Five Percent Rule: What it is, How it Works, Example (2024)

What Is the Five Percent Rule?

The five percent rule is a stipulation of the Financial Industry Regulatory Authority (FINRA), which oversees brokers and brokerage firms in the U.S. Dating back to 1943, it stipulates that abroker shouldn’t charge commissions, markups, or markdowns of more than 5% on standard trades, both stock exchange listings and over-the-counter transactions, along with proceeds sales and riskless transactions.

Although also known as the FINRA5% markup policy or 5% policy, the five percent rule is more of a guideline than an actual regulation. The aim 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.

Key Takeaways

  • The five percent rule, aka the 5% markup policy, is FINRA guidance that suggests brokers should not charge commissions on transactions that exceed 5%.
  • The five percent rule is more of a guideline than an actual regulation, aiming to ensure that investors pay reasonable commissions and that brokers are ethical in setting their fees.
  • Certain individuals or securities may be exempt from FINRA regulation and therefore the 5% rule.
  • In the context of investing, the five percent rule may also refer to the practice of not letting any single security or asset comprise more than 5% of a portfolio.

How the Five Percent Rule Works

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 seea firm buy a security from its own holdings and immediately sellit to acustomer.

The rule itself has several exceptions. For example, it does not apply to securities sold through a prospectus—such as in an initial public offering.

According to FINRA, "the policy has been reviewed by the Board of Governors on numerous occasions and each time the Board has reaffirmed the philosophy expressed in 1943".

What Determines a Fair Commission?

If the five percent rule aims to establish a reasonable fee, it's natural to wonder: How do firms determine what's fair? Elements that are considered when determining what is fair and reasonable include:

  • The price of thesecurity 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 cost to execute the transaction (some firms impose a minimum transaction)

It should be noted that each factor may contribute to a higher or lower commission than 5%; a large equity transaction that was simple to execute may be done so for far less than 5%, while a small, complicated transaction of a more lightly traded security could be far more than 5%.

Five Percent Rule Example

If a client wanted to buy 100sharesof Hypothetical Co. at $10 a share, the total value of that transaction would be $1,000. If the broker's minimumtransaction cost was $100, the total fee would be 10% of the trade—far more than the five percent rule. However, as long as the client knew of the transaction minimum in advance, the rule would not apply.

Special Considerations

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 is not codified by any investing agency; it is simply a rule of thumb to guide 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 protects against material losses should that single company perform poorly or become insolvent.

What Is Exempt From the 5% Markup Policy?

Anything that is being offered under a prospectus is exempt from the 5% markup policy. This is because all of the commissions and charges are all detailed in the prospectus. This extends to open end mutual funds or offering of securities.

Who Is Exempt from FINRA?

Certain individuals are exempt from from FINRA requirements. Employees exempt from FINRA registration include individuals whose functions are clerical/ministerial in nature, limited partners, or related exclusively to transactions executed on a securities exchange.

How Was the 5% Policy Created?

FINRA's Association Board adopted the policy in 1943 in exchange for feedback from customers who executed transactions. In general, studies based on a majority of transactions were effected with a mark-up of 5% or less.

The Bottom Line

The Financial Industry Regulatory Authority, which is in charge of regulating brokers and brokerage companies in the US, has a requirement known as the five percent rule. It dates back to 1943 and states that commissions, markups, and markdowns of more than 5% are prohibited on standard trades, including over-the-counter and stock exchange listings, cash sales, and riskless transactions.

Five Percent Rule: What it is, How it Works, Example (2024)


Five Percent Rule: What it is, How it Works, Example? ›

Five Percent Rule Example

What is the 5 percent rule example? ›

In a simple example of the 5% rule, an investor builds their own portfolio of individual stock securities. The investor could pass the 5% rule by building a portfolio of 20 stocks. (At 5% each, total portfolio equals 100%.)

What is the 5 percent strategy? ›

The Five Percent Rule is a simple strategy that involves investing no more than 5% of one's portfolio in any single investment. This approach is based on the principle that by limiting the exposure to any one investment, investors can reduce the risk of significant losses.

What is the 5 percent rule in investing? ›

5% Rule: No single stock holding should represent more than five percent of a client's total portfolio. I'm reminded of a case where a client held a highly concentrated position of a particular bank stock. Over the decades, this stock had performed well and created significant wealth for this client.

What is the simple rule of percentage? ›

If we have to calculate percent of a number, divide the number by the whole and multiply by 100. Hence, the percentage means, a part per hundred. The word per cent means per 100. It is represented by the symbol “%”.

Is the 5 rule real? ›

Deciphering the 5% Rule

Comparing the costs of renting versus owning a home is the fundamental function of the 5% Rule. While calculating rental expenses is straightforward—simply tally up your monthly rent—determining homeownership costs demands a more intricate strategy.

What does 5 percent equity mean? ›

1 crore for 5 percent equity means 5 lakhs of the whole valuation. Equity means the amount of money that a person own's or has put into something. Equity is equal to total assets minus its total liabilities. now, actually we know that. 5 percent of 1 crore is = (5/100)*(1crore)

What is the 5 in 5 strategy? ›

Our 5 in 5 Wealth Creation Strategy is all about curating a personalized portfolio for you and your goals. This portfolio consists of 15-18 rigorously research stocks that have a strong potential to grow 4-5 times over the next 5-6 years.

What is the 5 3 strategy? ›

Clear guidelines: The 5-3-1 strategy provides clear and straightforward guidelines for traders. The principles of choosing five currency pairs, developing three trading strategies, and selecting one specific time of day offer a structured approach, reducing ambiguity and enhancing decision-making.

What is a lazy portfolio? ›

The key principles of a lazy portfolio are diversification, low fees, and patience. Instead of actively building and managing a portfolio, you invest in a handful of low-cost index funds and hold onto them for the long term.

Is 5% a good return on investment? ›

Return on Stocks: On average, a ROI of 7% after inflation is often considered good, based on the historical returns of the market. Return on Bonds: For bonds, a good ROI is typically around 4-6%. Return on Gold: For gold investments, a ROI of more than 5% is seen as favorable.

What is the 5 3 1 trading strategy? ›

The number 5 stands for choosing 5 currency pairs that a trader would like to trade. The number 3 stands for developing 3 strategies with multiple combinations of trading styles, technical indicators and risk management measures. The number 1 guides traders to choose the most suitable time for trading.

What is the 1% trading strategy? ›

The 1% rule is a great way to keep traders afloat without big losses. For beginner traders or experienced traders, this strategy will help you play it safe and reduce your risk of losing funds in any given trade by limiting how much money goes into each bet.

What is the 1% strategy? ›

Improving sales by just 1% per month can have a significant impact on overall revenue growth. This could involve optimizing pricing strategies, increasing marketing efforts, improving customer engagement, or developing new sales channels.

What is the 1% risk strategy? ›

The 1% rule demands that traders never risk more than 1% of their total account value on a single trade. In a $10,000 account, that doesn't mean you can only invest $100. It means you shouldn't lose more than $100 on a single trade.


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