Wall Street Journal Online's Guide to Online Investing : How to Make the Most of the Internet in a Bull or Bear Market

by PETTIT, DAVEJAROSLOVSKY, RICH

• ISBN13: 9780609807385
• ISBN10: 0609807382
• Edition: Reprint
• Format: Trade Paper
• Copyright: 2002-01-01
• Publisher: Three Rivers Press

Summary

The clearest, most practical guide for steering investors through the Internet's vast array of financial information, tools, resources, and opportunities . . . from the Internet's most authoritative and successful source of financial and business information. The only book investors need to reap the rewards and avoid the treacheries of the investing cyber-jungle. The Internet world has changed drastically in recent years, but that doesn't mean you should shy away from online personal investing. It simply means that Internet investors need to be more careful in navigating through a confusing, possibly treacherous cyber-jungle. Who better to guide you than the reporters and editors of The Wall Street Journal Online, the Internet version ofThe Wall Street Journal, the world's most authoritative source of business and financial information? In this updated paperback edition, Dave Pettit, Rich Jaroslovsky, and the reporters and editors of The Wall Street Journal Online provide you with the best and most complete coverage of everything you need to know about online investing. The 1990s dot-com euphoria is over, but you can still use the Internet to your investing advantage. You just need to know how. Let The Wall Street Journal Online show you. Special offer for a discount subscription to The Wall Street Journal Online inside.

Author Biography

Dave Pettit is deputy managing editor of <i>The Wall Street Journal Online</i>.<br>Rich Jaroslovsky is senior editor of <i>The Wall Street Journal</i>, helped create <i>The Wall Street Journal Online</i>, and was its first managing editor.

Table of Contents

An Introduction to Online Investing	1	(11)
Part One
Trading Stocks Online	11	(56)
Initial Public Offerings	67	(23)
Day Trading	90	(10)
Mutual Funds	100	(34)
Bonds, Futures, and Options	134	(43)
Part Two
Tools of the Trade	177	(31)
Message Boards	208	(23)
Scams and Deceptions	231	(26)
Recourse	257	(16)
Banking and Other Personal Finances	273	(50)
Appendixes
Getting Online	293	(4)
Glossary of Message-Board Jargon	297	(4)
Major Online Brokerage Firms	301	(1)
URLs Used in the Text	302	(19)
Permissions	321	(2)
Index	323

Excerpts

Trading Stocks Online

It started out as a curiosity, quickly became a fad-and now it's a revolution. The simple act of tapping a stock trade into a personal computer has transformed a multi-billion-dollar industry. The biggest names on Wall Street have had to tear up their business plans. "My broker says" has been replaced by "I read on the Net." Some of this interest will be fleeting. The public's fixation with stocks and trading clearly was stoked by the historic bull market that swept stocks higher through much of the 1990s. As investors have seen since then, it is a lot more fun to talk about stocks-and easier to make money trading them-when prices seem to do nothing but rise. A long bear market for stocks (or even a period of stagnation where prices barely move) takes the glamour out of trading.

For some time, many on Wall Street bet that a bear market would quickly snuff out online investing. (In fact, the Internet itself was considered a fad at first. Many predicted that interest in the Net would quickly fade out-a 1990s version of America's brief 1970s infatuation with citizens band radios.) But that talk petered out as Internet-accessible brokerage firms posted year after year of growth in customer accounts, even when the market struggled.

Charles Schwab & Co. (www.schwab.com) was the first established brokerage firm to embrace the Net, and it quickly saw thousands of its clients give up its toll-free phone lines and place their orders online. By the end of 2000, more than 80% of its stock trades came in over the Net, and across the industry, roughly one in five stock trades originated from orders that were placed online. In 2001, there were more than 20 million online brokerage accounts, up from just 1.5 million in 1996, according to Gomez Advisors, an Internet consulting firm in Lincoln, Massachusetts. The number of accounts is expected to top 50 million in 2004, estimates Forrester Research in Cambridge, Massachusetts.

As if any more evidence were needed that Wall Street couldn't

afford to remain aloof from online investing, Schwab's total stock market value edged above that of Merrill Lynch & Co. (www.ml.com) in late 1998. If there is one measuring stick that always has Wall Street's attention without fail, it is the stock market. Schwab, a discount-brokerage firm barely 25 years old, was king of the hill. The fun didn't last for Schwab, though. Its value plunged when the stock market soured, falling back to half of Merrill's level.

Trading volume shriveled on Wall Street-online and off-line-when the late 1990s tech-stock bubble burst. And online firms, whose earnings depend more on commission income than big investment banks like Merrill, saw their share prices plunge. But even as investors traded less frequently, they still were opening new online accounts. Schwab alone, amid the slump, added 600,000 active customers in one twelve-month stretch. Investors sought more advice from the brokers and account growth leveled, but there weren't any signs that large numbers were fleeing back to traditional, old-line brokers.

