Published in: Buying Stocks | Dec. 18, 2018
How Does a Brokerage Account Work?
By: Dan Caplinger
Find out what you need to know in order to invest better.
There are dozens of companies that offer brokerage accounts to potential customers. Many of them even offer lucrative rewards to open an account. But amid all the advertising and promotional material from these companies, it's easy to lose sight of exactly how a brokerage account works and why you should have one.
The basics of a brokerage account
A brokerage account lets you buy and sell different types of investments. Most popular brokerage companies offer accounts that let you trade stocks, bonds, and exchange-traded funds. Some brokers add the ability to participate in other financial markets, such as foreign exchange, commodities, options, and even cutting-edge asset classes like cryptocurrencies.
Brokerage accounts come in two broad categories. Those who want to have a close personal connection with a financial advisor at their chosen brokerage company might prefer a full-service brokerage account, which usually includes the opportunity to consult with in-house experts to help you choose investments, do bigger-picture financial planning, manage the tax impacts of your investing, or just get a gut-check when an unexpected market downturn makes you nervous. However, the downside of full-service brokerage accounts is that they typically require you to pay expensive fees along the way, with some charging hefty commissions while others collect a certain percentage of your assets at regular intervals.
Online discount brokerage accounts, on the other hand, are more of a self-service option for investors. The fees that these accounts have are generally extremely low, largely because when it comes to making choices about your investments, you're more or less on your own. Some discount brokers do offer access to advisors or investment research, but you shouldn't expect the same level of commitment that a full-service broker could provide, because you're not paying as much with a discount brokerage account.
Why do I need a broker?
Already you might be wondering whether you really need a brokerage account. How exactly does the brokerage account help you invest?
The answer lies in the mechanics of investing. Without a brokerage account, if you wanted to buy a certain amount of stock in a company, then you'd have to somehow find another investor who happened to want to sell exactly the same number of shares of that same stock. Then, you'd have to agree on a price. That's a lot of work.
To make things easier, financial exchanges bring buyers and sellers together. But only members of a given exchange can use it to conduct business. By opening a brokerage account with a broker that's a member of the major financial exchanges, you agree to have your broker act as your intermediary in making trades.
It's because of this relationship between you and your broker that you have to be very precise when you tell your broker exactly how you want to invest. There are many different types of orders that you can use in your brokerage account that will get you the results you want:
- Market orders tell brokers to buy or sell at whatever the best price is that they can get. That way, you'll definitely end up making the trade, but you have no guarantee going in what the trade price will be.
- Limit orders tell brokers to buy or sell at the limit price you specify in the order. You therefore know that if the trade goes through, you'll get that price, but there's no guarantee that your broker will find anyone willing to take the other side of your trade.
- Stop orders tell brokers to take action only if the price of the investment hits a certain level. For instance, if you own a stock that's currently worth $25 and place a sell stop order for $20, your broker would only sell your stock if the price dropped to $20 or below.
- Three different orders tell brokers how long you want the order to remain active. Fill-or-kill orders execute immediately or else they're cancelled. Day orders remain active all day until filled, and if they're not filled, they automatically cancel at the end of the day. Good-til-cancelled orders stay in effect indefinitely, usually subject to a 60-day or 90-day limit as defined in your brokerage account agreement.
Are brokerage accounts safe?
Brokerage accounts are generally as safe as the investments that you hold in them. If you make a bad investment that loses value, there's no protection that will get you your money back.
However, most brokers do offer protection against problems involving the brokerage company itself. The Securities Investor Protection Corporation offers up to $500,000 in protection per account, including a $250,000 cash limit. If your brokerage firm fails, then the SIPC will work to replace your missing investments up to those limits. Again, though, the SIPC provides no protection if your losses are due to your investments falling in value.
What to look for in a brokerage account
If you want the best brokerage account you can find, it's smart to look for the characteristics that are most important for you. These include the following:
- Low costs. Look for brokers that charge minimal commissions for trading and have few or no ancillary fees for things like account maintenance. That way, more of your hard-earned money will go toward building the value of your investments.
- Appropriate investment minimums. If you're just starting out, then you might not have that much money to invest. That's not a problem with many brokerage companies, but a few have hefty minimum balances. If you don't meet the requirement, then such brokers will either charge a low-balance fee or prevent you from opening an account entirely.
- Full range of account types. In addition to a regular brokerage account, you might benefit from having IRAs, health savings accounts, and other tax-favored specialty accounts. Many brokers offer these tax-favored accounts, but not all do, so be sure to check before you open an account.
- Investment research. If you value having your broker provide research for you in your investing, either on its own or from third-party sources, then check to see what resources each broker will provide.
- Other financial services. It's becoming more common for brokerage companies to go beyond simple brokerage accounts to offer a wider range of financial services. For instance, many brokers let you open bank accounts to hold cash, along with ATM access, debit cards, and even loans. If having all of your financial relationships with one company is important to you, then make sure the broker you choose offers a full suite of such services.
Find the right fit
The most important consideration in finding a brokerage account is whether you'll be able to do everything that you want with your investments in a way that's comfortable to you. The best brokers offer the support their customers need without being pushy about it, at a price that's right. Fortunately, with so many different financial providers offering brokerage accounts right now, you have a very good chance of finding the perfect fit between what a broker has to offer and the particular needs that you have toward reaching your financial and investing goals.
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