Five Percent Rule - Explained
What is the Five Percent Rule?
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Table of ContentsWhat is the Five Percent Rule?How Does the Five Percent Rule Work?The determinants of a Fair Commission in the Five Percent RuleExample of the 5% RuleImportance of the Five Percent RuleOther Application areas of the 5% Rule
What is the Five Percent Rule?
In investment, the five percent rule is a philosophy that says an investor should not allocate more than five percent of their portfolio funds into one security or investment. The rule also referred to as FINRA 5% policy, applies to transactions like riskless transactions and proceed sales. With this rule, investors can diversify and obtain more assets minimizing risks on financial returns. The rule calls for brokers to make use of ethical and fair methods to set commission rates on all transactions investors perform over the counter. The commission can either be five percent up or five percent down on the set standard rate, to allow investors to pay reasonable prices for their securities in the market. The broker needs to legally justify their reason for increasing or decreasing their commission rates.
How Does the Five Percent Rule Work?
The five percent rule does not need any calculations, but it requires the broker to adhere to the Financial Industry Regulation Authority's (FINRA) regulations. Although the rule has its exceptions, it applies to the following transactions:
- Principal transactions: The rule allows a broker to buy or sell investments from a holding company. Using the company's charges, the broker can then decide to raise or lower the commission by five percent.
- Proceed sales: When a broker sells a clients securities and uses the money to buy new securities, the client counts that as a single transaction and not a double one. The broker cannot charge the client a double commission.
- Agency transactions: Instead of a broker charging a commission on securities, the brokerage firm takes charge of all commission transactions on behalf of the broker.
- Riskless transactions: A company can buy securities from another company and sells it immediately to a client.
The determinants of a Fair Commission in the Five Percent Rule
When determining whether the brokers commission is fair, the firm looks at the following elements;
- The type of security that the client wants to buy or sell including; stocks and options, and bonds.
- The price of the investments. The prices of stocks and options are generally higher than the prices of bonds.
- The overall value of the transactions, as a client performing a large transaction, may qualify for discounts.
- The costs for the firm to execute all the clients transactions. Some brokerage firms have a minimum charge on each transaction they execute.
The above elements can each contribute to a lower or a higher commission rate, than the standard five percent. A small transaction that has a lot of complications can generate a commission of more than 5%, while a large but simple transaction can generate a commission of less than 5%.
Example of the 5% Rule
A client wants to purchase 200 shares of Company XYZ at $10 per share. The total value of the shares will be $2,000. Assuming the charges of the broker was a fixed rate of $100, equating to a 5% commission. The broker's fee doesn't go below or above the five percent rule. In case the client buys 100 shares from the same company at the same rate, the value of the shares will be $1,000. Deducting the brokers fixed charges of $100 will mean a commission rate of 10%, which is more than the standard 5%. However, if before the transaction, the client knew of the broker's charges, then the 5% rule will not apply. In the example, the 5% rule will help the investor analyze the transactions to avoid making the wrong investment decision, which might later cost him high commission rates. The investor has the flexibility of diversification to manage future risks.
Importance of the Five Percent Rule
- The 5% rule is necessary because it provides the brokerage firms and clients with the necessary guidelines to protect themselves in case of an aggressive takeover.
- The rule also gives the shareholders a chance to analyze the ownership of different companies before investing.
- The rule prevents unfair trade between the client and the broker, as the broker needs to justify his reasons to increase or decrease the commission rates.
- The violation of the 5% rule leads to the prevention of participants from trading in the market.
Other Application areas of the 5% Rule
Investors and brokers are not the only ones who can use the 5% rule. Business owners can make use of the 5% rule to ensure their businesses are a success. A business can be 95% perfect, but that will not be good enough for the manager. The manager will focus on the 5% that is making the business not succeed by finding strategies to make it perfect as well. In psychology, the counselor can use the five percent rule to solve arguments between two parties. Psychiatrists say that arguments are common among people, but there is a percentage that allows people to meet on middle ground. So, they advise a person to find at least 5% of the other persons content to agree with even when they don't agree with 95%. The 5% agreement opens a room for dialogue between the parties. The theory has proven successful when solving arguments between two or more parties.