Kiplinger's Personal Finance Magazine: Goodbye Wall Street, hello Omaha

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Goodbye Wall Street, hello Omaha

Steven T. Goldberg

Ron sundermann is taking his shower, CNBC blaring so he can listen to market chatter. "The guy on the TV says the only stock he likes right now is Archer Daniels Midland. We have an ADM factory right here in Cedar Rapids, and the Andreas boys [the chairman and president of the firm] grew up near here. So I literally jump out of the shower and, dripping wet, run to the computer, fire it up and buy shares from my Internet broker."

He isn't buying for the long haul. Sundermann has noticed that stocks tend to spike after favorable mentions on CNBC or in other financial media. After a bit, enthusiasm usually wanes and the stock drifts down. So Sundermann puts a tight stop-loss under his ADM shares, which will trigger their sale if the price drops to a certain point. As the price rises, he moves the stop-loss up. Sure enough, he sells his ADM shares a few days later, netting about $3 per share.

Sundermann, an Iowa insurance agent, is a foot soldier in a revolution that is profoundly altering the investment landscape. To Sundermann and his fellow rebels, Wall Street and its legions of analysts and brokers are largely irrelevant. Emboldened by online investment newsgroups, investors are abandoning full-service stockbrokers and mutual funds--or are using them less--in favor of buying and selling stocks on the Internet. Instead of paying $100, $200 or more in commissions, they're executing trades for $12, $7.95 and even $5.

The brokerages of the Internet Age are more likely to be headquartered in Omaha or Austin than in lower Manhattan. Thanks to fierce competition among scores of online brokers, many commissions are less than half what they were just a year ago. Abandoning full-service brokers means picking your own stocks. It's no accident that the growth of online trading has coincided with an enormous increase in the quality and quantity of investment information on the Internet.

Until 1993 the Internet was a mystery even to most personal-computer owners. The first Internet trading didn't occur until mid 1994. Last year, according to Piper Jaffray electronic-commerce analyst Timothy Klein, 17% of all trades by individual investors took place online; this year, he says, almost one-third will. Klein projects that revenues from online trading will balloon at a 50% annual rate, to $2.2 billion by 2001. Already, some online brokerages are among the few Internet ventures actually turning profits.

Dirt-cheap commissions save many investors money and allow some to execute strategies that were once impossible. Sundermann's ADM profit would have vanished under full-service commissions. Instead, his successful trade encouraged him to try it again. Over the past several months, he has quickly bought and sold Texas Utilities, American Express, Southland, GKN Sinter Metals and Sterling Commerce, to name just a few. He figures his annualized gain is 64%. Most of Sundermann's portfolio resides in mutual funds and buy-and-hold stocks. But he's done much better, at least so far, with what he calls his "play money."

NO MORE `LITTLE INVESTORS'

The Internet is leveling the playing field in more ways than one. Not only can individuals make trades at the same price as institutional traders, they can also mine much of the lode of investment information that until now was the sole province of the big boys. The result is a sort of democratization of investing--at least for those who have the savvy and time to find the nuggets amid the vast quantifies of information (and misinformation) on the Internet.

Let's research stocks: Head to your computer and screen stocks for any of a variety of criteria (such as low price-earnings or price-sales ratios, or rapid earnings growth) by going to, say, www.marketguide.com and downloading StockQuest. Or if you prefer to start with experts' picks, visit www.lehman.com and find out what stocks full-service broker Lehman Brothers is recommending to its clients. Once you narrow your search to a couple of stocks, trek to www.yahoo.com or any of a number of other sites for the latest news about them. There, you can examine the companies' fundamentals, study their income statements and balance sheets, and look at charts showing their stocks' past performance.

Next, visit www.zacks.com to obtain brokerage analysts' consensus earnings estimates and to find out whether analysts recommend the stocks. Complete Securities and Exchange Commission filings on every U.S. public company are at www.sec.gov. Moreover, this entire research process can be done any time of the day or night, wherever you have a computer--and none of it costs a nickel. (For a list of some of the better Internet investing sites, see "Where to Mine the Data," on page 87.) And you can keep track of your portfolio for free through personal-finance sites such as www.kiplinger.com.

