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Are Stockbrokers Parasites?

The truth about stockbrokers
An Illuminating Conversation
The following conversation appeared in a classic book on stockmarket investing, "The Money Game," by
'Adam Smith.' (That's a pseudonym. The author's real name is George J. W. Goodman.) In the
conversation, the author is talking to a stockmarket investor, Mr. Thatcher, who after having dealt with
many stockbrokers, is a frustrated man:
"A broker," said this Mr. Thatcher, "is a true parasite. He is the most overpaid individual in the world. He
doesn't produce anything. He doesn't make shoelaces, he doesn't tell you the law, he doesn't make the
traffic move. He just takes orders, like a clerk, and for this - do you see the size of those commissions?
Fantastic! When trading gets light, the brokers scream, they want to raise the commissions. But when the
trading goes from five to ten million shares a day, do we hear that commissions are being reduced? We
do not. The brokers just sit there piling up the money."
"You're not happy with your broker," I ventured.
"The one I've got now," said this Mr. Thatcher, "is no more a thief than the rest of them. The jails aren't
big enough to hold all the brokers who should be in them. Take information. When a broker gets a piece
of information, does he call me right away? No. First he buys some himself, then maybe he calls me. I
always ask, when he calls up to tout me, has he bought it yet himself. If he hasn't, I don't buy. Of course,
when I want to talk to the bastard, half the time I can't get him on the phone."
"He's busy."
"He's busy all right, the lousy tout. And take selling. You think they tell you when to sell? Never. First they
sell themselves, then you watch the stock going down day after day, you can't get them on the phone,
finally you get them they say, 'While the outlook near term is uncertain, long-term holdings need not be
disturbed.' They suckered me in with that a couple of times, but no more. That means, 'I sold last Tuesday,
Charlie, and I forgot you were still in that dog.' You know how long that long term they talk about is?
Five hundred years. Maybe seven hundred years. But whatever happens, they make it, coming and going.
You make money, they take those commissions. You lose money, they take commissions. You leave your
account alone, they call you up and tout you, they don't make any money when it's sitting still. It's got to
keep moving or they starve to death. That's what's wrong with the system. They have to keep pushing.
They don't get rewarded for doing a good job, like a brain surgeon. They could put you in some stock,
that would go up ten times, but then they would starve to death, they only get the commissions when you
buy and sell. So they keep you moving. The other thing wrong with the system is the type of person who
becomes a broker. Who would stand to sit and watch numbers all day, making unconscionable amounts of
money from touting on the telephone? A bookie maybe, or a thief. They're all thieves."
"You haven't done too well in the market, I gather."
"I've done just as well as anybody else, you can't believe half of what people tell you. Especially brokers.
Did you ever hear a broker say, 'I don't know' when you ask him a question? No. He's always got an
answer. 'Why is my stock going down?' Profit-taking, he says. 'Why is the market going down?' Taxes are
going up, he says, or the President is having a press conference this afternoon, or there is a war
somewhere. They can never tell you anything straight, they are so used to lying.
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"Take my Syntex. I should have sued the lousy thief who put me into that. This was on the last swing. The
stock has a good move, from eighty to one hundred ten. I tell this lousy tout, I say, I want to sell if it's
going down. He says the future looks good. The stock drops to seventy, I'm actually losing money. After
seventy all of a sudden he sees the problems, the stupid lousy tout. He wouldn't let me sell at one hundred
ten, but at seventy he makes me sell.
"Well. naturally I canned that guy. But the next broker was no better. First he touts me into a couple, they
barely move, he touts me out again. Then I give him one I heard at the country club, United Fruit isn't
making bananas anymore, something like that. The stock is twenty-eight, at thirty-five the lousy tout
makes me sell. The stock goes right on to fifty-five but the lousy tout makes me sell. Then he makes me buy
some piece of junk he's touting."
"It sounds like you need a better broker."
