Monday, October 4, 2010

The right attitude about commissions

Are full service stock brokers charging too much commission? Are mutual fund managers charging too much management fees? Are real estate commissions too high? Who cares?

As an investor you cannot do everything. One of the first things you learn is that you need to surround yourself with a good team of experts and advisors. It is not only important to have the right leverage for your investment portfolio, it is even more important that your time and efforts are properly leveraged.

As a small investor it is expensive to hire a full time staff of lawyers, stock brokers, portfolio managers, property managers, financial planners, etc. So, you pay them piece meal using commissions! These people make up the staff of your investment company. Whether small or large, your investment company will need staff.

Guess what happens if you do not properly compensate your staff? Staff typically does not only work for money; a lot of satisfaction is found in providing the right service and in adding value to the company. But motivational studies of employees have found that a certain level of compensation is required along with the recognition that staff contributes to the overall company success.

A good team that enthusiastically works for your investment company deserves to be treated with respect, empowerment, recognition of contribution and appropriate compensation (commissions). Of course, the performance of your employees should contribute to your company’s bottom line. In fact, I do not necessarily care how many hours my staff puts in, I only care for how much they add to the bottom-line.

When you invest in Berkshire-Hathaway do you care about how much Warren Buffett makes or do you care more about the returns you receive from investing in that company? If you have a person that markets your services do you care how much that person makes or is it more important that you sell profitable services and make a certain amount of money?

I teach sometimes geology courses using a marketing agency. They always are concerned about me being concerned how much commission they charge. I tell them, I don’t care as long as I get paid at least what I want. The Agency can even set the price of the courses that I teach and often I have no idea how much they charge participants. Why should I? Since my courses are offered via several avenues, agencies that charge too much will not sell and clients will go buy the course using another agency. The same is true for my investment company; I really don’t care how much my staff makes in commissions as long as I get what I want.

Take for example mutual fund investments. In most cases I want at least the same performance as a comparable stock market index (e.g. the TSX). Since most mutual fund managers and their companies cannot achieve that performance I look for an alternative. Solution, Exchange Traded Funds or ETFs! You may also look at Index Funds. Either way, the fees charged by these funds are low enough that I get the desired performance.

If ETFs did not perform, I could always buy the individual stocks that make up the exchange index. This maybe a bit difficult to do for a small investor and for them buying ETFs through a discount broker makes sense. So here we introduced a few important concepts:

1. For small investors to set up a diversified portfolio it is more cost efficient to buy an ETF fund rather than buying stocks piecemeal. Just image buying 1 share of the Royal Bank at $53.00 plus a minimum full brokerage commission of $85. Next you buy 0.94 shares of TD Bank for $63.00 per share or $59.22 plus $80 minimum commission. This would be crazy!

2. Even if you would buy every month $100 of a particular ETF a full service brokerage minimum commission of $80 for each trade would not make sense. Hence the small investor ends up at the discount brokerage. Even if such a small investor would want to retain a full service broker, he/she would have to have a minimum portfolio size before it becomes worthwhile for the full service broker to take you on as a client. So this is clearly a two-way street.

The staff that you hire has to fit-in with your small investment company model. Even for a larger investor, using a full service broker to buy an ETF fund often does not make sense. Such an investor would still use a discount broker for this type of investment. The same is true when trading options, for example covered calls (which we may discuss in future postings). Often the high commissions of a full service brokerage do not make sense and these trades (up to a certain level) can be done more efficiently by the discount broker.

When your investment portfolio is large enough you may want to buy shares in individual companies, then it is time for a full service broker. However before going that route, most people first will buy their starter home. So that is the time to start looking for a Realtor on your team instead. Even though you are investing initially in ETFs, this should not stop you from studying stock market investing or investing in realty. Your investment education should start even before you put your first penny into a discount stock brokerage account and you will continue learning until the end of your life.

After you have read a few books on stock market investing and possibly attended some seminars on real estate investing, you are still a beginner. So, when buying your first house with all the pitfalls of real estate would it not make sense to hire an expert if you could? Of course it does! The Realtor enters the stage. You are lucky, the Realtor does not require a minimum account size and he does not even require you to pay a commission. The seller will take care of the commission. Wow!

As always there are exceptions, but if you stick to an MLS listed property (and there are plenty) the seller pays the commission. Yet Alberta law states that your Realtor has to act in your best interest not that of the seller. The seller is represented by his/her own Realtor as well who has to act in the seller’s best interest. Often the total commissions involved for selling a property in Alberta are 7.5% or $7500 on the first hundred thousand dollars and 3% on the remainder of the purchase price. So on a $250,000 starter home that would be $7,500 plus $4,500 is $12,000 dollars. A lot of money! However, only half ends up with the buyer’s Realtor and the other half with the seller’s Realtor; so $6,000 for each. The Realtor has to pay out of this his/her expenses but really you don’t care about that.

So, this is the time to select your new staff member for your growing investment company, the Realtor. A lot of consideration goes into the selection of your new staff member. Realtors vary in experience level, service level, expertise (residential, commercial, investment properties) etc. So once you have decided what kind of property you need then you can define what type of Realtor you need. I suggest you don’t select a Realtor for just one deal but one with whom you build a relation that could last for many transactions. As long as you pay for the property what you want, you really don’t care what the Realtor gets. And guess what, as long as you get the service and results you desire when you sell a property, you shouldn’t care about what the Realtor gets either.

Use your Realtor to teach you in Real Estate and real estate investing. Even after you bought many houses, you still may find it useful to use a Realtor. Often you have enough experience by that time to do all by yourself. Yet, do you really want to spend a lot of time on finding your next property or on selling it when a Realtor can do it more efficiently and with less trouble? Isn’t your time better spent on more profitable matters – things you are expert in?

Now that you are securely established in your starter home, your investment money has reached the level where you could use the services of a full service broker. Now you may be interested in a more targeted portfolio and you will need some objective advice and ideas. Your investment company’s staff is in expansion mode once again. You don’t pay minimum commissions anymore on your trades and your stockbroker (who has gone through a couple of stock market downturns and spends all day yakking about and dealing with stocks) will be not only buy/sell investments. Your broker will generate investment ideas and act as devil’s advocate for your investment ideas while providing market background information. As long as you get the value and performance you need, you really don’t care how much you pay your staff. Of course, you should compare what other brokers charge. But apart from working at a reasonable level of commission, the performance of your broker and how comfortable you feel working with him or her is more important.

Overtime you will deal with more and more people and your investment company will grow as well as the company’s staff. You are the CEO and Chairman of the Board. You decide the direction of the company and which staff members perform, meeting your company’s needs, and those that you no longer wish to retain. You may also notice that when your company evolves, your staffing needs change as well. So, really, there is no need to worry too much about commissions, you will hire staff when your company grows and when you are ready. The commissions will prove to be justifiable.

Some investors fret forever about commissions and it is no fun for their company’s team members to deal with them. There is something called the ‘pain factor’ and it seems that those people who always complain about commissions also represent the investors with the highest ‘pain factor’. These investors are just not worth dealing with; they’re causing too many problems (pain) and are not worth pursuing. The result is obvious; these investors are not likely to attract the staff their investment company needs.

Are you ready to set up your investment company and hire the staff you need to achieve success?

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