Because online brokerages want to keep you at their Web site, in the hope that you'll place a trade with them, many offer these tools and information themselves. Some online brokers also offer free company reports by Argus, Hoover's and Standard & Poor's--information that might cost money elsewhere on the Web.

About the only thing full-service brokerages can still keep private are their own analysts' reports. But even that is changing. Some brokers are selling their research reports at Web sites such as www.zacks.com. Discover, the discount-brokerage arm of Morgan Stanley Dean Witter, is providing most Morgan Stanley research to Discover clients for a fee--the only difference is that the research reports are labeled "Discover" instead of "Morgan Stanley." Clients of Fidelity's discount brokerage can buy Salomon Smith Barney research. DLJ Direct provides research reports from parent Donaldson, Lufkin & Jenrette to customers who maintain at least $100,000 in assets in their accounts. Charles Schwab plans to offer analysts' research, most likely from Credit Suisse First Boston and Hambrecht Quist, by year's end.

The changes wrought by the Internet have come with blinding speed and will almost certainly accelerate. For almost two centuries, full-priced brokers were the only way to buy and sell stocks. In 1975 the SEC changed the rules to allow discount brokers like Schwab to charge less than the fixed rate. But those commissions were still ten and 20 times higher than the fees being levied today on the Internet.

The obvious question: How in the world can a brokerage make money buying and selling stocks for $5 or even $10 a pop?

THE OMAHA CONNECTION

To see the future of stock trading in America, drive to the west side of Omaha, into an industrial park that's past the Kellogg's cereal factory and the Oriental Trading Co. You've reached the headquarters of Ameritrade.

It seems an odd setting for a financial-services firm, but Ameritrade is one of the nation's fastest-growing online brokerages. The parking lot is jammed. At tables set up in the lobby, job applicants take tests and get interviewed, while new hires are fingerprinted and photographed. Throughout the low-slung brick building, employees are being trained in makeshift classrooms. "We have a saying that if you've been here three months, you're training someone else," says Mike Anderson, Ameritrade's president. In fact, the company is growing so rapidly that it recently leased the floor space of the biggest store in an Omaha shopping mall for its third location. (Rapid growth is not unique to Ameritrade; many of the brokerage Web sites include advertisements for new employees.)

The overflowing offices at Ameritrade are astir with people answering customers' questions over the telephone, doing back-office work required at any brokerage and taking buy and sell orders (at a higher price) over the telephone. But they aren't the heart of Ameritrade.

That's in a locked room filled with blinking lights and roughly 100 computers. The temperature and humidity are kept constant--cool and dry. No one is allowed inside without authorization. Sixty-three people work here; they rotate shifts so that someone is on duty 24 hours a day, 365 days a year. There are multiple computers for each job. "If one goes down, the others work," says Tim Gilkerson, director of systems engineering. A backup power supply can keep the computers going for two or three hours if electricity fails, then a 600-gallon, diesel-driven generator can supply power so long as trucks can deliver more fuel.

The computers are linked via the firm's Web site to investors' computers. They route customers' orders instantaneously to computers at other firms that fill Nasdaq trades, or directly to the New York or American stock exchanges. Most orders are filled automatically, without human intervention. Trade confirmations route back through the Omaha computer bank to investors' PCs.

"We're at the beginning of a revolution," says Ameritrade chairman Joe Ricketts, "that will be more significant than the Industrial Revolution." The 57-year-old Ricketts founded the firm in 1975. But for years it was a relatively sleepy outfit, and until recently it was in danger of being bypassed by other firms sprouting on the Internet.

Then Ricketts, according to a colleague, "bet the company." In March 1997 Ameritrade made an initial public offering of its stock. Much of what was raised was spent in six months on a $34.5-million advertising blitz. The company bought commercials on Monday Night Football and Seinfeld, and placed glossy ads in magazines (including this one), partly to lasso new customers but also to create a buzz.