Few people expect online stock trading to go away. Even Merrill is deeply committed to online trading. The phenomenon has clearly touched a nerve with the investing public and tapped into investors' desires to use technology as a means to accomplish things cheaper and faster. "Take my word, it's really easy," said Charles Schwab, founder of the company that bears his name. "Even I can do it, and I'm all thumbs." Mr. Schwab called online trading "the ultimate empowerment of the individual." As Home Depot discovered, we really are a nation of do-it-yourselfers-whether it's hanging wallpaper or buying a stock.

FIRST AND FOREMOST: IT'S CHEAP

There are many reasons to trade online, but the most obvious one-and the one that first caught the attention of investors-remains its biggest selling point: Online brokers are just so dirt cheap.

E*Trade, one of the first cyberbrokers and the one that first really captured Wall Street's attention, stunned the industry in 1996 when it went on the Internet with a $14.95 stock commission-and launched its in-your-face "Boot Your Broker" advertising campaign. Like the discount brokerage firms (which offer trading but little or no advice) that sprang up in the mid-1970s after the Securities and Exchange Commission put an end to fixed stock commissions, online brokers had found a cheaper way, through new technological efficiencies, to offer an old service.

Because of the way brokerage firms charge for stock trades, it's difficult to compare prices precisely. Internet brokers usually charge flat rates, often for transactions up to 1,000 shares, with additional fees for larger or more complicated orders. Traditional brokers, by contrast, levy fees based on how much stock an investor wants to buy or sell, and how much the stock is trading for at the time. But, even factoring in the discounts many big brokerage firms reserve for their best customers, online brokers charge commissions anywhere from half to one tenth, or even one twentieth, the cost of an old-style full-service trade.

That's changing-but not because online brokers are becoming more expensive. Instead, traditional firms have reworked their pricing structures to become more competitive. Even mighty Merrill Lynch, long the most popular brokerage firm for individual investors, and one that for years dismissed the online trading phenomenon, now offers online trading accounts designed to stem the flow of business out of the firm. One type of account offers trades for $29.95, but no advice from a broker. Another promises unlimited trades, either over the Internet, by phone, or with a broker, for an annual fee based on a customer's assets. Right now, Schwab is charging many of its customers a relatively steep $29.95, but that's still far less than the $300 a customer in a traditional Merrill account (it's still offered) would pay to buy, say, 300 shares of a stock traded on the Nasdaq Stock Market. The same trade would have cost $19.95 at E*Trade (because trades for Nasdaq stocks cost more than those for issues listed on the New York Stock Exchange), and $9.99 at high-tech Datek Online. The fee at George Brown & Company, a niche firm based in Boston and now owned by J. P. Morgan Chase? A mere $5.

Traditional brokers, of course, also offer sophisticated advice and financial planning along with their stock trades. That's the card full-service firms, such as Merrill and Salomon Smith Barney, hope to play as they try to woo cyber-savvy customers with their new Internet-based accounts. These firms are betting that investors still want-and need-the help of a broker. Schwab, which controls the biggest share of the online stock-trading business, seems to agree, at least up to a point. In another example of how the Net has turned things upside down, Schwab-which made its name offering stripped-down service and low prices-now markets itself, in part, by calling attention to the service and advice it offers customers, contrasting them with the bare-bones firms that offer still cheaper trades. Those even less expensive firms offer no apologies for their lack of bells and whistles. That, they say, is what their customers want. "Our customers are financially literate," explained Jeffrey Citron, the former chief executive of Iselin, New Jersey-based Datek. "They know exactly what they want to buy."

Not everyone is that sophisticated. But even less savvy investors probably realize that most professionals, with all their stock-picking prowess, usually can't beat the returns of major stock market indexes. So why pay more for their services?

"If you're paying 1.5% each way on a trade, or if you're paying 1.5% or 2% a year (to have your money managed) and you're not even doing as well as the averages, how do you ever make up the cost of this intermediary who's actually sucking value away from you?" said Samuel Hayes, a professor of investment banking at Harvard University. But that's not to say that people who opt to do it themselves necessarily do the right thing on their own. Many investors jump "from the frying pan into the fire" trying to pick a handful of winning stocks once they are out on their own, rather than buying and holding a selection of mutual funds (mostly index funds) as the bulk of their portfolio.

Ever-falling commissions marked the online brokerage industry's first few years. The $14.95 commission at E*Trade was followed by the $8 trade at Ameritrade in late 1997, promoted by a huge advertising campaign. Soon after, Quick & Reilly, now a unit of Fleet Boston Financial Corporation, launched a deep-discount broker called Suretrade (www.suretrade.com), which boasted a base commission of just $7.95 a trade. Many other sites emerged offering commissions of $10 to $12 a trade, including Datek Online (www.datek.com) and TD Waterhouse Securities (www.tdwaterhouse.com), which are now two of the biggest online firms. (Suretrade has since folded into Quick.)

