What Is a Brokerage Account?
How Brokerage Accounts Work and The Types of Investments They Can Hold
Have you ever wanted to ask, "What is a brokerage account?" but were too scared? You hear about brokerage accounts on the news. You know that many successful people have them. How do they work? What are the benefits and drawbacks? Why should you open one? My goal in the next few minutes is to answer those questions and more so you have a solid understanding of not only what a brokerage account is, but how it works, what you should expect once you have one, and the types of investments they can hold.
What Is a Brokerage Account? Understanding the Basic Definition
A brokerage account is a type of taxable account that you open with a stock brokerage firm. You deposit cash into this account either by writing a check or linking it to a checking or savings account at your bank. Once this cash is deposited, you can use the money to acquire many different types of investments. In exchange for executing your buy and sell orders, you typically pay the stock broker a commission.
What Are Some Types of Investments a Brokerage Account Can Hold?
A brokerage account can hold many different types of investments including, but not necessarily limited to, the following:
- Common stocks, which represent ownership stakes in businesses.
- Preferred stocks, which usually don't get a cut of a firm's profit but, instead, tend to pay higher than average dividends.
- Bonds, including Sovereign bonds such as U.S. Treasury bills, bonds, and notes, corporate bonds, tax-free municipal bonds, and agency bonds.
- Real Estate Investment Trusts, or REITs, which represent pools of real estate related assets including some specialty types, such as hotel REITs, which focus on owning and operating hotels.
- Stock options and other derivatives, which can include call options and put options that give you the right or obligation to buy or sell a given security at a given price before an expiration date.
- Money markets and certificates of deposit, which represent either ownership in pools of highly liquid mutual funds that hold cash and fixed income investments or loans you make to a bank in exchange for a fixed rate of interest.
- Mutual funds, which are pooled investment portfolios owned by many smaller investors who buy shares in the portfolio or trust that owns the portfolio. Instead of trading throughout the day the way other assets do, orders buy and sell orders are put in at the end of the day all at once. Mutual funds include index funds.
- Exchange traded funds, or ETFs, which are mutual funds, including index funds, that trade like stocks.
- Master Limited Partnerships, or MLPs, which are highly complex partnerships with certain tax advantages to certain types of investors.
Some brokerage accounts will allow you to hold membership units in a limited liability company or limited partnership units in a limited partnership, typically tied to investing in a hedge fund, which can be difficult for new or poorer investors. However, the broker is likely to charge a not-insignificant fee for having to deal with the trouble of non-standard securities, as they are sometimes known.
What Is the Difference Between a Cash Brokerage Account and a Margin Brokerage Account
When you open a brokerage account, you have to pick between a so-called cash and margin account type.
A cash brokerage account is one that requires you to deposit cash and securities, in full, by settlement, in order to engage in transactions. The brokerage firm won't lend you any money. For example, if the trade settlement on your stock is three business days, and you sell your stock today, even though the cash appears in your account right away, you can't actually make a withdrawal until it is really there after settlement. A margin account, on the other hand, allows you to borrow against certain assets in the brokerage account with the broker lending you money in exchange for what is usually a low-interest rate.
I typically suggest people seriously consider investing through a cash brokerage account for several reasons. First, I'm slightly concerned that rehypothecation could be a major investment disaster.
It's an esoteric topic but one that you should learn about if you have a margin brokerage account. Second, margin brokerage accounts can result in some weird things happening with the way you collect dividends on your stocks. If things don't work out exactly right, you might not qualify for the super-low dividend tax rates and, instead, be forced to pay ordinary tax rates which can be roughly double. Third, no matter how well you think you've thought a position through, using margin can end in life-altering disaster. For example, late last year, I did a case study on my personal blog of a guy who went to bed with tens of thousands of dollars in net equity in his brokerage account and woke up to find he owed his broker $106,445.56. Many other individuals and families lost huge portions of their life savings, and in many cases, their entire liquid net worth or more, by purchasing shares of a company called GT Advanced Technologies on margin. It's not worth it. It's simple enough to get rich if you have a long enough period of time and you let compounding work its magic. I think it is a grave mistake to try to speed up the process to the point you risk destroying what you've built.
For what it's worth, this is one of those areas where I put my money where my mouth is. I feel so strongly about it that in all but the most remote circumstances for very specific type of investors, Kennon-Green & Co., my global asset management company, will require discretionary individually managed accounts to be held in cash-only custody. I don't care if widespread utilization of margin could make the firm more money due to the larger asset base on which we can charge investment advisory fees, the particular brand value investing, dividend investing, and passive investing we practice doesn't lend itself to borrowed money. It's a foolish risk and I want nothing to do with it.
Are There Any Limits To The Amount of Money You Can Deposit or Hold in a Brokerage Account?
There are no limits to the amount of money you can put into a brokerage account like there are with a Roth IRA or 401(k) and, thus, there are generally no restrictions on when you can access the money unless you buy some sort of restricted security or asset. Depending upon your personal tax situation and the type of assets you hold in the brokerage account, you may owe capital gains taxes, dividend taxes, or other taxes on your holdings.
One thing you may want to consider is the financial strength of your broker and the extent of SIPC coverage. This is the insurance that kicks in and bails out investors when their stock brokerage firm goes bankrupt. Different types of assets have different levels of coverage, and some have no coverage at all. Another alternative is to consider using a brokerage firm to execute trades but holding your securities through the Direct Registration System, or DRS.
Is There a Limit to the Number of Brokerage Accounts I Can Have?
No. There is no limit to the number of brokerage accounts you are allowed to have. In fact, you can have as many, or as few, brokerage accounts as you want and as institutions will permit you to open. You can have multiple brokerage accounts at the same institution, segregating assets by investing strategy. You can have multiple brokerage accounts at different institutions, diversifying your relationships and exposures.
What Is the Difference Between a Discount Broker and a Full Service Broker?
A full service brokerage account is a special type of brokerage account where you work with a dedicated broker who knows you, your family, and your financial situation. You can pick up the phone and speak to him or her. You can walk into his or her office and regularly have meetings and discuss your portfolio.
Part of the compensation for these sorts of arrangement typically comes from trading commissions so instead of paying rates of $5 to $10 at a discount broker per trade, you might pay anywhere from $40 to $150 depending upon the circumstances. While this increases costs, there are some who argue that it also encourages investors to hold their positions longer and stay calm during market collapses by having someone to hold their hand. You will have to make a decision for yourself which approach works better for your temperament.
A discount broker, in contrast, is generally online-only these days, perhaps with a few branch offices around the country. Everything is pretty much do-it-yourself and you have to execute your own trades.
Some financial institutions offer both models. To learn more, read Is a Full Service Broker Right for You?.
More Information about Stock Brokers and Brokerage Firms
This is part of our beginner's guide to stock brokers and brokerage firms, which contains a wealth of resources for new investors trying to understand how to choose a stock broker, how to read a trade confirmation, and much more. Also learn about cash management accounts.