Throughout much of Wall Street's history, investors who wanted to buy stocks had no choice but to use expensive full-service brokers. But the rise of discount pioneer Charles Schwab (NYSE:SCHW), and other discount brokerage companies, changed all that. Thanks to the convenience of the Internet, choosing an online broker has given investors a much better option to buy stocks and other investments. By using your online broker to take advantage of investing opportunities, you'll be much more likely to reach your financial goals than if you use higher-cost alternatives.
How Wall Street gets rich at your expense
Despite the lucrative returns that the stock market has given investors over the decades, investors historically had to share a much larger portion of their investing profits with the professionals who facilitated those investments. With brokerage commissions often costing hundreds of dollars just for a single simple stock trade, investors had a big hurdle to overcome just to get back to break-even.
More importantly, over long periods of time, the money that you spend on commissions and other trading costs really adds up. By leaving you less money to invest, moreover, you end up losing not only the commissions and fees themselves, but also the big returns that the money you spend on them would have produced had you been able to keep it in your portfolio.
As offensive as it is to spend big money on trading commissions, the most pernicious fees are those that full-service brokers charge on an annual basis. Often, products like wrap accounts and managed portfolios come with fee agreements that charge 1% to 2%, or more, each year. That might not sound like much, but, over time, it can keep you from becoming rich.
What high fees really cost you
To illustrate this point in real dollar terms, take a simple example: Two people invest $50,000 in a portfolio of stocks that produces an average annual return of 8% over 40 years. One uses an online broker and pays no ongoing fee; instead, he or she just pays a one-time upfront commission. The other uses a full-service broker that charges a 2% annual fee.
The person who invests with an online broker might pay a modest amount in upfront commissions. But with most discount brokers charging $10 per trade or less, you wouldn't expect to spend more than $500 to put together a well-diversified portfolio. And, with no fees, the remaining $49,500 would grow to more than $1,075,000 in that 40-year span.
By contrast, the full-service broker wouldn't charge upfront commissions, but it would take out 2% year in and year out. Because your net return would be two percentage points lower each year, you'd essentially pay $1,000 or more each and every year during that 40-year span. Add in the lost investment returns on that money paid as fees, and you'd end up with less than $515,000 -- not even half what the person with the online broker ended up with.
When brokers compete, you win
Those who argue that you won't get the same service from an online broker that you get from full-service brokers haven't seen the competitive environment among discount brokerage companies lately. Most brokers now offer plenty of additional services, some at no extra charge, to their investors.
If you pick wisely, you can also find an online broker that offers perks, like commission-free ETF trading. Schwab pioneered that trend, but privately held brokers Fidelity and Vanguard soon answered with free ETFs of their own, and TD Ameritrade (NASDAQ:AMTD), E*Trade Financial (NASDAQ:ETFC), and several other brokers have come up with extensive lineups of no-commission ETFs.
Picking an online broker might not seem like that big a deal, but the cost savings that your broker can provide will make your retirement nest egg that much bigger. That's a deal you can't afford to pass up.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends TD Ameritrade. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.