The ads were atypical. Peter Horst, the Ameritrade official who orchestrated much of the media campaign, says the ads "make it fun" to invest. They are populated with happy people who say things like "I bought a major Hollywood studio for $8" or "I got into Club Med for $8," or "I dumped my Playboy for $8."

Ameritrade got the buzz it sought. All of a sudden it had a recognizable brand name. Phone calls about opening accounts flooded its switchboard. In nine months, 181,000 accounts were opened--doubling the firm's customer base. In the three months ending June 26, average daily trading volume rose to 21,412 shares, more than triple the number a year earlier.

Without the increased trade volume sparked by the ad campaign, says Robert Slezak, Ameritrade's chief financial officer, the company lacked the efficiencies to turn a profit at its newly lowered prices of $8 per trade ($13 for a limit order). Also essential are cheap office space and telephone reps, most of them licensed brokers, who are paid about $12 per hour.

But commissions are just one source of Ameritrade's revenue. Almost as much--$7.80 per trade--is interest income. In addition to charging for trades, Ameritrade lends money to customers who borrow to leverage their investments. More than $600 million is on loan in margin accounts at rates as high as 9.25%. "They're paying the freight for the rest of the customers," says Kurt Halvorson, who runs Ameritrade's back office.

Moreover, Ameritrade has more than $1 billion in cash deposits and generally pays just 3% interest to its investors. While a money-market fund with about a 5% interest rate is available, accountholders have to know to ask. You can't place a trade at Ameritrade or at most other online brokerages without having cash already in your account.

Ameritrade also makes about $2.24 per trade from what's known as "payment for order flow." This means that Ameritrade, like many brokers, sells Nasdaq orders for a penny or so per share to a market maker, who actually executes it. (The New York and American stock exchanges employ different trading systems that don't allow for payment for order flow, although brokerages often route trades for these stocks to smaller, regional exchanges that do pay for order flow.) Some critics say that this practice discourages online brokers from looking for the best market maker to execute your trade. When you buy a stock, it might be for 24 15/16 per share rather than 24 7/8, the critics say.

But brokers' revenues from payment for order flow have been cut in half in the past year or so, in part because of a successful $1-billion class-action lawsuit that alleged market makers were colluding to give investors unfair prices on Nasdaq trades. The suit and tighter regulation mean that investors are getting fairer prices nowadays.

(If you buy or sell a stock at what you think may be an unfair price, go to www.quicken.com and call up a one-minute intraday chart, which shows precisely how much a stock trades for during the day. Compare the price with the time and price for the stock you bought that day, which your broker is required to give you if you ask. If the stock spiked just as you bought it--or slipped just as you sold it--that should raise a red flag. Bring it to your broker's attention.)

Payment for order flow is generally made only on market orders, in which investors agree to buy or sell a stock at the current market price. Brokers usually get nothing on limit orders, in which customers specify they want to buy (or sell) a stock only at a certain price or better. That's one reason that many online brokers charge extra for limit orders.

WHO'S DOING IT?

More than just low trading costs bring investors online. People like the fact that online brokers aren't telephoning them to buy or sell. They like the convenience, speed and privacy of online trading. "People are going online to gain control of greater portions of all of their life," says Stephen Killeen, vice-president of Fidelity Interactive. "Baby-boomers are much more likely to be do-it-yourselfers. Just look at Home Depot."

Computer traders tend to be younger, wealthier, better educated and to trade more often than other investors. According to a 1997 survey by the Securities Industry Association, the brokerage industry's trade group, the average online trader is a 45-year-old male with a college diploma in a household that has an annual income of about $100,000 and more than $343,000 in financial assets. While only 8% of those surveyed had traded by computer, 47% had obtained investment information over the Internet. Moreover, one-fourth of those who hadn't traded by computer said they were likely to do so in 1998.

