If you want to trade or invest in securities, you will need a broker or brokerage firm. A broker might be an individual, a boutique firm or an arm of an investment bank. Brokers manage your brokerage (securities trading) account, ensure your trading will comply with certain SEC regulations, and may provide liquidity (market making), investment advice and market research to clients.
How do you know if you are getting your money’s worth from your broker? Well firstly, you should have done your homework before you hired her. If you didn’t, it’s not too late. Do that research now.
Before You Hire Your Broker
Understand if you are hiring a broker-dealer, financial/investment advisor or both. An investment advisor has a fiduciary duty to you, the client, meaning he must provide investment recommendations that are in your best interest. In contrast, the role of a broker-dealer is to buy and sell investment securities such as stocks, bonds, mutual funds, etc, at the behest of their customers (as a broker), and for their own investment accounts (as a dealer). A broker’s recommendations to her client must be appropriate, for example stock picks, risk management and portfolio composition based on the clients’ investment objectives. However she does not have to act in his client’s best interest, per the current regulations.
Why wouldn’t a broker act in your best interest? One reason is the structure of the broker’s compensation. Some brokers are paid (wholly or partially) by commissions, which can distort their investment advice. This creates an incentive to advise clients to trade more often than might be necessary (churning).
Secondly, many brokerage firms are both brokers and dealers (broker-dealers), which is known as dual capacity. The broker’s duty is to ensure that she gets your transaction order delivered at the best price possible. However, broker-dealers do not only transact trades on behalf of clients but are also themselves principals investing and putting their own money at risk.
So before you sign with any broker you should ask:
- Where does your fiduciary responsibility lie?
- Do you invest as a principal as well?
- What are your potential conflicts of interest?
- How are you compensated? On commission?
- What are the total fees or commissions I will be paying? And how are they calculated?
- Do you give discounts on trades and commissions and how do I qualify?
- Do you make a market on your recommended stock?
A ‘yes’ answer to the second question is not necessarily a negative. Large broker-dealers can command significant liquidity. In instances where the broker may find difficulty in filling a client order, broker-dealer firms can take the other side of the transaction and provide liquidity for their clients. This known as market-making.
Finally, you should of course confirm that your broker is registered by the SEC or with FINRA or a state agency. Brokers must hold Series 63 and Series 7 qualifications to trade securities in the US. Your broker should be able to quickly and confidently answer the following questions:
- What professional licenses do you hold?
- Which regulator are you registered with?
Review their history with the regulatory authorities; any past or current investigations are red flags.
Working with Your Broker to Make Your Money Work Harder
Information is a broker’s most valuable offering to you. Any broker can put in a buy or sell order. Great brokers have deep market experience, unique market insights and, most importantly, will work diligently on your behalf.
How can you make sure your broker is giving you quality and timely information? Make sure to ask her the following questions:
- What level of study do you do for each recommendation?
- How many research sources do you use? What are they?
- Explain the rationale behind the principal positions of the brokerage (if she is a broker-dealer) or behind her recommendations for your portfolio.
Your broker should walk you through her research process. She should use at least three sources of information. And she should be willing and able to clearly explain her positions. Don’t be fooled by a condescending attitude implying that the financial strategy is to complex for the layman. She will be investing your money and regardless of the complexity of the instrument, she should be able to explain i) the degree of risk ii) the intended timeline of the investment iii) how the investment is supposed to make money and iv)why it is appropriate for your portfolio. If your broker is unwilling or unable to discuss these items, find another broker.
Other questions should evaluate your broker’s experience in the market, such as:
- What are the trends in the market?
- What are larger investors (pension funds, Warren Buffet) doing and why?
- Describe your past experience with this security.
- How many years have you been a broker?
- How many clients do you work with?
A good answer to the last question will expound on the broker’s years trading in the security as well as the forces driving that particular market.
The ideal broker will give you as much concise and relevant information as possible. She will be responsive to your needs, understand your portfolio and investment goals, be aware of the appropriate risk tolerance of your portfolio and have aligned compensation incentives. Asking some basic questions can help ensure that your broker has the listed qualities. A good broker will address these questions transparently and without becoming defensive.
