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News Release: 99-19

GRAY DAVIS, Governor
Date: 12/29/99

WILLIAM KENEFICK, Acting Commissioner

Investors Urged to Beware of Online Brokerage Advertising

 

Sacramento, December 29, 1999 — The Department of Corporations today cautioned investors to be wary of claims in the media and on the Internet about how easy it is to get rich investing online.

With online securities brokerage firms poised to spend a reported $1 billion on advertising in the coming year, the Department of Corporations joined other state securities regulators in warning investors to look beyond the hype of the current spate of online broker advertising and beware of hidden costs, delayed executions and the risks of excessive trading activity.

The department warned that with the current hot stock market and increasing competition for investor accounts, some online brokerage firm ads cleverly imply online investors will get rich enough to own islands and bail out small countries. The ads imply that anyone who isn’t trading online is hopelessly old-fashioned and behind the times. However, making sound investment decisions is not as easy as clicking a mouse, securities regulators say.

Although trading online may result in lower commissions and may give small investors greater access to information about stocks and other securities, the Department of Corporations noted some of the risks to trading online:

  • Hidden costs — Behind the scenes but legal payments between online brokers and market makers - so-called "payment for order flow" - may reduce the incentive to get the investor the best price when buying or selling a stock. These payments could cost investors much more than they save on commissions.
  • Trading delays and how to protect yourself — Most online ads suggest that investors have instant access to the market and are directly linked to order desks. Contrary to such claims, investors are not connected "directly to the markets." Online trading simply gives investors the opportunity to place a trade in a firm’s trading system. Moreover, delays in order execution can result in worse prices than what investors are seeing on their computer screen at the time that they place the order. Investors can protect themselves by using "limit orders" instead of "market orders" that allow investors to specify the price or price range at which they are willing to buy or sell securities.
  • Trading too much — The message implied by many online ads is that in a hot stock market the more trading an investor does, the better he or she will do. However, experience suggests that the more trading an investor does, the less well they do. Experience also suggests that real wealth in the investment marketplace comes from careful research and patience in buying the securities of quality companies and holding them for the long term. A recent study of day trading, published by the North American Securities Administrators Association (NASAA) in August 1999, showed that 70% of investors lost money with a trading strategy that sought short-term profits by trading hundreds of times a day and closing out all positions at the end of each day.
  • Limitations of technology — There is nothing inherently wrong with online trading, but it is merely an alternative form of trade placement and execution that is dependent on technologies that are constantly changing. Online investors should make sure that their online brokerage firm has the technological capacity to meet the fast-paced needs of online investing. Investors should find out about the online trading company’s technology backup systems, such as telephone access and local branch offices. Investors should keep records of orders and confirmations in case there is any dispute about the orders placed on line.
  • Going it alone is not for everyone — Online accounts with discount brokers are less expensive but the customer does not have access to the research, due diligence, recommendations, support services and fiduciary relationship of an account with a full service broker. The bottom line is that investors must decide if they have the time, the temperament and the interest to actively manage their own money alone. Otherwise, a traditional relationship with a broker or investment adviser, and old-fashioned reliance on diversification through mutual funds and less risky financial products, may be a better way to go.

A November 22, 1999 report entitled "From Wall Street to Web Street: A Report on the Problems and Promise of the Online Brokerage Industry" published by the New York Attorney General’s office highlighted technology problems and bottlenecks that have plagued the online brokerage industry and urged more disclosure to investors by online brokers and less hyperbole in their advertising. State securities regulators have also raised questions about whether suitability determinations that full service brokers are required by law to make for consumers are applicable to the rapid-fire world of online trading. Investors should be warned that if they choose to trade online, they might have to accept more responsibility for the investment decisions they make.

The Department of Corporations is California's Investment and Financing Authority, reporting to the Business, Transportation and Housing Agency and the Governor. The Department is responsible for the regulation, enforcement and licensing of securities, franchises, off-exchange commodities, investment and financial services, independent escrows, consumer and commercial finance lending and residential mortgage lending. For further information or to obtain a complaint form, see the Department's Web site at www.corp.ca.gov.

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