It's not so easy to put Internet investors into a box, though. Most are long-term investors, industry officials and analysts say. "I'm definitely a buy-and-hold type of person," says Charles Brown, 54, who runs a computer-software firm in Lexington, Ky. "I have six stocks and the rest in mutual funds." Others, like Sundermann, are trading more frequently to try to capture small gains with some of their money, while keeping the bulk of their assets in more conservative investments. Still others are trading a lot with all their assets--and sometimes borrowing money to finance still more trading.

One thing that virtually every observer of the online-trading phenomenon reports is that people tend to increase their trading--no surprise, considering the low cost. "What the low rates really give me is more of an opportunity to experiment until I develop an investment approach that is right for me," says Alan Stauber, a technician for a direct-mail firm in Warrenville, Ill., who is in his thirties. "My very first Internet execution with Brown & Co. resulted in a 12% one-day loss, but it was the product of an error that I will never repeat. I take great comfort in knowing that all it really took to learn that lesson was a $5 commission." Of course, Stauber, who says he usually trades at least once a day, also lost that 12% in principal on his $5 trade.

Rapid trading--going in and out of stocks based on short-term hopes rather than any appreciation for a company's long-term potential--may not be good for most investors' bottom lines. A new study of how well individual investors did at one major discount brokerage (which opened its files on the condition that its name not be revealed) found that, on average, individual investors do about as well as the stock market as a whole. But the more people traded, the worse their results.

While the average stock investor from 1991 through 1996 earned an annualized 15.3%, those who traded the most earned only an annualized 10%. On average, these active traders, who comprised one-fifth of the brokerage's customers, turned their entire stock portfolios over almost three times annually. "Our central message is that trading is hazardous to your wealth," the report concludes.

Terrance Odean, a finance professor at the University of California at Davis and co-author of the study, says active traders may overlook the fact that the commission is only part of the cost of trading a stock. The other part is the spread between the bid and the ask price on a stock, which goes to a Nasdaq market maker or to a New York or American stock exchange specialist. Before factoring in commissions and spreads, active traders didn't do any worse than their buy-and-hold counterparts in the study. They lost money solely because of commissions and spreads. Those, on average, add 0.5% to the cost of a typical trade--far more than the price of an online commission. The spread on a $12,000 trade, Odean estimates, adds $60 to its cost--compared with $5 or $10 for an online commission.

THE INTERNET LIFE

But try telling that to some of the practitioners of computerized investing. Bob Dean gets up at 6:30 every morning in Carrollton, Tex., downloads financial information from the Internet, eats breakfast and gets back on the computer to look for more stocks. "It's like playing blackjack," says the 60-year-old retired airline pilot. "I love to play blackjack in Las Vegas. I don't trade stocks like it's investing. I play it like it's gambling. I should put a picture of a sexy woman on my computer."

Before he began trading stocks on his computer, Dean says, "I was in and out of commodities, stocks, bonds, futures--anything you can imagine." Now he employs what he calls his short-term trading strategy, which relies on esoterica such as Bollinger bands, moving averages "and about ten other indicators."

Dean usually owns only six or seven stocks at a time, but "I buy in big chunks. I move around so much I don't like to watch too many stocks at one time." He often holds stocks for just a day or two and claims that 65% to 70% of his trades are successful. "Playing the stock market, you have to look at patterns that are successful." When you're losing money on a stock, Dean says, "You need to get out right away and let your winners roll. Sometimes I get emotional. That's a trader's biggest flaw. It's just human nature. If you stick to the system, it pays off for you." Dean claims he's doing just fine with his system, thank you.

Susan Park is less sure of the payoff from access to cheap trades. Park, 27, trades about $170,000, including the pension fund for her father, a doctor, and his employees. "He doesn't know much about investing," says Park, who lives with her parents in Buena Park, Cal. She makes about five trades per day and says she's "moderately ahead" of where she started a year ago.

Her days are sometimes spent glued to the computer from the 6:30 A.M. Pacific time opening of the stock exchanges to the 1 P.M. close. "It feels really crappy. I feel bad if I don't make a lot of money and I've spent all day at the computer. It feels good if you've made a lot of money, but that rarely happens. I'm working hard to not have my life revolve around the computer because it is an addiction, and I think I am addicted."

