What Is a Brokerage Account?

If you want to buy and sell stocks, mutual funds, and ETFs and build wealth through the stock market, you'll want to open an account at a brokerage firm. There are various types of brokerage accounts -- online or at brick-and-mortar locations, full-service or discount, and many with financial advisers available, too.

Here's a comprehensive answer to the "what is a brokerage account" question, along with guidance on how to choose and use a brokerage account.

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What is a brokerage account, and why might you want one?

A brokerage can be defined in various ways: It's a company that connects buyers and sellers; a business that acts as a middleman, facilitating transactions; and/or an enterprise that buys and sells various assets for its clients. When it comes to the stock market, brokerage accounts exist to help investors buy and sell securities.

A brokerage account allows an individual investor, who has deposited money with a licensed brokerage firm, to make orders to buy and sell assets with the firm serving as their representative for the transactions. Depending on the brokerage, you can create an account online, over the phone, or in person. Once you have an account, you then need to fund it with money in order to buy and sell stocks, mutual funds, or other securities. There's more to it than that, of course, so let's take a closer look.

If you're not yet sold on the need for a brokerage account, check out the table below, which shows how much money you could potentially amass by investing in the stock market for various lengths of time. The long-term average annual return for the stock market has been close to 10% over long periods, but there's no telling exactly how it will perform over the specific period that you invest, so a more conservative 8% rate is used. 

Clearly, if you sock away some significant sums each year and invest them effectively, you can accumulate some powerful sums. If you can grow a nest egg of $500,000 over 20 years, for example, that would be enough to generate about $20,000 in your first year of retirement, if you use the 4% rule when you withdraw funds.

Calculations by author.

Types of brokerages

There are different kinds of brokerages to choose from. Some, for example, exist solely or mainly online, which is where you conduct much or all of your business with them. Others have branches all over the country, allowing you to walk in and talk to a customer service agent face-to-face. Most of these brokerages with branch networks also offer online access to your accounts and the ability to trade online, as well.

These are the three main categories brokerages fall into:

• Full-service brokerages: If you remember the famous TV commercial from the 1970s and 1980s that asserted, "When E. F. Hutton speaks, people listen..." -- that was for a full-service brokerage, which was the norm at the time. Full-service brokerages do much of the investing work for you -- recommending various investments and often managing your money. That might seem like a good arrangement, but they also charge hefty fees, some as much as several hundred dollars per trade, and it's possible not all of their recommendations will serve you well. (That's especially true if they had you trading frequently, thus generating lots of commissions.)
   
  Full-service brokerages today include Morgan Stanley (NYSE: MS) and Merrill Lynch, now owned by Bank of America (NYSE: BAC). Go ahead and consider a full-service brokerage if you don't want to do much managing of your own money, and if you trust the expertise and ethics of the firms you're agreeing to work with. It's important to note, though, that you can save a lot in fees just by opting to invest in low-fee index funds such as ones that track the S&P 500.
• Discount brokerages: Today we have a slew of discount brokerages to choose from and their service is not cut-rate, despite their name. They typically charge trading commissions between $15-$5 or even less per trade, and many of them offer research and access to financial advisors, too. This option is great for many, if not most, investors. You can enjoy low commission costs while accessing ample research on companies, and buy and sell shares of stocks and mutual funds. Or you can take a simpler route, and use these brokerages to invest regularly in low-fee index funds and let your money grow over many years. Major discount brokerages include TD Ameritrade (NASDAQ: AMTD), Fidelity Investments, and Charles Schwab (NYSE: SCHW).
• Free brokerages: Some brokerages charge little to nothing per trade. That's the best option for some, but not all, investors, because there are often restrictions or limitations involved, too. Interactive Brokers (NASDAQ: IBKR), for example, offers trades for less than a penny apiece, but it also has a $10,000 account minimum ($5,000 for retirement accounts) and it doesn't offer reinvestment of dividends. The Robinhood app offers free trading, but that doesn't include access to mutual funds or bonds. Those who want to trade frequently should aim for the lowest commission fees possible, but frequent trading isn't as promising of a wealth-building strategy as buying and holding stock over long periods of time. 

Types of brokerage accounts

In addition to the various types of brokerages, there are several different options among brokerage accounts. Here's how some of those accounts differ:

• Taxable accounts: A taxable account is the main kind of account that most brokerages offer. In it, you buy and sell securities, generating capital gains and losses that are subject to taxes. Fortunately, the tax code allows us to offset gains with losses, thereby shrinking our tax hit.
• Tax-advantaged accounts: Many brokerages, as well as mutual fund companies and other financial services companies, let you open tax-advantaged accounts such as IRAs -- both traditional and Roth, Some are also in the business of administering 401(k) plans for various employers. Thus, you might have a taxable account at a brokerage, as well as an IRA at the same one or another, and also a 401(k) through your job that's being administered through a brokerage.
• Cash vs. margin accounts: Many brokerage accounts need to be designated as cash or margin. A cash account is the simplest option and will serve most investors just fine. It requires that you have the cash in your account to cover the investments you make. Want to buy $2,000 of stock in a company? You need $2,000 in the brokerage account -- plus enough to cover the cost of the commission. If you sign up for a margin account, though, you can invest in various securities with money that you borrow from the brokerage "on margin." Using margin will amplify both your gains and losses, so while it can be enticing, it also can be disastrous. Proceed with caution if considering a margin account or just avoid it entirely.

