Merrill Lynch Bows to the Inevitable

At this point, hearing someone talk about his stockbroker sounds about as odd as having someone tell you he wants to go the soda fountain for a root-beer float. The mainstreaming of discount brokers–most obvious in the precipitous rise over the last decade of Charles Schwab–and, more recently, the advent of online trading (remember that the two phenomena are actually distinct, although online trading has certainly accelerated the growth of discount brokers) has revealed brokerage commissions as the preposterous vestiges of a regulated era that they always were, while the bull market has arguably convinced people that they’re smarter traders than they really are.

Of course, a huge number of Americans still have stockbrokers. If you spend too much time on the Internet, it’s easy to believe that everyone else does as well. But the number of investors who use E*Trade, Ameritrade, Datek, and all the rest is still dwarfed by the number who invest through Merrill Lynch, Paine Webber, etc. But this will not last forever, which is why last week Merrill rocked the brokerage industry by announcing that at long last it would be offering its customers online trading for $29.95 a trade. That’s still almost four times as expensive as the cheapest discount brokers, but when you consider that Merrill’s average commission is currently better than $200 a trade, it’s a significant concession.

Not surprisingly, the market almost immediately knocked Merrill’s stock down sharply. The company employs 14,000 brokers, and derives a quarter of its annual income from its retail brokerage business. That doesn’t look like a company that will be able to adjust to an entirely new cost structure with the greatest of ease.

Merrill is hoping that it can retain its brokers by encouraging most of its clients who are interested in discount trading to move instead to what Merrill’s calling a relationship account. That will give clients access to a real broker and assorted other perks–Visa card, ATM and checking access, mortgages–in exchange for 1 percent of a client’s annual assets. The logic behind the relationship account is sound, so sound in fact that one wonders why Merrill didn’t embrace it before. (The answer, of course, is that it didn’t want to give up those fat commission checks.) Charging per-trade commissions was always an incredibly dubious approach, given the fact that the broker’s incentive was to encourage his clients to trade, even though trading heavily is, for most people, a recipe for disaster. Going to a fee-based structure at least takes that incentive away.

The broader question, though, is whether the advice people get from their brokers is worth 1 percent of their assets. It’s undoubtedly true that the hype surrounding online trading has given people a false impression of the ease with which money can be made in this market. Reading this week’s New York magazine, for instance, it’s impossible not to feel as if all these stories about people making hundreds of thousands of dollars day trading always fail to omit the crucial coda, when the day-trader’s favorites stocks crash and his fortune dries up. The next time you hear someone talk about how much money he’s made, ask him how much he started with and when and then compare his performance to the market as a whole. Only rarely will you find someone outperforming the market over any significant period of time.

But that doesn’t mean that brokers are going to do any better. The argument that brokers are important because they help people think concretely about things like asset allocation, planning for the future, and savings patterns has always seemed plausible to me. But looking to brokers for stock tips or inside information is silly, because it rests on the idea that brokers have some special insight into the market. They don’t. Now, they may very well be smarter and know more about investing than their clients. But that’s irrelevant. The only important question is whether they know more than the market does. If they don’t, the alternative is clear: Invest in an index fund.

In the wake of the Merrill announcement, we’re hearing a lot of people say that brokers take an unfair rap. The New York Times went so far as to write, “Many are honest and hard-working, and bring years of experience and professionalism to bear on their clients’ behalf.” That’s probably true of brokers, just as it’s true of barbers and optometrists. But it doesn’t matter. What brokers were expected to do was always beyond their capabilities. It just took deregulation and the rise of real competition to make that clear.