While online, Park keeps a sharp eye on news about the ten or so companies she owns and studies the upward or downward momentum of each stock, most of them volatile Internet stocks. She's had her ups and downs on the Internet-traders' learning curve. Once she bought more stock for the pension account than she had cash, and you can't borrow money to invest in retirement accounts. Another time, she sold a stock twice, by accident, and ended up selling it short (a way of betting a stock will fall in price) without intending to.

On a recent day she bought Egghead, a software retailer she hadn't heard of until reading a few stories about it on the Internet that day. She bought at $18.50 and sold out the following Monday at about $27.50 because "I knew it wasn't going to sustain that level." Sure enough, the stock dropped, but went up a bit toward the end of the trading day. So Park bought it back at $25.75 "knowing tomorrow it would open higher. But Tuesday morning I didn't sell it quickly enough. It went up, but only for a few minutes, and then it went down." She sold at $24.50. Then late Tuesday "it looked like it was in a pretty strong uptrend, so I bought it at $24, and the next morning it just dropped $4.' The stock rose a few days later, and Park sold at $23.38.

To judge from the activity in the financial chat rooms and message boards on yahoo.com, a lot of people are trading as much as Dean and Park. In fact, The Electronic Day Trader, by Marc Friedfertig and George West (McGraw-Hill, $34.95), is one of the best-selling hardback books on Amazon.com, the Internet bookstore. Friedfertig runs an online brokerage at www.broadwaytrading.com, which is one of several that cater to day traders--people who make frequent trades daily and often attempt to make a living at it (see "Skewered," on page 90).

BUY ONLINE AND HOLD

Most people who use online brokerages are investing for the long term, much as they would if they were using a full-service broker. These investors are likely to attain the best results. Leonard Golub, for instance, generally won't buy a stock unless he plans to hold it for five years. In addition to saving on trading costs and taxes, he says, such a time horizon forces him to focus on a company's long-term prospects. He looks for great companies that are temporarily out of favor.

For instance, he purchased America Online in 1996 when people dialing up were getting busy signals. While the stock was hammered, Golub says, "the busy signals showed me that there was a lot of demand for AOL." The stock is up almost tenfold since he bought it. Similarly, the 32-year-old MBA candidate at the University of Texas in Austin bought Nike, which has had earnings troubles. "Nike is able to command higher margins for its products than other shoe companies," he says. "That gives it the ability to cut prices and drive competitors out."

Golub used a full-service broker when he began investing but didn't like it. "I was working with someone whose primary objective was to generate commissions. The relationship was not necessarily focused on my goals." A former computer-network engineer, Golub says he started using the Internet early and was attracted to online trading. "I like the ability to execute a trade without having to talk to a person when I know what I want to do."

THE EMPIRE STRIKES BACK

Full-service brokers seem unalarmed by the rise in online trading. "Our client base is different than their client base," says Bobbie Collins, vice-president for technology communications at Merrill Lynch. "We have clients who are looking for long-term relationships and long-term growth of their portfolios." Merrill Lynch plans to roll out online trading this year, but at no discount. No major full-service broker yet offers Internet trading.

But maybe Wall Street's nabobs should be worried. Bill Burnham, electronic-commerce analyst with Credit Suisse First Boston, says online trading poses a threat to full-service brokers. "They have been doing a lot of hand-wringing," he says. "But the fundamental issue that has prevented them from acting isn't going to go away--namely, the brokers keep showing up to work every day." Any discount online brokerage that a full-service broker sets up competes with the firm's commissioned salespeople.

Even the traditional discount brokerages, such as Schwab and Fidelity, are challenged by the Internet phenomenon. Their fees for online trades are well into double digits--for a market order, $29.95 at Schwab (with 1.8 million accounts) and $25 at Fidelity (1.3 million accounts), although Fidelity discounts commissions to $14.95 for its most active clients (see "Cheap Frills," on page 92). To keep the loyalty of their customers, both of these giants are layering on services. In addition to discounts, active Fidelity traders get in on some initial public offerings.

