On the other hand, if you like to keep track of your stocks, do investment research, and have a pretty good understanding of how the market works, an online discount brokerage can save you tons of money.

Sure, a full-service brokerage gives you access to that firm's proprietary research, but all of the online discount brokerages offer access to high-quality research. For example, when I log into TD Ameritrade and look up any of my stocks, I have several research reports to choose from -- written by big-name firms like Standard & Poor's and Credit Suisse.

IPOs and proprietary funds
One area where full-service brokerages do have a real advantage is in the initial-public-offer market. If your brokerage firm is underwriting an IPO, as a client you should be able to get in on the day-one pricing. The biggest underwriters of IPOs are Goldman Sachs, Credit Suisse, and Morgan Stanley, none of which offers a discount brokerage service.

There are a few new issues available through the discount brokerages, but for the most part, they don't participate in too many IPOs. However, this is a tricky and specialized area of investing, and those who are interested should be aware of the risks involved and should look into brokerages that specialize in IPOs.

The bottom line
There are very few circumstances where the high commissions and fees charged by full-service brokerages are worth it. You might be surprised at how much those high commissions can take a bite out of your returns over the long run. The $240 commission on a $50,000 trade can mean a difference of more than $1,800 over a 30-year investment time frame, and the effect of the commissions is even worse if you trade in and out of your positions every few years.

From a Foolish perspective, using an online discount brokerage just seems like the much better deal.

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