What Is a Brokerage Account?

You know brokerages send you statements and charge you fees. But what are brokerages, really, and how do they work?

Jun 21, 2014 at 12:00PM

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Source: Wikimedia Commons user Rimshot.

If you're new to investing in the stock market, one of the first things you'll need to do is find a brokerage and open an account. That means making one of your most important decisions about investing -- who will make your investing transactions for you -- before you invest a dime.

Knowing what a brokerage account is, how to choose a brokerage, and what to expect from your brokerage account is essential to getting the best return on your investments with as little risk and frustration as possible.

How a brokerage works
If you want to invest in stocks and other securities, what you're looking for is a stock brokerage.

You start a brokerage account by filling out an application and sending cash to the brokerage. The brokerage firm then acts as your representative to buy stock. If you tell the brokerage you want to buy 100 shares of a company, the brokerage handles the transaction for you.

The brokerage doesn't necessarily buy stock for you on the floor of the stock exchange. A small order placed by an individual is more likely to be "internalized" and transferred to your account from stock already held at the brokerage.

The brokerage keeps track of your stock holdings, cash balance, and other information for you. It also sends you and the IRS tax information at the end of the year.

Do I have to use a brokerage?
You don't have to use a brokerage at all. In fact, some companies let you buy or sell their stock directly. This will spare you the commissions charged by brokerages, but you probably won't find it practical for most of your investing. For one thing, you may have to pay fees that offset your commission savings.

However, you may not be able to buy stock directly from a company unless you are an employee or you already own stock, and some companies place a minimum on the number of stocks you can purchase. Buying stock directly also limits your flexibility. You can't generally buy or sell shares at a specific market price or at a specific time. You have to buy or sell shares at predetermined times, which may be daily, weekly, or monthly. The amount you pay or receive may be an average market price, rather than the price at the moment you buy or sell.

When you use a brokerage, you can buy any quantity of stock at the time you choose. You can also set orders to buy or sell stock when it reaches a certain price. Using a brokerage gives you a great deal more flexibility and convenience than trying to purchase stock on your own.

Full-service versus discount brokers
If you're beginning to save and invest in the stock market, you need to decide how much handholding, if any, you want from a broker.

You can use a full-service stockbroker who will guide and advise you in your purchases and sales. They may call you with tips, or you can even authorize them to make trades on your behalf as they see fit. You'll pay a price for this service in the form of higher commissions.

If you don't want a broker recommending stocks or handling your funds for you, you'll probably want a discount brokerage. You'll pay considerably lower fees and commissions. You'll have to do all your own research, make your own decisions, and accept the losses or gains resulting from those decisions.

Some people have two accounts -- one being watched over by a full-service stockbroker, and one they direct themselves.

How safe is a brokerage account?
Brokerages are not banks. Your deposits at a brokerage are not insured by the FDIC in the way they are in the savings account at your bank.

However, the government provides some assurance of a brokerage's uprightness and financial standing. Brokerages are required by federal and state law to be licensed or registered. They must also make certain information public.

The SEC recommends that you make sure a brokerage is registered or licensed and that you check for disciplinary problems or other trouble with regulators before you use the brokerage. If they've received serious complaints from customers, or even disciplinary measures from regulators, you can find out about it online through FINRA's BrokerCheck program.

A brokerage should be a member of the Securities Investor Protection Corporation. The SIPC gives you limited protection should your brokerage firm become insolvent and go out of business. Note that this protection does not extend to capital losses resulting from declines in your investments' market value.

How do I open a brokerage account?
When you open a brokerage account, you must fill out an application. Besides the usual name, address, and phone number, the brokerage may ask you questions you didn't expect, such as your driver's license number and passport information, your employer, your annual income, and your net worth. Brokers need this information to comply with laws and regulations.

You also must tell the brokerage whether you want to open a cash or margin account. A cash account is the most straightforward. You pay in full for any securities you purchase. With a margin account, you can borrow money from the brokerage to purchase securities.

Unless you're opening an account at a discount brokerage, you must tell the brokerage how much discretionary authority you are giving someone. If you use a discount brokerage, you will be making decisions yourself.

A brokerage account normally has a certain amount of cash in it that is not invested in securities at any given time. You must specify how you want spare cash to be handled -- for example, you can have it swept into a money market fund.

Lastly, you must tell the brokerage how you want to receive account statements and trade confirmations. You may receive statements online or in the mail, and you can also have someone else, such as your adult child or a financial counselor, receive copies of the statements.

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