Why Discount Brokerages Aren't Always a Bargain

“A nickel ain’t worth a dime anymore.” – Yogi Berra

Discount brokerage firms such as E*trade, Schwab, Fidelity and, more recently, robo-advisor firms such as Wealthfront and Betterment have pushed strongly to encourage investors to invest on their own and bypass an advisor. They claim advisors charge high fees imbedded with conflicts of interest. This is false. Discount firms are a great place for the do-it-yourselfers, but even those who elect to go it alone should consider the pros and cons through an objective lens. 

Behind the Curtains of Discount Brokerage Firms

When an individual invests on his or her own at a discount firm, they pay a commission for each trade or a fee to invest in funds. These individuals’ assets are also held at the firm’s respective bank, allowing the bank to earn interest in addition to any mutual fund revenue sharing agreements. It’s in their best interest that investors do it themselves. One might be paying less, but he or she is also getting less. If you are a do-it-yourselfer, these firms could be a good low-cost solution. (For related reading, see: Full-Service Brokerage or DIY?)

A Fuller Perspective on Investment Fees

When advertisements are made to promote a do-it-yourself low-cost product, they often do not provide a full perspective on the fees of advisors and/or mutual funds.

  1. The ads imply that advisors only use mutual funds for a commission. Advisors have the investing universe at their disposal. They can invest client funds in stocks, an index or a mutual fund. A good advisor will charge a flat fee based on assets while holding investments that have low expenses. Simply ask your advisor for a breakdown of fund expenses, or you can easily find the information online by searching the ticker symbol.
  2. Mutual fund share classes matter! Typically, when an advertisement cites high investment expenses, it references the A, B, or C share classes, which are more expensive. A good advisor will use the institutional share class (Class I), providing clients access with significantly lower expenses. This is only available to retail clients in a fee-based account (also known as an advisory or wrap account).
  3. Fees are not discussed in the context of performance. Fees need to be taken into the context of net performance and the investment objective. I fully agree that the majority of funds underperform their benchmark, thus not earning their fees, but there are rare gems that do. Take for instance Dimensional Fund Advisors (DFA). They actively manage some of the longest standing funds available and consistently outperform their benchmark net of fees. See Table 1 below.

You Get What You Pay for

Discount firms are an excellent solution for those who are just starting to invest or don’t need a human guide. But here are a few factors to consider longer term:

  1. When you do it yourself, you have to make decisions yourself. During a downturn, headlines will read "Crisis" or "2008 again" with red across the screen. You will not receive a proactive call from your discount firm, and this is when we see investors make the biggest mistakes. Investors panic during major declines and go to cash or try to time the markets, further compromising their portfolios. (For related reading, see: One Thing to Never Do When the Stock Market Goes Down.)
  2. Is investing $1,000 the same as $1,000,000? Rhetorically no. Discount firms are a great place to start investing without a lot of expenses. However, as your wealth grows, so do emotions in addition to the intricacies of managing a larger sum of money (think tax and estate planning strategies for example).
  3. Saving money is easy. Not running out is hard. Everyone knows how to save money, but not everyone knows how to spend without outliving his or her money. This is where a human can be more effective. Some of these firms do offer planning services (in some cases for free) but when an agent is servicing thousands of clients, how personal will your attention be and is that the type of service you want for your retirement planning?

At the end of the day, you get what you pay for. When investors pay less to these firms they’re essentially swapping the cost savings with their time and energy. And time always equals money when it comes to investing.

(For more from this author, see: Why You Should Avoid the Stock Picking Game.)

 

Disclaimer: Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial advisor to take into account your particular investment objectives, financial situation and individual needs. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets. Information provided in this article is general in nature and does not constitute financial advice.