Stock buying techniques

Stock buying techniques

Holding securities directly

So if you want to buy individual stocks through a broker, how should you do it?

First, you'll have to open an account with a broker. If you don't plan on trading much, you can open a cash account which means you'll have to pay for the stocks or other securities soon after you place your buy order. This way you can take custody of the securities and have dividends and proxy materials sent directly to you.

Street name

However, regulatory changes are making it more difficult to hold securities personally. And if you plan on trading a lot, you'll have to hold your stocks in so-called street name.

When you put your stock into street name, you're still the owner of the shares, and you control all trades in your account. However, placing the shares in street name means the broker acts as your custodian for the shares. This allows you to trade stocks more quickly.

If you're a trader, you'll also probably want a so-called asset management account. This is a checking account or money market account offered by the brokerage house.

You can use the account like a regular checking account, but you also can use it as a vehicle to buy or sell other securities. Your broker also can sweep the dividend and interest payments from your securities into your account.

If you place your shares in street name, make sure your broker offers SIPC insurance. SIPC stands for Securities Investor's Protection Corporation.

The SIPC is similar to the Federal Deposit Insurance Corporation. The SIPC insurance is there to help you get your money back in case your broker goes bankrupt while holding your securities.

However, the SIPC does not insure your individual holdings against loss. If your stock goes down, you just lost money. This is different from FDIC insurance which insures bank depositors against any loss in principal.

Wrap accounts

Although asset management accounts are a reasonably good deal if you want to do a lot of trading, you should avoid wrap accounts. Different brokerages use different names for wrap accounts, but they all involve expensive advice.

In a wrap account a money manager normally will invest your money in various stocks, bonds and even no-load mutual funds. Wrap account money managers may provide good advice, but the cost is too high.

Most wrap accounts levy an annual fee of 2 to 3 percent of assets under management. This is way too much, especially when you consider the fee is in addition to any fee the underlying mutual funds may charge.

If you want advice, fine, but don't pay 3 percent of your assets for it. A more reasonable fee is 1 percent. Better yet, deal directly with no-load mutual funds and save yourself a bundle.

Trading authority

When you open an account with a broker, she might ask you if you want to give her trading authority over the account. This probably is a mistake for most people.

A broker might say that giving her the authority to actively manage your money will be to your advantage, but there's an opportunity for abuse. The most obvious threat is churning.

Churning occurs when the broker switches you in to and out of a number of different stocks in a short period of time. The broker says she's trying to put you into the best stock, but the real intent is to generate commissions.

If you travel a lot or otherwise have special circumstances you may want to grant trading authority to your broker, but it's usually best to control trades yourself.

Margin

When you open an asset management account or otherwise hold your securities in street name, the broker will ask you if you want to open a margin account.

Margin loans enable you to buy more stock than you could otherwise because the broker extends you a loan. These loans are safe for the broker because the loan is secured by the stock you're buying.

You presently can borrow up to 50 percent of the value of your stock. You can borrow up to 70 percent of the value of less volatile corporate bonds, and up to 90 percent of US Treasury bonds if you have a margin account. You also can borrow against mutual fund shares you own if they're held in a mutual fund supermarket from a brokerage like Schwab or Fidelity, which I describe in my tape on mutual funds.

Brokers of course charge interest on the money you borrow, and some brokers make more on margin interest than they do on commissions.

Margin loans might not be a bad idea if you need a short-term loan and want to avoid the capital gains taxes associated with a sale of your securities, but I can't recommend that you use margin to amplify your potential investment gains.

And whatever you do, don't buy volatile small company stocks on margin. Buying a high flying small cap stock on margin might seem like a good way to get rich quick, but when the stock starts to fall, the margin call might kill you.

Short selling

Finally, short selling is another esoteric way of playing the stock market. When you sell a stock short, you're betting the stock will go down, not up.

There are, however, regulations and other quirks which limit the profitability of short selling for individuals. Short selling is something best left to investment professionals.