Understanding the Five Percent Rule: Guideline for Brokerage Commissions

What Is the Five Percent Rule?

The five percent rule, established by the Financial Industry Regulatory Authority (FINRA), serves as a guideline rather than a strict regulation. It stipulates that a broker shouldn’t charge commissions, markups, or markdowns of more than 5% on standard trades, stock exchange listings, and five types of transactions: agency, over-the-counter, principal, proceeds, and riskless.

The rule, also called the FINRA 5% markup policy, was adopted in 1943. Its purpose is to require brokers to use fair and ethical practices when setting commission rates, so that the prices investors pay are reasonably related to the market for the securities they buy.

Exemptions exist for certain individuals, such as those in clerical roles, and securities, such as those involving prospectuses.

The five percent rule also enhances diversification by advising against any single security making up more than 5% of an investment portfolio.

Understanding the Application of the Five Percent Rule

The five percent rule itself does not set forth any criterion for calculating commissions or fees. Instead, it indicates that the broker should follow guidelines. The rule is applied to various transactions, including the following:

• Principal transactions: A broker-dealer buys or sells securities from its own holdings and, based on that, charges a markup or markdown.
• Agency transactions: A brokerage firm, acting as a middleman, charges a commission on a transaction.
• Proceeds transactions: A broker-dealer sells a security for a client and uses those proceeds to purchase other securities. This constitutes one transaction, not two.
• Riskless transactions: Such simultaneous transactions see a firm buy a security from its own holdings and immediately sell it to a customer.

The rule doesn't apply to securities sold through a prospectus, like in an initial public offering.

Factors Influencing Fair Commissions in the Five Percent Rule

If the five percent rule seeks to set a reasonable fee, how do firms decide what's fair? Elements that are considered when determining what is fair and reasonable include:

• The price of the security in question 
• The total value of the transaction (larger transactions may qualify for discounted pricing)
• What kind of security it is (options and stocks transactions have higher costs than bonds, for example)
• The overall value of the members' services
• What it costs to execute the transaction (some firms impose a minimum transaction)

Each factor can lead to a commission above or below 5%. Easy, large transactions might incur less than 5%, whereas small, complex trades might cost more.

Example to Illustrate the Five Percent Rule

If a client buys 100 shares of Hypothetical Co. at $10 each, the total is $1,000. If the broker's minimum fee is $100, the cost equals 10% of the trade, exceeding the five percent rule. However, as long as the client knew of the transaction minimum in advance, the rule would not apply. 

Additional Aspects of the Five Percent Rule

The five percent rule also has another meaning. In the context of investing, it may also refer to the practice of not allocating more than 5% of a portfolio to any single security—in other words, of not letting any one mutual fund, company stock, or even industrial sector to accumulate to comprise more than 5% of the investor's overall holdings. This rule isn't established by any investing agency; it's a guideline to help with investment decisions.

This sort of five percent rule is a yardstick to help investors with diversification and risk management. Using this strategy, no more than 1/20th of an investor's portfolio would be tied to any single security. This helps protect against losses if a single company performs poorly or becomes insolvent.

The Bottom Line

The five percent rule aims to ensure fair and ethical brokerage practices. It's a guideline rather than strict regulation and is aimed at protecting investors.

While the five percent rule suggests brokers should not charge commissions, markups, or markdowns exceeding 5% on standard trades, exemptions exist for some individuals (such as those in clerical positions) and securities (such as those sold through a prospectus).

The five percent rule also has an investment-related interpretation regarding portfolio diversification and risk management. It suggests not allocating more than 5% of a portfolio to any single security or asset.

Elements determining fair commissions in the five percent rule involve the security price, transaction value, and type of security.

The five percent rule provides a framework for preventing excessive costs in trade executions. Brokers' disclosure of their fees and commissions helps to maintain transparency.