Schwab customers who trade at least 24 times a year and have at least $25,000 in assets in their accounts, or have traded 48 times and have at least $50,000 in their accounts, get access to better Web sites. These sites contain a powerful stock screener and allow users to download company reports that Schwab has pieced together from various sources, including Vickers, First Call, Standard & Poor's and Market Guide. Less complete versions of most of these services are available to regular Schwab customers. Fidelity and Schwab believe they will be the big Internet winners--taking customers from both full-service and deep discounters--because they provide sophisticated and timely information on their Web sites.

Meanwhile, the Internet brokers keep branching out. Joseph Fox, president of Web Street Securities (www. webstreet.com), says he plans to offer "a variety of products," including banking, insurance and mortgages. And the modest cost of setting up a Web brokerage is attracting niche players. There's www.wyse-sec.com for Chinese speakers, www.wallstreete.com for both Spanish and English speakers, www.mrstock.com for options traders and www.gfn.com for gay investors.

Where will it all end? Web Street Securities charges no commission on trades of more than 1,000 shares of any Nasdaq stock selling for more than $2 per share. As for those millions of Internet-investing enthusiasts, perhaps a sustained market decline will cause the hypertraders among them to go broke or slink away in discouragement. But with the next upturn, they or those like them will be back, glued to their monitors, excited by the thrill of the chase. For good and for ill, the lure of low trading costs on the Internet has set something loose among investors that can't be put back into the box. Says Brown & Co. boss George Brown of his Boston firm's $5 rate: "That's not a commission, it's a tip."

RELATED ARTICLE: A SHORT HISTORY OF STOCK TRADING, FROM THE BUTTONWOOD TREE TO THE INTERNET

1792

Twenty-four stockbrokers and merchants meet under a buttonwood tree on the north side of Wall Street and agree to a common commission: 0.25%. Their organization is a precursor of the New York Stock Exchange.

1817

Brokers create the New York Stock & Exchange Board at 40 Wall Street. But outdoor trading by members would continue until 1836. NYSE's present name was adopted in

1896

The Dow Jones industrial average begins with 12 stocks, including American Cotton 0il and Standard Rope & Twine.

1908

The American Stock Exchange, at first called the New York Curb Exchange because trading occurred on the street, is formed. After the NYSE limits itself to high-grade stocks in 1910, the Amex becomes home to smaller companies.

1933

The Securities Act of 1933 mandates full financial disclosure of publicly traded companies and prohibits fraud in the sale of securities.

1971

The SEC prods the National Association of Securities Dealers to create an electronic bulletin board displaying bid and ask prices of market makers on over-the-counter stocks. This becomes Nasdaq.

1974

Bob Kahn and Vinton Cerf create the Internet and its basic protocols for communicating between computers.

1975

The Securities and Exchange Commission ends fixed commissions on May 1. Discount brokers spring up.

1983

Discounter Quick & Reilly introduces DOS-based trading software for individuals, accessible through CompuServe. Two years later comes Charles Schwab & Co.'s Equalizer, linking PCs directly to a discounter.

1991

Tim Berners-Lee releases a new, user-friendly interface for the Internet and calls it the World Wide Web. When a browser, Mosaic, appears in 1993, Web traffic increases that year by 289,000%.

1994

The K. Aufhauser discount brokerage begins stock trading on the Internet on August 24. Schwab follows in 1996, and in a year's time opens 617,000 online accounts.

1995

The SEC makes corporate and mutual fund financial reports available to the public at its EDGAR system.

1997

Ameritrade starts an online price war by lowering its commission to $8. Within a year Web Street Securities offers to trade some Nasdaq stocks for free.

1998

Online trading volume grows by 26% in the first three months. A survey finds that 6.9% of Americans recently stopped watching TV, but 3.9% started using computers.