The upside of online brokerages is that they're cheap. The downside: You get what you pay for.
That's the trade-off, which does not seem to have been understood by quite a few customers, according to two official reports released last week. Some are said to believe that when they sit down at their computers, they have a direct line to the trading systems of the major exchanges, when, in fact, the only direct line is to the computer of the online brokerage, which relays it to another computer, which forwards it to the marketplace.
Some online investors, said a report from the New York Attorney General's Office, have been shocked and disappointed to discover that trades may not be executed as rapidly as they hoped or that--especially when the market is in a frenzy--they can't even log on. Some say they have lost money as a result--the price goes down before they can sell, or it goes up while they're waiting to buy.
Having been disappointed myself with execution problems over the years, I certainly can sympathize with the concerns outlined in the studies by the New York AG and the Securities and Exchange Commission. There is a "significant gap between the expectations of online brokerage firm customers and the services that online brokerage firms provide," said the New York AG's report. It blamed advertising campaigns, in part, for this "expectation gap."
But online brokerages are able to charge low commissions because they are low-service operations. There's only one reason to use them--they charge low commissions--and that's a good reason.
They don't advertise their limitations. I searched a dozen online brokerage Web sites last week, running through their trade demos, their home pages and their education sections, and couldn't find one that really laid it on the line by saying, in effect, you can't always count on us. I'm confident we won't see any ads where the tow-truck driver or the barkeep or the excited junior executive gets all excited about buying a stock and can't manage to log on.
What online brokerages do say, somewhere, in small print, is: "System response times may vary due to a variety of factors, including trading volumes, market conditions, and system performance."
What they should say is "system response times may vary a lot . . . sometimes the computers won't work . . . sometimes we'll make mistakes in your transactions . . . sometimes, when you're really anxious, we won't be there for you at all."
While you should hold your online brokerage to high standards, my own experiences have taught me that you can't expect them to achieve them, especially now, with the proliferation of newer firms (there are 160 or so) and the explosion of customers as the brokerages struggle with demand that has risen from about 3.7 million accounts in 1997 to about 10 million.
The burden is on you to protect yourself--as it is, frankly, with traditional brokerages as well. Here are a few suggestions to avoid disaster.
When you're buying shares, the brokerage will offer you two types of order methods: a limit order and a market order. A limit order means, if you're buying, that you will pay no more than a specified price; if you're selling, it means you'll accept no less than a specified price. A market order means you'll accept the going price.
Avoid market orders whenever you can, even at the risk of not getting your shares.
This is a critical issue for online investors. Even when your computer and your phone line are working smoothly and the brokerage's systems are working smoothly, execution speed varies dramatically. It can be a few minutes or--in some instances, reportedly--a few hours.
The stock isn't sitting there waiting for you. It may be moving, sometimes with considerable velocity. Especially with heavily traded, volatile stocks, especially with Internet stocks, the $40 price you saw on the screen when making your decision could be $50 by the time of execution.
Use the limit-order option to keep your price within range, to make sure you don't pay more than you want. If that's $40, then say $40. The downside to this is that you may not get the stock. But that's better than getting the stock at a price you don't want to pay or, worse, at a price you can't afford. Your $40 limit on a buy is a ceiling, not a floor, so if the price goes to $38 at the time of execution you'll get it at $38.
Use a limit order when selling, too. You may be taking a profit because your share price has hit $100. But that earthquake in Taiwan, or that downgrade of your stock by some analyst after you place your order, could eliminate the profit if you don't put a floor on the sale price.
After you have filled out all the blanks involved in placing an order, you'll get a screen reviewing the details. Read it carefully. I know people who have bought the wrong stock because of a mistake in the ticker symbol or have inadvertently added or dropped a zero from the number of shares being bought or sold. The thousand shares you got vs. the hundred shares you wanted--that could be awkward.
The computer doesn't ask "Are you sure?" Any decent broker would.
So take your time. Don't let your adrenaline take over. Make sure the order is precisely what you want before you confirm and actually place the trade. After you place your order, you'll get a confirmation that you've placed it. That does not mean the order has been executed. You still have time to cancel. At some point after execution, not necessarily right away, you will receive notification of execution. Print that and save it.
Keep plenty of cash in your account to cover trades in full. If you can't do that, pay up as quickly as possible after you've bought something. Get the brokerage the money within three days. If you don't, you may wind up buying on margin--that is, taking a loan from the brokerage--and you'll pay interest.
Some people purposely buy on margin, with limits determined by the level of equity in their account. That would scare the devil out of me--if your portfolio declines in value, they'll make you send real money. If you don't have enough real money, they can sell your stocks to get it.
Do not expect to be able to "bail out" when the market is plummeting. You may not be able to log on at all. If you can, things may be moving too fast, with backlogs of orders, and yours may not get executed.
Some people try to limit possible losses or preserve profits by putting a "stop-loss order" on particular shares, so that when the price reaches a point specified by you, it's automatically sold. Among the problems with stop-loss orders is that they aren't really automatic. The price can spiral downward, with volume so high that your order gets left in the dust, becoming at that point a market order, so that your stock could be sold well below the price you specified.
We may feel like masters of the universe at our keyboards. But in the scheme of the markets, we're fleas.
And remember--the nice folks who run these companies are interested in making themselves millionaires first; you're second in line, at best.
Fred Barbash (barbashf@ washpost.com) is business editor of The Washington Post.
Ranking the Brokers
Here are the scores (and rankings) of online brokers, according to Gomez.com. The overall score is based on up to 100 criteria selected by Gomez experts.*
Overall score Ease of use Overall cost Customer
E-Trade 7.74 (1) 7.36 (1) 6.62 (32) 7.22 (9)
Schwab 7.72 (2) 6.86 (4) 4.35 (45) 8.86 (2)
Investments 7.02 (3) 5.75 (9) 4.61 (44) 7.91 (4)
NDB 6.96 (4) 7.10 (3) 6.76 (29) 7.76 (5)
DLJdirect 6.94 (5) 6.74 (5) 6.47 (34) 8.23 (3)
Online 6.21 (6) 7.30 (2) 6.62 (31) 7.03 (13)
AB Watley 5.99 (7) 4.31 (28) 8.48 (13) 7.13 (10)
Broker 5.66 (8) 6.09 (7) 8.18 (16) 5.08 (41)
*Includes such criteria as whether the broker offers financial planning tools, provides unlimited real-time quotes and offers buying power updated in real time. See http://www.gomez.com/scorecards/methodology/cfm?topcat_id=3 for more on methodology.