Beginner's Guide to Brokerages
Dan is a lawyer and financial planner. He has been writing since 2006 and covers topics ranging from investing and tax planning to personal finance.
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If you want to start buying stock or other investments, you need a brokerage account. But many people don't even know what a brokerage account is, let alone how to open one or what to look for in a broker. Below, you'll learn everything you need to know about brokerages so you can find the one that’s right for your investing needs.
What is a brokerage account?
A brokerage account is a financial account that allows you to buy and sell stocks, bonds, mutual funds, currencies, futures, options, and other types of investments. A wide variety of financial institutions offer brokerage accounts to investors.
How do brokerage accounts work?
In some ways, brokerage accounts work similarly to bank accounts. As with bank accounts, you can deposit and withdraw money into and from your brokerage account at will. Brokerage accounts also allow automatic transfers. And some brokerage accounts even offer check writing.
However, there are also some major differences between the two types of accounts. Brokerage accounts let you make investments that can have far greater returns than bank accounts. But there's also a risk that the value of your brokerage account will go down. Bank customers are used to having FDIC insurance protection to prevent losses, but nothing can protect your brokerage account from investment losses. The insurance available for brokerage accounts guards only against brokerage failure.
What are the types of investments you can make with a brokerage account?
There are many different investments available in brokerage accounts. They include the following:
Common stock is the most common ownership interest investors take in a company. The shareholders of a company's common stock share in certain benefits, such as gains in the stock price or dividends that the company pays. Shareholders also have the right to vote on certain corporate decisions.
Companies most often use common stock to raise money through equity financing. For instance, companies seeking capital for the first time typically issue common stock in an initial public offering, or IPO. That gives the business cash, and stock buyers get an ongoing ownership stake in the business. Later, companies can then do follow-on stock offerings to raise more cash.
Preferred stock is a completely different type of stock from common stock. Its preference comes from the fact that when a company pays dividends, it has to pay preferred shareholders full dividends before it pays common shareholders anything. Similarly, if a company goes out of business, then any remaining cash upon liquidation first goes to preferred shareholders up to a set amount, with any remainder going to common shareholders.
Preferred stock actually looks more like a bond in many ways. Preferred shareholders usually get fixed dividend payouts for a period of time, with the expectation of getting the par value of the shares back at a certain point in the future. As a result, the price of preferred stock often moves more with the bond market than with the stock market -- especially when interest rates are volatile.
Bonds are loans that investors make to companies or governments. They don't represent ownership in a company, but rather are debt obligations that the entity has to repay.
In exchange for getting the investors' money, the company or government agrees to make fixed interest payments over the course of the loan. At maturity, the entity then repays the principal amount in full. Therefore, bonds don't typically see growth in their value but rather are attractive almost entirely for the interest they pay.
REIT stands for real estate investment trust. REITs collect money from shareholders to invest in various types of real estate. In some cases, REITs buy commercial or residential property and then lease it out to collect income. Other REITs prefer to build their own buildings, while still others mostly trade financial securities tied to the real estate market.
REITs are like mutual funds, except they focus solely on real estate. Each share of a REIT represents a fractional interest in all the real estate in the REIT's portfolio, with managers of the REIT deciding which properties to buy and sell.
Money market accounts and CDs
Investors often use bank accounts to earn interest on spare cash they don't want to invest but also don't need immediately for expenses. Money market accounts are like savings accounts, but with some additional features that often include check writing and higher interest rates. Certificates of deposit, or CDs for short, require the depositor to keep their deposits with the bank for a fixed period of time that typically ranges from three months to five years. Both types of accounts pay interest, and you'll see various minimum investment levels depending on which bank you use and which type of account you want.
Mutual funds are investment vehicles that let many different investors pool their assets together, with fund managers then taking the money and putting together a portfolio of stocks or other investments.
Mutual funds come in two types. Actively managed funds have dedicated professional fund managers who pick stocks in the hopes of finding top returns. On the other hand, index funds just try to track popular market benchmarks to match their performance. Either way, your mutual fund shares entitle you to a portion of any investment gains in the fund's portfolio -- but also let you share in any losses as well.
Exchange-traded funds are very similar to mutual funds, with the main difference being that ETF shares trade on major stock exchanges. Like mutual funds, each ETF share represents a fractional stake in the fund's portfolio. Most ETFs use an index tracking strategy to match the returns of certain defined markets.
