The best stock brokers will focus on client profits, rather than their own. That includes avoiding frequent trading and stock options

As you know, we feel your best way to profit in the long term is to buy a portfolio of well-established stocks that meet our Successful Investor criteria and make changes only when there’s good reason to do so. If you buy carefully to begin with, you may only have to replace 10% of your portfolio per year on average. Some years, you may not need to buy or sell anything.

This is best for you, but it provides a meager living for your broker. Only the best stock brokers will refrain from straying from this strategy and will avoid conflicts of interest, including the frequent selling of stocks.

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The best stock brokers will focus on client profits, rather than their own

Suppose that a broker’s clients have placed total assets of $50 million with him or her—– a reasonably healthy “book” for a broker who has been in the business for a number of years. Assume the broker charges an average commission of 2%, and sells and replaces 10% of his or her clients’ total assets every year.

That would give the broker gross commission income of 20% (10% selling, 10% buying), times 2%, times $50 million, or $200,000 a year. But that’s the “gross”—revenue, not income. The broker might get to keep half that sum, and pay his own advertising and other expenses out of what’s left.

A broker can make a lot more money by spurring his clients to trade more actively. If he sells and replaces 20% of his clients’ assets each year, he’d generate gross commission of 0.8%, or $400,000. At 30% yearly, he’d generate 1.2%, or $600,000.

Suppose he “turns over” a client’s entire portfolio every year. For a $500,000 portfolio, that would amount to transactions totaling $1 million per year—$500,000 in buys and $500,000 in sells. (Of course, the broker might leave half of the portfolio untouched, and “turn over” the other half two times.) For a $50 million “book,” for example, that would generate $2 million a year in gross commissions.

At that rate of turnover, however, the broker is bound to make mistakes that can cost clients money. That means the broker will regularly lose some clients and have to replace them. Client loss will speed up a great deal during the inevitable market downturns, when most of the broker’s clients will experience deep losses rather than modest gains.

The best stock brokers will keep their clients away from stock options

With stock options, you pay a higher percentage commission on your outlay, perhaps 3% to 10%. Also, your stock options would have a limited life—they would expire in a fixed period of weeks or months. Then you would pay another commission to replace them.

Stock-options trading is a great deal for brokers, however, because options players pay much higher commissions than stock investors, and they pay commissions much more often. That’s also why options trading is a bad deal for Successful Investors.

Of course, a handful of options players do make money—after all, somebody has to win the lottery. But on average, you just can’t make enough of a gross profit to pay the commission costs and leave yourself with any significant gains. That’s why most options players wind up losing money.

Maintain a healthy sense of skepticism when looking for the best stock brokers

Overall, investors lose more money to conflicts of interest than to any other single risk. That’s not a comment about the average broker’s sense of ethics. It’s simply a matter of frequency of exposure times risk per exposure, coupled with the low standard presented by the suitability rule (by law, brokers only need ensure that investments they sell are “suitable” for a client).

So maintain a healthy sense of skepticism and follow the Successful Investor philosophy. Learn to distinguish between fact and opinion. Watch out for opinion that’s tainted by conflicts of interest. You don’t need to settle for investments that are merely “suitable” for you. Hold out for investments that are in your best interest.

The difference may seem subtle on the day you buy. But learning to tell the two apart will make a huge improvement in your long-term investment results.

Bonus Tip: You’re likely to lose money with automated stock-picking systems 

Some investors who want to trade by themselves, rather than use a broker, may turn to automated stock-picking systems to help them make investment decisions. These systems are typically marketed with impressive-looking performance records designed to make investors think they are sure to make guaranteed profits.

However, those records are typically derived by “back-testing” the program against past data. In other words, the promoters go back through old trading records and see what would have worked in the past.

Automated stock-picking systems essentially do two things: First, they narrow down the data you use when you make investment decisions. Second, they apply a fixed rule, or rules, to draw a conclusion or an investment decision from that selection of data.

Unfortunately, the market’s key concerns continually change. Today’s good investments can turn into tomorrow’s dead ends.

Should a broker be compensated based on the number of transactions performed for a client?