"There's no such thing. They're all lousy touts hustling commissions. If there was a good one, he wouldn't
stay. Saint Peter would grab him, an honest broker makes a marvellous example for the angels. Believe
me, I've had half a dozen brokers. They're always touting, and they're always a right a little, and then they
tout you out of what you know is right."
"You ought to follow your impulses."
"That's all very well, but I'm a busy man. I could beat these touts seven ways from Sunday, but I don't
have time, I've my own business to take care of."
"It sounds like you ought just to use a broker to execute orders, not for any kind of advice."
"I should. I should. I'd be a rich man today if the lousy touts didn't always make me sell at the wrong time,
or buy the wrong stock."
Rarely will you find a piece of literature that so accurately portrays the current feelings of thousands of
Indian investors who trusted their brokers, and who, consequently, are now cursing themselves. The
reason for including the above conversation in this column, however, is not to rub salt on your wounds, if
indeed, you're a wounded soul. Rather, the objective is to highlight some fundamental issues about the
stockbroking business that you should know.
Fundamental Conflicts of Interest
What the above conversation points out is that there is a fundamental conflict of interest in the brokerage
business: Your broker is not in the business of making money for you. He is in the business of making
money from you. Stockbrokers do not make much money from investors who buy and hold for a long
time. They make lots more money from speculators and traders who frequently switch from one stock to
another. It's quite understandable why brokers love hyperactive clients. After all, the brokerage industry's
income depends upon how often prescriptions are changed, not upon the effectiveness of the medicine.
Investors, on the other hand, make money not from flitting like butterflies from flower to flower but from
buying stocks of great companies at reasonable prices and then holding them for a long, long time.
Brokers, typically try to talk their investor clients into selling their good stocks by giving some stupid
reasons, such as "You can always buy it back later at a much cheaper price," or "you can't go broke taking
a profit." This reminds me of two quotes, one from Warren Buffett and another from Charlie Munger,
Buffett's partner:
"A parent company that owns a subsidiary with superb long-term economics is not likely to sell that entity
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regardless of price. "Why," the CEO would ask, "should I part with my crown jewel?" Yet that same CEO,
when it comes to running his personal investment portfolio, will offhandedly - and even impetuously move from business to business when presented with no more than superficial arguments by his broker for
doing so. The worst of these is perhaps, "You can't go broke taking a profit." Can you imagine a CEO
using this line to urge his board to sell a star subsidiary? In our view, what makes sense in business also
makes sense in stocks: An investor should ordinarily hold a small piece of an outstanding business with
the same tenacity that an owner would exhibit if he owned all of that business." - Warren Buffett.
"There are huge advantages for an individual to get into a position where you make a few great
investments and just sit back. You're paying less to brokers. You're listening to less nonsense." - Charlie
Munger.
The Economics of Stockbroking
Any industry - manufacturing or service - can be examined by looking at a few key factors. The same
rules apply to the business of stockbroking.
The first thing to remember is that stockbrokers sell a commodity service - one that cannot be successfully
differentiated in a customer-important way. By this I mean that 100 shares of Tisco bought through
Jardine Fleming are similar in all respects to 100 shares of Tisco bought from the your nephew sub-broker
operating from his bedroom with one telephone line and an assistant who is also his wife. You won't get
higher dividends on your shares simply because you bought them from Jardine Fleming.
It's not that stockbrokers don't try to differentiate themselves from their competitors. They try very hard.
But my point is that while they may be able to differentiate themselves, say, by offering additional
services such as a quicker execution of orders, usually they are unable to recover the costs of
differentiation by charging a sufficiently high commission or by doing sufficiently larger amount of
business on your behalf. This inability of stockbrokers to pass on the cost of differentiation arises out of
the commodity nature of the service.
The second thing to remember is that the volume of business done by stockbrokers depends upon a factor
which is largely unpredictable and is also beyond the control of any individual stockbroker. That factor is
liquidity. In highly liquid markets, by definition, a large number of buy and sell transactions occur every
day. The more the transactions, the more the volume of commissions generated. Liquidity, however is
unpredictable because it depends on the movements of stock prices. Bull markets are highly liquid
because a large number of investors, sitting on unrealised profits in their portfolios sell their shares to
realise their profits. Usually, they reinvest the proceeds of sales back in the stockmarket. During bear
markets, however, investors sitting on large unrealised losses in their portfolios shy away from the market
in anticipation of better times to come.
