Brokers will usually charge a commission (service fee) for handling the purchase or sale of a security or other asset. Commissions are also common among investment advisors.
Among full-service brokerage companies, it is very common for commissions from their clients to make up the bulk of the company’s revenue.
The size of the commission, and how it is calculated, varies widely from one broker (or advisor) to another, and even within the same company. Different rules can apply for how different client groups are charged when it comes to commissions. It is therefore very important to read all the find print about commission before you sign up with a broker or financial advisor.
There are brokers and advisors that do not charge any commissions on transactions. They derive their income from other sources, e.g. margin account fees or by earning interest on money held in client accounts.
Limit orders vs. market orders
Some brokers will charge a higher commission for limit orders than for market orders.
- A market order is an order to buy or sell as soon as possible, at best price available right then.
- A limit order is an order to buy or sell at a specific price.
With some brokers, a limit order will cost you several dollars more than a market order.
On May 1, 1975, brokers in New York switched from fixed commissions to negotiated commissions. This paved the way for the pioneer Charles Schwab, who launched no-advice accounts with very low brokerage fees, making stock trading more accessible to the public. Today, internet discount brokers have managed to cut costs even further, bringing stock trading within the reach of the Average Joe.
What’s flat dollar?
Many brokers charge a fixed dollar commission (instead of a percentage based commission) for transactions above a certain minimum size. In everyday finance speech, this is often referred to simply as flat dollar.
Conflict of interest
When a broker or advisor gets a commission for each transaction, this creates a conflict of interest. It can be tempting for the broker / advisor to encourage frequent transactions.
Beware of extra costs
A lot of brokers and financial advisors are trying to attract customers by offering low commissions. Instead of simply go for the one offering the lowest commission, it is a good idea to take a look at other costs as well, to make a more well-informed decision.
Here are few examples of costs that you may encounter:
- Transfer fee: Transferring your account from one broker to another can be costly. An alternative way of doing it is to simply sell all your assets and withdraw all money from your account with the broker you wish to leave, instead asking for a transfer of your assets. Of course, commission costs and any tax impact must be taken into account when you select your route.
- Inactivity fee: Some brokers have a mandatory fee that you must pay if you don’t carry out enough transactions during a specified time frame. When a broker is making money from commissions on transactions, inactive clients will not be appreciated. The bar can be set in number of transactions or in total transaction value for the time period.
- Penalty for not fulfilling the minimum equity requirement: Some brokers will have a minimum equity requirement and charge clients that do not fulfill this requirements. Usually, both cash and assets (e.g. stocks) count as equity in this regard, so you don’t have to keep a lot of cash in your account if you own enough securities.
- Fees for specific services: Discount brokers will often charge for services that would be “free” (i.e. not charged separately) with a more full-service broker. You may for instance need to pay extra for obtaining historical data or get statements mailed out to you.
Management fees and management expense ratio for mutual funds
If you don’t want to place individual orders and pay a commission on each trade, a mutual fund might be a tempting alternative. You should know however that mutual funds also charge you, but it is called fees instead of commissions.
Always check the management expense ratio and management fees before purchasing units in any mutual funds, because the fees – and how they are calculated – varies widely from one fund to another. Just like commissions, fees and other expenses can make a big dent in your investment portfolio over time, since you aren’t just losing money today, you are also losing the income that those dollars could have yielded if they had been invested instead.
Ask the mutual fund company for a prospectus. This is a document where you should find information about the fees associated with the fund, such as management fees, account fees and fees associated with selling (sales charges). Some expenses will not be borne openly by you (the investor) but they are nevertheless important since they will impact the overall return for the fund.
Management fee is not the same thing as management expense ratio (MER). The management fee will typically only cover direct expenses for managing the assets, e.g. paying the fund manager. The MER is a broader measurement of how expensive the fund is for you, the investor, and simply looking at the management fee while ignoring the MER is therefore not a wise thing to do. Another key figure to check out is the trading expense ratio, which will show you the direct transaction costs for the buying and selling carried out by the fund.
Examples of expenses that may be incurred by a mutual fund are transaction costs for buying and selling securities, staff costs, marketing costs, legal costs, insurance costs, auditing and filing costs, and various administration costs. Some costs will be difficult to do anything about, since they are necessary in order for the fund to adhere to applicable laws and regulations.