I'm sure we all have that friend or family member who hangs on to obsolete technology out of pure stubbornness, and we may have a few chuckles at their expense. Perhaps we snicker at their desire to resurrect Blockbuster instead of signing up for Netflix. I personally know someone who still has VHS tapes and uses maps, and, bless their soul, they'll never upgrade to DVDs or GPS so long as they live.
So while we chuckle at those friends, you could be using something just as obsolete in 2013: full-service brokers. Are you one of those investors? If so, who's laughing now?
Setting the stage
A full-service broker is a big-name company that spends massive amounts of money on its brand image and advertising to rope you in -- think Bank of America's (NYSE:BAC) Merrill Lynch, Wells Fargo (NYSE:WFC), and Morgan Stanley (NYSE:MS).
These full-service brokers are typically broken into different segments: investment banking, retail, and research. Because of the different divisions, you might be paying a steep premium for biased information -- not a winning combination for investors.
A big profit-driver for full-service brokers is the investment banking division, where the companies underwrite initial public offerings of new companies, Facebook being a recent example. Meanwhile, the research division is full of talented analysts who sort through the data that you don't have time to review and publish it in a way to help you make quick and informed decisions regarding stocks.
Unfortunately for individual investors, these two divisions often have a conflict of interest.
Because investment banking is a major profit-driver for full-service brokers, the companies don't want their research divisions to ruffle the feathers of their IPO clients by saying the stock is overvalued, even if that's a valid statement. This is especially true because the brokerage firms have an opportunity to purchase shares, often at a lower price, and stand to make a significant profit if the stock price rises during its IPO. Face it: With only thousands of companies yet millions of potential investor clients, the leverage isn't always in our favor to receive fair and unbiased information regarding some of the companies covered by a full-service broker.
The last division, the retail arm, is the one you deal with on a daily basis. You have an adviser who offers information regarding potential trades, and you confirm the action. Unfortunately, to support a full-service broker the cost of making trades can be 10-20 times higher than a discount trader such as Charles Schwab or E*TRADE -- a brokerage firm that doesn't delve into IPOs and thus lacks any conflict of interest regarding company research. Some brokers are even paid commission off your trades, giving them incentive to encourage clients to trade more often, costing you big money.
Research shows that paying a premium for full-service brokers on each trade can take a big chunk out of your portfolio returns. Last year, my Foolish colleague Matt Koppenheffer summed it up perfectly:
Bottom line, the research showed that the accounts that used financial advisors had lower returns (net of fees) than the accounts that did not. How much lower? A whopping five percentage points lower. That smarts. But just how much does that hurt? Starting with a $100,000 portfolio, over the course of 30 years, getting 7% returns instead of 12% means a difference of a cool $2.2 million, or having a $761,226 account value instead of nearly $3 million.
Obsolescence takes hold
This isn't 1950. Technology has revolutionized the way the stock market works. Needing a full-service brokerage firm with brokers on the NYSE exchange floor to complete a trade is just as ridiculous as needing a video rental store to watch a movie in 2013. As most of you know, the Nasdaq doesn't even have a trading floor!
If you're doing your own research, monitoring your own portfolio investments -- as you should -- and paying a full-service fee in the process, you're as outdated as my family member stuck on maps and VHS tapes.
To be fair, these full-service brokers can provide expertise in matters other than investment research and might be exactly what you need -- and may therefore be worth paying for. Those services can provide insight regarding macroeconomic events, help plan for estate issues or retirement, or even help solving complicated tax issues. If that's not what you're paying a full-service brokerage firm for, you could be overpaying for biased information, and that's causing more investors to do it themselves, leaving the retail division of full-service brokerage firms nearly obsolete.