If stockbrokers could predict the timing of bear markets, many would have quit at the top of the bull
market and sold off their stock exchange seats for a crore or so and bought them back for a few lacs
currently. The fact that no stockbroker did any such thing, is proof that stockbrokers cannot accurately
predict the timing of future bear or bull markets. This unpredictable makes stockbroking a highly cyclical
business.
The third point about the stockbroking business is that it has low entry barriers. Becoming a stockbroker
is not like becoming a brain surgeon. Anyone with sufficient money can become a stockbroker. The result
is that whenever brokers are rolling in money, which is during bull markets, thousands of new brokerage
firms are formed.
The fourth thing about stockbroking is that the costs of running a brokerage firm are largely fixed. Under
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The fourth thing about stockbroking is that the costs of running a brokerage firm are largely fixed. Under
these circumstances, the more the business a brokerage firm does, the higher will be its profitability, as
measured by returns on capital employed. But, it is precisely these cost-side pressures that result in the
conflicts of interests mentioned above. The generation of high volumes, that is more transactions, is very
much in the interests of a brokerage firm's profitability and very much against the interests of its clients.
The fifth thing about stockbroking business is that it is becoming more and more capital intensive.
Technological changes over the last three years have brought about a sea change in the way the business
will be done in the future. A few years ago, brokers could get by without investing too much in
technology. That day is gone. Today, no broker can hope to retain his clients if he does not invest in
technology. Moreover, motive of the extra investment is not future prosperity but mere survival. Take the
example of your friendly small broker. Three years ago this broker could offer you satisfactory service for
which he charged you a commission of say, 2 percent per trade. Now, with the advent of competition
from technology through the National Stock Exchange, this broker, if he wants to survive, has to invest
more capital in obtaining access to NSE terminals. The cost of this investment cannot, however, be
recovered from clients by raising brokerage fees. If your broker raises his fees to recover the cost of his
NSE membership, you will simply walk away to another broker charging lower fees. This extra
investment in technology, therefore, will not earn your broker any extra returns. It will merely protect his
current market share with no improvement in future profitability.
The combined impact of the above points can now be examined. When over-capacity exists in any capitalintensive, commodity-type business which is operating in a free market, then the results are predictable: a
price war. That is exactly what is currently happening in the stockbroking business. The arrival of NSE
has hugely increased capacity. The bear market has shrunk volumes dramatically. The net result is a huge
excess capacity.
Many Indian stockbrokers are suffering from a "triple whammy" effect. An example will explain this
effect. Assume that a stockbroker bought and sold a total of 1 crore shares in 1994-95 on behalf of his
customers. Assume further that the average market price of each share transacted was Rs 50. Also assume
that the brokerage fees charged on each transaction was 3 percent of value transacted. Under these
assumptions, this broker's total revenue for 1994-95, a boom year, would have been Rs 1.5 crores. If total
costs during the year were, say, Rs 25 lacs, this broker made a pre-tax profit of Rs 1.25 crores in one year.
Assuming a capital investment of Rs 20 lacs, this translates into a pre-tax return of 625 percent on capital
employed! Not bad at all.
Now fast forward to 1996-97, a bad year for brokers. Assume that due to the bear market, volume shrunk
to 50 lac shares and the average price of each share transacted fell to Rs 25. Moreover, due to competitive
pressures, the broker could not charge more than an average of 2 percent of the value of each trade. Under
these new circumstances, this broker will find, to his horror, that his total revenues have shrunk to Rs 25
lacs, a fall of more than 80 percent. The causes of this triple whammy effect are: (1) a 50 percent fall in
business volumes; (2) a 50 percent fall in stock prices; and (3) a 33 percent fall in commission rates.
