How to Buy Stocks and Bonds

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Although TV and Hollywood paint Wall Street as chaotic and mysterious, buying and selling stocks and bonds is really straightforward.  In the age of the Internet, buying and selling has become especially user friendly.  Because most investors use brokers, this post will concentrate on them: later posts will deal with alternatives.

How Brokers Work 

Brokers have many advantages.  Because they have membership on the organized exchanges where stocks trade, they are well placed to act quickly and effectively.  And because of their web of associations, brokers can easily navigate the complexities of bond trading for their clients.  Bonds generally do not trade on organized exchanges.  Instead, in what are called principal transactions, a seller, for instance, offers the bond through a broker to an investment bank, which, after settling on a price, takes ownership of the bond and then finds a more permanent buyer.  As a brokerage client, however, you don’t have this bother.  You simply tell your broker what to do, the broker comes back with a price, and you either agree or reject the trade.

Selecting a Broker

Choose a broker in much the same way you choose a bank. (See this earlier post.)  Most people get recommendations of family or friends.  Your boss, accountant, or banker might offer suggestions.  The Internet can offer guidance, too.  A good place to start is with the Financial Industry Regulatory Authority (FINRA) website, https://www.finra.org. Once you have a list of potential brokers, talk to them or go on line to research the following:

  1. Find out what account size the broker requires.  A high minimum may not be right for you.
  2. Ask for references.  If a broker refuses, that is a bad sign.
  3. How long has the broker been a broker?  It’s a plus if the broker practiced during a difficult market environment, such as 2008-09.
  4. Ask the broker for ideas on how to invest your portfolio.  If the broker responds by questioning you, that indicates that he or she is sensitive to your needs. You can then judge if the broker’s response is appropriate, even if it is not quite what you have considered.  Beware if you get an answer filled with references to hot stocks of the day: it suggests an effort to impress you without much regard for your needs.

Setting Up an Account

 Once you decide on a broker, establishing an account is easy and costs nothing up front.  The broker will need to determine that you are who you say you are and get your personal information, including social security number (for tax purposes).  Post 9/11 laws put to prevent money laundering have made this process more elaborate than it once was, but it remains straightforward.  The broker should ask about the following: the size of your assets, how long you have been an investor, what your objectives are, and what is your tolerance for risk.  Though this may seem intrusive, it is necessary so that the broker can serve you better, for instance, to make recommendations and to warn you when you contemplate an action that the broker feels might conflict with your general goals and preferences.

Types of Accounts

 Once your account is established, the broker will report to you regularly and almost certainly give you online access to review your holdings.  The broker will not only trade at your direction, but will also take custody of the assets you have bought and sold through these trades: the ownership remains yours.  This custody arrangement enables the broker to keep track of the securities, their associated cash flows, dividend and interest payments, and tax reporting.

Brokers are compensated mainly by charging, as a fee, a small percent of the total amount traded each time you buy or sell a stock. With bonds, brokers are paid because the price they bid to buy the bond for themselves is slightly lower than the price they ask when they then sell it to you.  This is called the bid-ask spread.  These fees or spreads are usually a fraction of a one percent of the amount involved in the trade.  So-called discount brokers charge lower fees but provide less comprehensive service.  Brokerage is a highly competitive business and fees remain relatively low with all brokers, certainly lower than they were some years ago.  Still, the expense should encourage you to keep your trading to a minimum.  (There are tax consequences, too, of which more in a coming post.)  There are basically four different sorts of accounts:

  1. Directed Account: (Some brokers call this by a different name.) Such an account effectively leaves all decisions up to you.  You direct the broker on all sells and buys.  Each action incurs a fee.  Full service brokers will offer advice based on their insight and research as well as on the strategy of their firm.  You can take the advice or not.
  2. Discretionary Account: Here, you authorize the broker to buy and sell for you at the  broker’s discretion.  (Discount brokers seldom offer this arrangement.)  Your broker will rely mostly on his or her firm’s research.   Before you begin such an arrangement, you should set out clear guidelines — you can always withdraw this permission or modify specific decisions.  Here, too, you pay a fee for each trade.
  3. “Account Fee Arrangements”: This is what I call such accounts. (They have many different names).  These accounts bill you based on the overall size of your assets but allow you to trade as much as you like without a fee.  Account fee arrangements are best suited to those who, for one reason or another, want to trade frequently.
  4. Margin Account: This arrangement, which can co-exist with any other account structure, enables you to buy securities on credit. The law stipulates how much you have to put down on each transaction and sets rules on the interest you pay on the borrowed portion of your purchase.  If the value of a security bought on margin drops, the broker may ask you for additional funds  (a “margin call”) because the security you have effectively pledged to ensure repayment is now worth less than when you originally pledged it.  Laws govern how margin calls (words investors usually say with a shudder) are handled.  Many tax-advantaged accounts, such as IRAs and 401(k) arrangements forbid margin purchases.

For many investors, especially small investors, mutual funds provide an easy, less costly way to put their money to work in stocks and bonds.  My next post will deal with these and other ways to get your investment dollars to work.

 

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