There are other kinds of brokerage accounts, too, such as ones cleared for options trading, joint accounts, custodial accounts for kids, rollover IRA accounts formed with funds from an old 401(k) account, and so on.

Image source: Getty Images.

How to choose a good brokerage

When you're ready to open an account, choose your brokerage firm carefully, it's important to select one that best suits your needs. Here are some considerations -- you can decide which are the most important to you:

• Minimum initial deposit: Some brokerages require at least several thousand dollars, while others have no minimum.
• Costs: All other things being equal, favor brokerages that charge little per trade. You can find fees of $5 or less to more than $100. Consider other fees, too, such as IRA custodian fees, wire transfer fees, account inactivity fees, annual fees, and so on.
• Research: Many brokerages offer free company research reports. If this is valuable to you, see what each of your contenders provides.
• Mutual funds: The range of funds offered by brokerages varies widely, with some brokerages offering hundreds of funds and others offering thousands. If you're interested in particular funds, see whether they're available. Know, though, that you can usually buy into funds directly from their companies, bypassing brokerages.
• Non-stock offerings: If you're interested in investing in bonds, for example, see whether they're offered.
• Usability: Look into how easy it is to use each brokerage's online trading system and how user-friendly each website is.
• Customer service: Ask some questions of the customer service department to gauge its responsiveness.
• Banking: Some brokerages feature banking services, such as check writing, money market accounts, credit cards, ATM cards, direct deposit, and more. Look for these if you want them.
• Convenience: Would you rather place trade orders through an actual person, your phone, or online? See which brokerages offer what you want.

Some of these factors are more important than others. For example, if you trade only twice a year, you don't need to seek out ultra-low commission costs. Make a list of all the features you need and how vital they are -- then evaluate each contender on the individual measures.

How to buy and sell stocks, funds, and ETFs

When you trade securities in your brokerage account, you'll be placing orders. The main orders you can place with your brokerage firm to buy or sell stocks are listed below. Note that some can be combined.

• Market order: This is for immediate execution at the best price available when the order reaches the marketplace. It's the most common type of order and is nearly always filled, since no price is specified. It can be risky if the stock unexpectedly moves sharply -- which isn't common.
• Limit order: This is an order to buy or sell only at a specified price (the "limit") or better. It's used by investors with a maximum or minimum price at which they're willing to trade. It can be handy if you like a company but think its stock is a little too rich, as you can place a limit order to buy it if it falls to a lower price.
• Fill-or-kill: If this order cannot be filled immediately, it's automatically canceled.
• Day order: If this order hasn't been filled by the end of the trading day, it terminates automatically.
• GTC (Good-Til-Canceled): This order remains in effect until executed by the broker or canceled by you. Many brokerages, however, will cancel GTC orders after a month or two.
• Stop order: This becomes a market order when a specified price has been reached or passed. Buy stops are entered above the current market price; sell stops are entered below it. For example, you might place a stop order to have your shares of a stock automatically sold if it falls below $25 per share. A stop order guarantees execution, but not price.
• Stop limit order: This becomes a limit order when a specified price is reached or passed. If you place a "sell 100 XYZ $55 stop limit" order, if XYZ drops to $55 per share or below, the order becomes a limit order to sell 100 shares at no less than $55. This order doesn't guarantee execution.

How safe is a brokerage account?

Just as our government insures our bank accounts through the Federal Deposit Insurance Corporation (FDIC), it also protects our brokerage accounts through the Securities Investors Protection Corporation (SIPC). Understand, though, that you're not protected from losses due to regrettable investing decisions, such as investing in a stock that plunged. Instead, you're protected from the failure of your brokerage. When selecting a brokerage, be sure that it's a member of the SIPC.

There can be danger with a brokerage account if you use your brokerage firm's handy smartphone app that lets you check your account balances and place trades, among other things. As with banking apps and other financial apps, the convenience is wonderful, but be careful using any apps tied to financial accounts. You don't want your precious financial accounts hacked or tampered with. If you're out and about, be sure to connect through a secure network, not an open Wi-Fi system.

You can change your mind

Finally, if you're ever unhappy with your brokerage or just want to do business with another company instead, you can always transfer your account (and all of its holdings) to a different brokerage. It's not an enormous hassle, and the new brokerage will be happy to do much of the work for you. Just contact it or find the relevant forms on its website. You won't have to sell all your holdings and your cost bases won't change, either. Some brokerages charge modest account-transfer fees, while others absorb all costs in order to get you in the door.

For many people, a brokerage account is more than just a fun or handy thing to have -- it can be a tool that helps you build a comfortable financial future. 

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