While commission revenue has shrunk dramatically, costs, on the other hand, have moved up. Because of
hiring an NSE terminal, this broker might find that his costs have gone up from Rs 25 lacs in 1994-95 to
Rs 35 lacs in 1996-97 resulting in a loss of Rs 10 lacs. If capital investment remained constant, this
translates into a pre-tax return of minus 40 percent on capital employed.
From a return on capital of positive 625 percent in 1994-95, this broker ends up with a return of minus 40
percent in 1996-97! This is what a bear market does to a broker.
The reason why I have given such a detailed write-up on the economics of the brokerage business is that
you should understand why brokers do what they do. Brokers may be called parasites by frustrated
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customers, but the fact is that it is the fundamental economics of the brokerage business which makes
brokers act in ways which are directly in conflict with your interests.
Conclusion: Living With A Parasite
There are many things which you can do to make sure that you do not become a "host organism" of a
"parasite" stockbroker.
First, find a broker who only transacts business on behalf of customers and does not trade on his own
account. This means that he is in the business of making money only through commissions and not
through dividends or capital gains on securities. There are numerous additional problems in dealing with
brokers who trade on their own account. For example, a broker who is interested in making money in
stocks for himself may palm off the lemons in his portfolio to his clients. Or, a broker who trades on his
own account may use his client's money to speculate in the market and losing it all.
Second, avoid acting on your broker's tips without checking out the story on your own. Most broker's tips
are not worth the paper they are written on. That is not what your broker would like you to believe. So,
here's an experiment you can do to find out the truth for yourself. Get hold of all the buy
recommendations made by your broker a few years ago. In many cases, this should not be a problem as
brokers publish their recommendation in their newsletters. Next, construct a hypothetical portfolio by
investing, say, Rs 5 lacs, based on those recommendations. Next, mentally liquidate that portfolio as of
today and calculate how much hypothetical money you are left with. Let this be called figure A. Now
assume that instead of listening to your broker, you had invested Rs 5 lacs in an unmanaged portfolio, say,
the Sensex. Mentally liquidate that portfolio as of today and calculate how much hypothetical money you
are left with. Let this be called figure B. Only if figure A exceeds figure B may you assume (but still
cannot be certain) that your broker may be an skilled stockpicker after all. Invariably, you will find that
after taking all his recommendations, the record of your broker pales in comparison to the Sensex. You
can also repeat the experiment by benchmarking your broker against high-grade company fixed deposits. I
will not at all be surprised if you find that when all recommendations are taken into account they rarely
beat the returns offered by high-grade company fixed deposits.
Your broker would like you to believe that his recommendations work. He may cite past examples. You
should remember, however, that if anyone makes 100 recommendations, 10 or 15 are bound to do very
well. It is only when all 100 recommendations are considered over a long period and the results compared
with some passive strategy such as investing in the Sensex or fixed deposits, that you may be able to get
some idea about your broker's stockpicking skills.
Third, always use the services of at least two brokers and let them know this fact. Whenever you are
buying or selling shares, break your order into at least two parts and let each execute one of them.
Suppose you want to buy 500 shares of Bajaj Auto. Let one broker buy 200 shares and another 300. This
way you can compare their prices.
Fourth, avoid dealing with sub-brokers unless they issue contract notes on the letterhead of the main
broker they are representing. This gives you added protection in case things go wrong.
Fifth, whenever you want to transact, decide in advance the maximum price you are willing to pay for
shares that you wish to buy and the minimum price you are willing to accept for shares that you wish to
sell. Unless you are in a hurry to transact (which should happen only in exceptional circumstances), make
it clear to your stockbroker that you intend to stick to the limits imposed by you.
Sixth, buy and hold stocks. In other words do not trade. If you refuse to switch from one share to another,
despite your broker's prompting, chances are that he will leave you alone and spend his time convincing
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despite your broker's prompting, chances are that he will leave you alone and spend his time convincing
others to jump in and out of the market.
Note
This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based
company called Corporate Investment Research Private Limited.
Sanjay Bakshi. 1997.

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