Published in: Buying Stocks | Nov. 20, 2018
What Is a Self-Directed Brokerage Account?
By: Jordan Wathen
Here’s how a self-directed brokerage account works, and how taking control over your investments can help save you money and earn higher returns.Image source: Getty Images.
Many investors are turning to self-directed brokerage accounts to put all of their investment decisions in their own hands. Self-directed brokerage accounts enable you to pick and choose from virtually every investment option under the sun, from funds to individual stocks.
Below, I’ll explain the advantages of self-directed brokerage accounts, why people use them, and how you can open your own self-directed account.
What is a self-directed brokerage account?
In simple terms, a self-directed brokerage account is one in which you have complete control over how you invest your money. That means you aren’t locked into a narrow selection of funds picked by a financial advisor or your employer. Instead, you can buy individual stocks, bonds, options, and even dabble in orange juice futures, if you wanted to.
When you contrast a self-directed brokerage account to a traditional retirement account like a 401(k), the difference becomes quite clear. Most 401(k)s only offer a limited selection of mutual funds approved by the 401(k) administrator. A study by employee benefits firm BrightScope found that the average 401(k) offered 22 different mutual funds to invest in.
In other words, of the more than 9,000 mutual funds in existence, your 401(k) is likely to offer access to less than 1% of them. And forget about buying individual stocks or bonds -- most 401(k) plans simply don’t allow you to do that.
By contrast, a self-directed brokerage account gives you far more flexibility. If you open an account with an online discount broker, you’ll be able to invest in thousands of different funds, buy or sell individual stocks and bonds, and dabble in options, if you desire. In short, a self-directed brokerage account is a path straight to the financial markets, enabling you to invest in more than just a pre-selected bundle of funds or stocks.
Why self-directed accounts are so popular with investors
Being a self-directed investor has its advantages, as it allows you to take more control over your money. More control begets three main benefits over a limited investment account.
- Lower costs -- Whereas many employer-sponsored plans only offer high-cost mutual funds, investors who use self-directed accounts can pick and choose from lower-cost choices. Over your career, the difference between paying fees of 1% per year and 0.25% per year can add up to hundreds of thousands of dollars. (For perspective, over a 40-year investment horizon, the difference between a 7% annual return and a 7.75% annual return adds up to $48,267 on a $10,000 investment. That’s no rounding error!)
- More precision -- Being able to select from a wider selection of investment choices can help you better allocate your money. If you want to put exactly 10% of your assets in small cap stocks, that’s easy to do with a self-directed account because there are countless small cap funds to choose from. Many employer-sponsored plans don’t have focused funds that allow you to pick your own allocation so easily.
- Fewer conflicts -- Hiring a financial advisor is a decision ripe with conflicts. Many advisors are paid more to sell certain products that carry higher fees. Some less ethical advisors will steer you toward products where they get the largest commission when you invest in them. Self-directed investors eliminate many of the conflicts of interest that can work against them.
Types of self-directed brokerage accounts
A self-directed brokerage account is mostly a descriptive label. It tells you that the investor, not an adviser or employer, has control over the investment decisions, and which investments are available at any given time. There are three types of accounts that are commonly used for self-directed investing.
- Individual retirement accounts (IRAs) -- An IRA is the most classic type of self-directed brokerage account because it is completely separate of any employer, and can be opened at any discount brokerage or fund company. By opening an IRA with a discount broker, you can choose from thousands of mutual funds, exchange-traded funds, and individual stocks to invest in on your own.
- Ordinary brokerage account -- An ordinary brokerage account gives you all the flexibility to invest as you please, without the tax advantages of a tax-deferred or tax-free retirement account. A brokerage account is a good way to invest after hitting the maximum contribution limits on a 401(k) or IRA.
- Some 401(k) and 403(b) plans -- Some employer-sponsored plans offer what’s known as a “brokerage window” through which you can invest in stocks or funds that aren’t normally offered in the retirement account. Only about 20% of employers offer a self-directed 401(k), and fewer advertise it, since they don’t want to be liable if an employee loses their retirement gambling on penny stocks. Be advised that placing trades through a retirement account is often more costly than placing trades through an IRA or traditional brokerage account that you hold with a discount broker, so a self-directed 401(k) may not be economical for frequent traders.
How to pick a broker for a self-directed account
Since the whole point of a self-directed brokerage account is to invest your money as you see fit, you don’t need to pay for the handholding of a full-service brokerage firm. Full-service brokerage firms offer more advice and customer service, but the costs are high -- some full-service firms can charge you to $250 or more just to trade a small block of stock.
Online discount brokers are often the best bet for investors who want to take control of their own accounts. Discount brokers charge commissions ranging from just $5 to $7 per stock trade, and offer hundreds (in some cases, thousands) of mutual funds and exchange-traded funds you can buy and sell without paying a commission.
Some of the most popular online discount brokers appear in the table below.
Large research selection for stocks and funds, plus an active trader platform
Low commissions and a $0 minimum investment
Top-tier research and low commissions, plus a wide selection of commission-free funds
Low commission plus special deals for Bank of America customers
Low commissions and some of the lowest fees on ETFs
Platforms designed for active traders, with thousands of funds for long-term investors
You can read more about each broker listed above in our complete review. Note that most brokers offer special deals (free trades and cash bonuses) for opening a new IRA or basic brokerage account. These offers are worth checking out, since they can substantially reduce your trading costs.
There are a few things worth exploring more carefully when picking a broker:
- Commissions -- Since commission prices vary by only about $2 per trade (most brokers charge $4.95 to $6.95 per trade), they aren’t a make-or-break decision point for long-term investors. That said, if you expect to trade more frequently, commissions will obviously play a more important role in which broker you choose.
- Fund selection -- Most brokers offer thousands of mutual funds, including funds that you can buy or sell without paying a transaction fee. Notably, Fidelity waives commissions for some iShares ETFs. Likewise, E*TRADE doesn’t charge a commission on many popular Vanguard ETFs. If you have a preference for iShares or Vanguard ETFs, for example, you might pick one of these two brokers just for the free trades.
- Account fees -- For the most part, fees you pay just to have an account are slowly going extinct, though it’s worth exploring the fee schedule for each broker before opening an account. (We reviewed the fees for each broker in our reviews. Click on the brokerages in the table above to see what we found when exploring the fee schedule for each broker listed above).
In contrast to other types of investment accounts, a self-directed brokerage account is limited only by what the brokerage makes available to you. For investors who want to buy individual stocks, there is little difference between brokerages, as all of them will at least allow you to trade every stock in the United States.
Mutual fund investors may want to be a little choosier, though, since funds from certain asset managers (Vanguard, Fidelity, Capital Group, Schwab, etc.) may not be available through every single brokerage firm.
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