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When (Not) to Pay Broker Fees

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Picture a broker in your mind. What do you see?

Perhaps someone sitting behind a desk piled high of reports, talking excitedly on the phone, and watching huge columns of numbers scroll across a big computer screen. Maybe she's young and energetic. Maybe he's older and has seen it all. Probably the whole presentation says "Trust me with your money. I know what I'm doing."

That's a good image, but it's incomplete. Most brokers are trustworthy and professional. Most are good at their jobs. Some are excellent. (As with any profession, a few—a handful really—are suspicious, but by far they mean well.)

Should you let someone else handle your money? Should you pay for the privilege of doing so?

That depends on what they charge and what they offer in return.

Remember that the goal of investing is to make money. It sounds so simple. How could anyone forget? Yet it's easy to dig yourself into a hole before you've even had a chance to make money—and one way to start by losing money is to pay too much to invest.

What Are Broker Fees?

Suppose your broker charges you a fee of 1% of your portfolio's value every year. (That's common.) If you have $10,000 invested, that's $100 a year. Your investments must make $100, or 1%, for you to break even. (If you only earn $95, that means you've lost money and you might as well have put that money in a bank account where you could have earned $20 on it instead.) Hopefully your broker's better than that and will help you break even. Hopefully; that doesn't always happen.

Unfortunately, the fees don't stop there. Suppose your broker charges you a fee of $20 every time you buy or sell something. If you have $10,000 invested and you sell one stock and buy another, that's $40 on top of the $100 already charged. Now you need to make $140 just to break even.

Is that reasonable? Maybe; you're not going to make those trades on your own. Then again, if you had a discount stock broker, you could pay $10 or less per trade.

Of course, you'll pay that commission for every transaction you make. Suppose your broker calls you with a great tip. A local company has gone through a restructuring and its stock looks like a bargain, as the business is solid, debt is gone, and revenue projections look great! You should transfer more money into your brokerage account and buy more stock!

Deposit another $1000 for that trade and you'll pay another $10 in annual fees and another $20 for the transaction. Now that $1000 investment needs to make a 3% return just to break even. If you sold something else to get that $1000, you paid $20 for that transaction too, so you need to make 5% to break even.

Yikes. If you've ever asked "How do brokers make money?", now you know—by charging you every chance they get.

How Do Fees Affect Your Return?

1% and 3% and 5% may not sound like a lot, but every dollar you give someone else to manage your money for you is a dollar that could be working for you. The S&P 500 has an 8% or 9% return rate on average over the past several decades. You'll have to beat that substantially to make up for these fees. Most brokers and most funds don't do better than that. Brokerage fees exist to make brokerages money, not to save you money.

There's nothing wrong with paying a professional to do a job you can't do yourself. If your broker is amazing and gets you 25% returns reliably, paying 3% in fees is well worth it. If your broker is good and makes a reliable 12% return, you're just as well off not using a broker at all and instead dumping your money into an S&P 500 index fund, where you can make 8-10% a year.

Oh, and if your broker actively moves your money around—charging you $20 for each transaction, of course—paying a 3% brokerage fee might start to look like a bargain. Six transactions a year is $120. Ten transactions a year is $200.

Add to that that the broker doesn't necessarily know what you know about the businesses you want to invest in. Your broker's goals may not to be to find a couple of great companies and buy their stocks and hold them for several years. After all, if your broker makes money on every transaction, the fewer transactions you make, the less money for your broker.

Should You Pay a Stockbroker?

It's not fair to paint brokers as greedy—they're not—or anything other than professionals. Some of them are excellent and worth every penny they charge. (The fees given as examples here are examples and not absolutes.) Can brokers have it all? No; nor should you expect them too.

Yet you can do most of what a broker does for yourself, for free. You can find great companies and good values and manage your investments on your own. You might get better returns than your investment broker could (in fact, if you're careful you're likely to pick a few great winners!). Better yet, you'll understand your investments and be able to explain why you own the companies you own.

If you get a fair value from your broker, by all means continue to do so. If you're not sure, count the costs and see how much more work your money could do for you. Alternately, you could find a great discount broker online and save yourself lots of money.