Technology has cut broker commissions, but there's more to know. Image source: Library of Congress.
Broker commission, also called "broker's commission" or "brokerage commission," is an important thing to understand. After all, you want to get the most for your money. The thing is, there are multiple ways you might be paying this fee, depending on what you're investing in, and it could be eating away at your returns without your knowledge.
With that in mind, let's take a closer look at broker commission for investing, the one area of life you're most likely to be faced with these fees.
Broker commission and investing
In short, it's the fees that you agree to pay a broker for facilitating a transaction. This is most commonly associated with buying or selling stock, bonds, or other marketable securities, as well as real estate.
If you're trading options, it gets a little more complex. Typical options fees will start with a base fee, plus a "per contract" fee. A typical option contract is for 100 shares (with a few exceptions for stocks that carry higher per-share prices), so the additional per-contract fee makes it simple and easier for investors who want to trade more than one contract to do so, without paying a lot more money for the trade.
When it comes to marketable securities like stocks, broker commissions are typically a fixed-fee, usually below $10 per trade with most online discount brokers. This is almost always the case with ETFs -- or exchange-traded funds, which are similar to mutual funds in many aspects -- as well.
If you invest with a full-service brokerage firm, you're probably paying much higher fees based on the number of shares you are trading or even the value of the transaction.
Mutual funds: You're probably still paying up
Mutual funds may be bought without paying an up-front brokerage fee, but that doesn't mean you're not paying a commission.
The brokers may be paid by the fund directly, based on a percentage of what you invest in that fund. The commissions paid to the broker are included as part of the management fee that the mutual fund manager charges you, which is called the expense ratio. The expense ratio is measured as a percentage, and is the percentage of assets in the fund that is taken out each year to cover the fund's expenses. You'll never see a bill for this, but you're definitely paying it.
If a fund you invest in shows a "12B-1" fee in the prospectus, this is almost guaranteed to be commissions paid to brokers who sell this fund.
Just because you didn't see a commission, doesn't mean you didn't pay one. Image source: Seniorliving.org.
There are also mutual funds that charge an up-front commission, called a "load." Depending on the fund, these loads are often used to discourage investors from selling out of the fund in a short period of time, and in many cases the load will actually be credited back to your account after a certain period of time, usually more than six months. The idea here is that by reducing churn in the fund costs are reduced, and in theory it makes it easier for the fund manager to get better performance.
A fund that doesn't charge this up-front commission is called a "no-load" fund.
When it comes to both ETFs and mutual funds, it's important to consider the expense ratio, which is taken from your returns every single year. These funds are divided into two kinds -- actively managed and passive funds. While some active funds may outperform the market for a year or two, there's a lot of evidence that actively managed mutual fund performance varies from year to year, and that the vast majority of actively managed funds underperform their benchmark index. Why does this matter? They almost always charge a higher expense ratio.
In short, you're probably better off investing in low-cost ETFs or mutual funds that track the benchmark index, versus active funds that charge more in an attempt to outperform it but typically fall short.
Broker commission: The less you trade, the less you pay
While it's certainly important to minimize the cost of fees, don't make the mistake of trading more just because you're "only" paying a few bucks per trade. There is a lot of evidence that the biggest driver of investor underperformance is excessive trading.
If you're not consistently getting better performance and you're trading on a regular basis, then you're probably better off picking the best companies or low-cost index-based funds and buying and holding them for the long term.
If you'd like to pay less in fees (and who doesn't?), an online broker might be a good option for you.
