What Is a Discount Broker?

Discount brokers are a relatively recent phenomenon in the world of investing. Discount brokers allow individuals to invest in a wide variety of assets at a cost significantly below what was previously available through full service brokers. Thanks to new technology and the widespread use of the Internet, investors around the world now have a cost-efficient option for making direct investments in the capital markets.

Bucket Shops

In the late 1800s and early 1900s, bucket shops were the original discount broker for the lower class. Investors using bucket shops were the ones who didn't have enough money to invest with a broker on Wall Street. Bucket shops acted as little more than a gambling house due to the incredibly low-margin requirements and the ease in which a trader could quickly lose all of his money. Instead of matching buyers with sellers, bucket shops simply took the opposite side of a trade that a customer wanted to make. If they had too many people piling onto a trade, they would often place their own sell order on Wall Street, which would cause the price to fall on the ticker tape. Since most investors used a massive amount of leverage, the brief downward dip would wipe out their positions. Today, bucket shops are synonymous with any fraudulent stock-selling operation.

Full-service Brokers

Full-service brokers were the precursor to discount brokers. They exist today and are commonly used by a wide array of mostly wealthy investors. Like the name implies, a full-service broker provides a range of services and acts more as an adviser. A full-service broker will actively call on clients to suggest trades and changes to their portfolio. Due to the research and advice they provide, full-service brokers charge a high level of fees and expenses.

Rise of the Discount Broker

The high fees and expenses of full-service brokers created an opportunity in the marketplace for brokerage firms to provide a cheaper alternative for investors who either didn't have a lot of money or didn't need the hand-holding that a full-service broker provided. The technology boom of the 1990s and the increasing availability of the Internet provided the impetus needed to create a successful discount brokerage platform.

What They Offer

Originally, discount brokers provided a bare-bones platform where people could do little more than buy or sell equities. Research was limited and the investor often had to pay for real-time quotes and news. As competition increased and the cost of technology declined, discount brokers began to offer some very sophisticated tools and access to the same information institutional traders used on a daily basis. Costs continue to plummet, and discount brokers are continually offering a broader array of investment products and services.

Shortcomings

Discount brokers have been a boon to small investors as well as larger, more sophisticated investors, but they do have their shortcomings. No longer does an investor have someone assessing their account and keeping an eye on its performance. Discount brokers provide some fairly in-depth portfolio analysis tools, but there is no one there to talk you out of doing something that exposes your portfolio to a level of risk that is higher than your comfort zone. There is also no one there to temper your emotions and keep you from bailing out at the bottom of the market or dumping money in at the top. In short, discount brokers provide cheap access to the markets but no real checks on your risk.

References

• Reminiscences of a Stock Operator; Edwin Lefèvre; 2006 Wiley Revised Edition