Bonus Topic: Which Is the Best Broker?

“When everyone has a distinct interest [in results], people will not complain of one another and they will make more progress.”

― Aristotle, Politics (330 B.C.)

A question commonly asked of us is “Which broker should I choose?”

Spoiler Alert: It’s really impossible to answer this question definitively because each broker offers an array of services and every client’s needs are different.

Instead of attempting to choose a broker for you, we should spend some time understanding how brokers operate. With that information you can research available brokers on your own and make a good decision about which one you should use.

Your broker is your partner in any investing or trading activity that you do. You should know how they are incentivized in order to understand any conflicts of interest in services they offer and fees they charge.

Brokers have a number of different revenues streams available to them which we will cover in detail.

These days, stock trades on retail brokerages are generally free. But the trading of other products (options, futures, FX, etc.) generally do still have commissions, so in your research of brokers you should understand these costs.

This revenue stream has come into the spotlight more over the last 20+ years as straight commissions on stocks have gone from a percentage of the transaction costs all the way to zero.

Many retail brokers send your orders to wholesale market makers rather than directly to an exchange. In exchange for this, the market maker pays the broker a small fraction of a cent per share for the "flow”.

This can become controversial because your “free” stock trade isn’t really free anymore. The wholesale market maker takes their cut and your effectively get a fill price that’s worse than if the broker sent the transaction directly to the exchange.

This is a category that might be less obvious to retail investors. “Spread” refers to the money that the broker can often make on the disparity between the bid and ask prices of the stock (or contract) that is being transacted.

Think about this example: Let’s say XYZ stock has a bid price of $10.00 and and ask price of $10.10 in the live market. And further assume that the broker has two customers, one wanting to buy XYZ and one wanting to sell XYZ.

The broker can buy the stock for $10.00 from the customer who wants to sell, and then sell to the customer who wants to buy at $10.10. The broker makes a zero-risk $.10 on every share transacted for acting as the bridge connecting the two customers on the transaction.

This category applies only to margin accounts. When you trade "on margin," the broker is lending you money. They charge interest on those loans, which can be a massive profit center when rates are high.

The broker is effectively lending money to their clients at a higher interest rate than they borrow it from investment banks. The broker makes money on the spread between the two rates.

Brokers often "sweep" your uninvested cash into partner banks. They earn a higher interest rate from those banks than they pay out to you, pocketing the spread between the two rates.

Brokers can lend the stocks held in your account to short-sellers. The short-seller pays a fee to borrow the shares, which can often be partially or completely kept by the broker.

Some larger brokers offer services to manage investments for their clients that are charged as a percentage of total assets under management. If a broker manages a $1M portfolio for a 1% fee, they make $10,000 in AUM fees regardless of how many trades the client makes.

These are one-time or recurring fees for professional financial advice, estate planning, or tax strategy.

Since many brokerages are publicly-traded companies, we can gain some insight into their operations and see the differences in the way that they make money.

Here is a comparison of two well-known, publicly-traded brokers with very different business models:

We can see that a broker like Robinhood is very dependent on revenue from the transactions themselves. This could cause them to attempt to get their clients to trade more frequently and in larger amounts on margin in order to generate more revenue.

A full-service broker like Schwab is less incentivized by the transactions themselves and more by a longer-term relationship with the client. This incentivizes them to attempt to upsell clients with banking/lending or asset management services.

This information does not make one broker “better” than another. But it is important to know this information when you make the choice of which broker(s) you use.

At Project Hedgehog over many years we have direct experience with Scottrade, Fidelity, Vanguard, Merrill Lynch, TD Ameritrade, and Charles Schwab. Each of these (the ones that still exist anyway) have pros and cons, offer different services, and make money in different ways.

Make sure you consider all the information above, understand how your broker makes money, and make your decision accordingly!

If you have any questions about your personal broker selection, please send us a note:

[email protected]

Disclaimer:

All content on this website and email newsletters - including any discussions of specific investments, trades, or strategies - is for informational and educational purposes only and should not be considered personalized financial advice.

Investing involves risk, and you could lose money. Any investment decisions, trades, or actions you take are made at your own risk. Always conduct your own thorough research before making any investment decisions.