Master limited partnerships are businesses set up in different ways from corporations. MLPs offer some tax benefits over corporations, and you'll most often find MLPs in the energy infrastructure and transportation industry.
MLPs typically have higher yields than most stocks. That's because their underlying businesses produce ample cash flow to return to investors. MLPs also have tax benefits by not having to pay taxes at the entity level, with only investors getting taxed.
Brokerage accounts are useful, but they come with costs. Here are some of the most common ones.
Brokers charge several types of fees just for maintaining an account. These can include:
- Regular annual fees just for having the account open
- Subscription fees for research providers
- Inactivity fees if you don't trade for a given period of time
- Extra fees for special account types such as retirement accounts
Brokerage companies charge commissions for trading, but commissions have become less of a big deal lately. Many brokers now charge no commissions at all for stock and ETF trading, with minimal charges for other types of investments. Nevertheless, it's smart to look at the fee schedule for the broker you're considering to make sure you won't face any surprises.
Some investments add on fees of their own for management costs. For instance, mutual funds and ETFs typically have annual expense ratios that cover their own costs of investing your money. Those fees don't necessarily show up on a brokerage statement, but they're taken directly out of the value of your fund shares. Similarly, brokers can charge for management on separately managed accounts and other types of services.
Cash vs. margin brokerage accounts
In simplest terms, the key difference between a cash account and a margin account is that cash accounts don't let you borrow money to buy more stocks. In order to borrow against the value of your investments, you have to have a margin account rather than a cash account.
With cash accounts, all transactions must involve available funds. If you don't have the cash in your account, then your broker typically won't let you make the trade. Similarly, when you sell a stock in a cash account, you'll have to wait until the trade settles for the cash to go into your account and be available for withdrawal. You might not even be able to use the sale proceeds to buy another stock immediately.
Margin accounts let you borrow from your broker. You can borrow against the value of your stocks and other investments to buy more investments, giving you access to leverage. In exchange, the broker collects interest on the amount of the margin loan. Limits on margin loans vary, but many let you borrow up to half your account value as long as you own only investments that are deemed eligible for margin loans.
The biggest risk of margin accounts is that if your stocks drop in value, your broker can force you to sell them if your account balance falls below a critical limit. That usually happens at the worst possible time.
Discount vs. full-service brokers
Historically, all brokers were full-service brokers. Stock trades used to be regulated, with commissions that would add up to hundreds or even thousands of dollars per transaction. That started to change in the 1970s, when discount brokers first came into being.
Full-service brokers are still useful for clients who are willing to pay up for personalized service. But for those of more modest means, the dozens of reputable online stock brokers share some favorable characteristics:
- No commissions on stock trades
- Online platforms to trade and track your portfolio
- Tools to help you evaluate and select appropriate investments for your needs
- A variety of different account types, such as regular taxable accounts as well as IRAs and other tax-favored accounts
What to look for in a brokerage account
There are plenty of great brokerage accounts to choose from. But you can narrow them down by looking for a few things in particular:
- Diverse investment options
- Reasonable commissions
- No unnecessary extra fees
- Affordable account minimums
- Research and educational resources
- Reliable online and mobile access
Different investors will weigh these factors differently, but they tend to be important for just about every investor.
How do I open a brokerage account?
Here's a simple seven-step process for opening a brokerage account:
- Determine the type of brokerage account you need.
- Compare the costs and incentives.
- Consider the services offered.
- Decide on a brokerage firm.
- Fill out the new account application.
- Fund the account.
- Start researching investments.
Get started today!
Brokerage accounts are one of the most useful tools you'll ever have to help you invest. By opening a brokerage account, you'll gain access to the entire investing universe, opening up new opportunities to become wealthy over time.
A brokerage account is a financial account that allows you to buy and sell stocks, bonds, mutual funds, currencies, futures, options, and other types of investments.
A full-service brokerage account will give you access to investing experts who can help you personally with your portfolio, financial planning, and minimizing the impact of taxes. A discount or online brokerage account will let you DIY the investing yourself.
You can trade stocks, bonds, REITs, money markets, CDs, mutual funds, ETFs, MLPs, and other investments with a brokerage account.
Although most online brokers have eliminated commissions on many types of trades, there might still be fees for trading mutual funds, options, etc. Some brokers also charge annual fees for having an open account, as well as inactivity fees if you don’t trade within your account for a given period of time. There might also be subscription fees for using research and tools.
Look for diverse investment options, reasonable fees and commissions, affordable account minimums, educational resources, research tools, and reliable access in a brokerage account.