Here at The Motley Fool, we have a pretty set opinion of whether you should use a full-service broker or a discount broker. We favor the discount brokers, who execute trades for about one-twentieth the amount that full-service brokers charge.

But in the spirit of fairness -- OK, we aren't going to be that fair, but indulge us -- we'll present some of what you should know about full-service brokers to make a more informed choice.

The way the financial industry tells it, you are hard-pressed to do very well without a full-price broker by your side, giving you tidbits of information while they execute your many trades. It is as if there are two doors for the individual investor to pass through. The first is a golden gateway to the nirvana of 10% annual returns without risk, the light from the other side shining through in an irritatingly bright manner. The second is a battered wooden wreck with a skull and crossbones painted on the front. Dangling from the arch is a sign warning, "Abandon All Hope, Ye Without a Broker."

Yeah, right.

The Truth About Full-Price Brokers

Full-service broker is the name given to those expensively dressed souls who work for Merrill Lynch, Salomon Smith Barney, Morgan Stanley Dean Witter Discover, etc. You've seen their oh-so-somber TV commercials too many times, particularly during sporting events and Sunday morning political commentary shows. These companies can afford to advertise during major TV broadcasts because they make a remarkable amount of money. A good deal of that lucre is made through "investment banking" (helping other corporations with their financing needs), but a very healthy percentage of the profits is made on the "retail side," through brokering.

Full-service (or full-price) brokers serve as the middlemen through which you can relay your trading orders to "the floor" of a stock exchange or to an electronic trading system. You send in an order, and they forward it on to their guys down in the trenches to fill for you.

Now, the phrase "full-service" indicates that these brokers are there to attend to ALL the needs of their clients. That includes generating investment ideas for you, giving you stock quotes whenever you request them, managing your account (in many cases), providing investment research materials, helping you with tax information -- the works.

In return for these services, the broker will charge you very high rates to trade stocks in your account. Where discount brokers typically charge between $5 and $20 for an individual online trade, you'll probably pay around $150 for the average trade done through the typical full-service broker. Further, full-service firms often charge annual "maintenance" fees through which they grant themselves a generous slice of your assets, say about $150 a year or more. Alternatively, full-service brokerages might grant "unlimited free trades" in an account, but would charge you around 1 to 1.5% of your total assets -- per year! In other words, full-service brokerages provide help at a very high cost. Very high.

OK, two problems here. (Actually, dozens of problems, but we'll keep it to a brief two right here.)

The first is that most brokers (or, more snootily, "Financial Consultants") who give advice are just glorified salesmen, shopping around their brokerage house's stock picks or pricey mutual funds. Brokers are getting paid a percentage (the commission) for every sale they make. While there are some knowledgeable brokers who do a knockout job for their clients, many aren't actually very good investors and lack impressive or even average performance histories. Certainly the performance of Wall Street brokerage "model portfolios," as reported from time to time in The Wall Street Journal, leaves virtually everything to be desired.

The second problem is that full-service brokers usually receive commissions on each trade, so their compensation is closely tied with how often their clients' accounts are traded. In other words, part of the commission YOU pay to the firm may wind up directly in your broker's pocket. So your full-service broker may be paid not for how well your investments perform (which is in your best interest, obviously), but rather on account activity (often the opposite of your best interest). Highly distressing. This is why full-service brokering of the common variety is rapidly wasting away with the increasing use of online brokerages.

Mark Dempsey, a former broker at Merrill Lynch, wrote a book about his experiences that he titled Robbing You Blind: Protecting Your Money From Wall Street's Hidden Costs and Half-Truths. In the book, Mr. Dempsey remembers saying to a colleague, "If the average investor only knew what really goes on behind the scenes with their money, they'd think differently about having us manage it."

We agree.

The full-service industry will save itself only when it bases its incentives on performance, not trading frequency. Your broker should be working to give you the best consistent long-term, market-beating return possible, and should receive bonuses based on a percentage of your long-term profits. Instead, he's getting paid slices of what he induces you to wheel and deal. Until this situation changes, we think you will continue to see full-service firms getting chopped at the knees by an ever-increasing amount of do-it-yourself investing.

It's certainly our hope anyway.

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