A:

Discount brokers generally don't improve profits by generating higher returns, although many purport to do just that. Rather, investors can profit from their reduced fees and improving the dissemination of financial information. The increased popularity of discount brokerages won't offer the average investor much by way of new trading strategies or products; instead, an investor might be able to increase the profitability of existing strategies by reducing costs associated with commissions and fees over time. The rise in discount brokerages has introduced cost-improving competition to the financial services sector.

Discount Brokerage Vs. Traditional Brokerage

Brokers are the financial intermediaries of investment markets. Most investors can only buy and sell stocks, bonds, mutual funds, exchange-traded funds (ETFs) and other products through a brokerage account. Traditional brokers act as intermediaries and advisers. These brokers tend to offer individually tailored financial and retirement planning, tax advice and professional market insight.

The rates, fees and commissions charged by brokers can vary dramatically. Generally speaking, an investor can expect to pay 1-3% on his or her managed assets through a traditional brokerage. Investors might choose to accept these fees for several reasons. It's possible that the expert recommendations and planning of the traditional brokerage could result in enough extra returns to compensate for the expense. It's also possible that the investor feels that he or she needs the added structure provided by a traditional broker to commit to a plan.

Ever since the advent of the Internet, however, discount brokerages have risen in popularity and drawn investors away from traditional brokerages. The relationship with a discount brokerage is much more passive; traders can execute trades online through a computerized system or call in an order over the phone. Discount brokerages don't often have professional advisers and full-service plans, which means they can operate at lower costs and don't have to charge as much.

Profiting from Discount Brokerages

Discount brokerages have added a lot of competition to the financial services sector. Competing providers offer additional services for little or no extra charge in order to entice traders. The net result of this competition is that investors can earn more over the long haul even without improved market performance.

To see how this works, consider an investor who switches from a full-service broker to a discount broker. Suppose the investor's goal is to earn 6% average annual returns on his or her portfolio over the course of 25 years. If the full-service broker charges 2% to manage the investor's assets, the portfolio has to actually generate 8% average annual returns. The net fees paid to the discount brokerage might only add up to 0.5% of his or her portfolio, which would mean that the investor only needs to earn 6.5% annual return to hit the goal.

Investing in Discount Brokerages

It may make sense to invest directly in well-performing discount brokerages. However, those companies don't automatically generate higher earnings or pay more dividends just because the market is shifting towards discount brokerages overall.

Economic theory shows that increased competition actually results in lower overall profits for companies within the industry. Investors benefit by acting as consumers of financial services and taking advantage of competition-driven costs, not necessarily investing in competitive markets.

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