To some extent, online commissions stabilized after that push below $10, though many firms have offered even deeper discounts to active traders or very wealthy customers. In 1999, American Express Company went so far as to offer some free online trades to customers who brought $25,000 or more to the firm and early in 2000, Schwab cut the commissions it charges its most active clients to as low as $14.95. Now, the battle largely has shifted to competition over who will offer the best services-such as customer service, personalized advice, and Wall Street research. There are signs that costs will rise for inactive investors. TD Waterhouse in 2001 raised the price of its basic online trade to $14.95 from $12.

GOOD-BYE, CHURN AND BURN

Stockbrokers have never had rock-solid reputations as trusted professionals. A 2001 Gallup public opinion poll found that in terms of honesty and ethical standards, stockbrokers ranked higher than lawyers and car salesman-but lower than journalists and building contractors.

Online brokers know that, and they're milking it for all it's worth.

Most stockbrokers are honorable, well-trained people. But for years, investors have lodged very legitimate complaints about traditional brokers who were more concerned with pushing a stock underwritten by their firm-in other words, a stock the firm needed to unload-than finding solid, suitable investments for their customers. At many brokerage houses, brokers get paid more for selling in-house products, such as mutual funds managed by the firm's portfolio managers, than outside products, regardless of the funds' performances. Even today, securities arbitrators, who handle all disputes between brokers and their clients, routinely face cases in which investors allege that brokers simply "churned" their accounts, recommending transactions mainly to generate commissions for themselves and without regard to the portfolio's rate of return.

"I have no doubt that some of the people who have gone online are the people who have had the horror stories," said Harvard's Professor Hayes. Indeed, it's hard to forget disasters such as brokerage firms' aggressive sales, in the 1980s, of limited partnership investments in everything from oil exploration to real estate. Many investors eventually filed claims charging they were never informed of the hefty risk of such investments. Prudential Securities, for one, paid $330 million in 1993 to settle SEC civil claims of widespread fraud in selling limited partnership interests. Its parent, Prudential Insurance Co. of America, has paid nearly $2 billion in legal fees and restitution.

That fundamental conflict-between generating income for the brokerage house and creating a safe, suitable portfolio for the investor-is something online brokers have exploited and parlayed into a resonant marketing message, and one that has undoubtedly helped their business. A famous television advertisement from E*Trade plays off the public's distrust of brokers and envy of their big paychecks by opening with an enticing shot of a brick mansion. An attractive, well-dressed couple strolls up the front walk. When the two reach the front door and turn around, an announcer intones, "Your investments paid for this dream house." The man and woman turn around, smirking. Then the kicker: "Too bad it belongs to your broker."

Many cyberbrokers, most notably Charles Schwab, tout their services as "unbiased," saying they have no interest in peddling any particular product. Schwab doesn't underwrite any stock deals, and its employees don't get paid based on the commissions generated by each customer. Though firms like Schwab and E*Trade make more money as the number of trades they execute grows, most of their employees receive flat salaries and bonuses, compared to the commission-based pay structure at most traditional brokerage firms. There are no "cold calls" from online brokers interrupting dinner or aggressively selling tiny stocks you've never heard of. Instead, the new Internet brokers have positioned themselves as mere trading and investment-information vehicles.

But even though online brokerage firms don't employ any unscrupulous individuals who aim to churn your account in search of commission fees, that doesn't mean plenty of online trading accounts aren't churned. Typically, though, the guilty party in these cases is the online investor himself. With the ease and low cost of making trades from the comfort of their office or home, many investors trade far too frequently and thereby rack up commission costs, instead of buying and holding stocks and funds.

THE CULTURE OF INVESTING

Even before online brokers burst onto the financial scene in 1996, Americans' love affair with the stock market had already blossomed. The reason was simple: For nearly 20 years, companies had been gradually shifting more responsibility for retirement saving and planning into the hands of their employees, instead of managing big pension funds themselves.

The rise of the tax-deferred 401(k) account, coupled with growing concerns about the adequacy of Social Security, meant many Americans had no choice but to focus on saving and to bone up on investment strategies. How could they amass enough money to retire if they couldn't figure out which mutual funds to buy and how long to hold them? That meant understanding expense ratios (a measurement of annual fees charged by funds), interpreting 10-year performance charts and wading through thick fund prospectuses. Many have done it: By 1999, about 44% of Americans owned mutual funds, up dramatically from about 6% in 1980, according to the Investment Company Institute.

The robust bull market of the 1990s intensified this investing fervor and made Americans more confident about investing in mutual funds as well as in individual stocks, whether through retirement plans or brokerage accounts. In 1999, the Dow Jones Industrial Average crossed the 10,000-point barrier, a milestone emblematic of the country's economic strength and Americans' seemingly unshakable faith in the stock market. The industrial average had tripled in just seven years.

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Excerpted from The Wall Street Journal Online's Guide to Online Investing: How to Make the Most of the Internet in a Bull or Bear Market by Dave Pettit, Rich Jaroslovsky
All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.