What Is a Brokerage Account?
You know that many successful people have brokerage accounts, and you may have also heard family and friends discussing their own brokerage accounts and investments. How does a brokerage account work? What are the benefits and drawbacks? Why should you open a brokerage account?
The following information will answer those questions and more to provide you with 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.
Defining a Brokerage Account
A brokerage account is a type of taxable investment account that you open with a stock brokerage firm. You deposit cash into this account either by writing a check, wiring money or linking it to a checking or savings account at your bank. Once this cash is deposited, you can use the money to buy many different types of investment securities. In exchange for executing your buy and sell orders, you typically pay the brokerage a commission.
Types of Investments a Brokerage Account Can Hold
You can buy many types of investments within a brokerage account, which includes but is 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 (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, buy and sell orders are put in at the end of the day all at once. Mutual funds include index funds.
- Exchange traded funds (ETFs), which are mutual funds, including index funds, that trade like stocks.
- Master Limited Partnerships (MLPs), which are highly complex partnerships with certain tax advantages to certain types of investors.
Some brokerage accounts will also allow you to hold membership units in a limited liability company or limited partnership units in a limited partnership, which is typically tied to investing in a hedge fund and can be difficult for new or less-wealthy investors.
Beware that some brokers are likely to charge a substantial fee to deal with the trouble of non-standard securities, as they are sometimes known.
Cash Brokerage Account vs. Margin Brokerage Account
When you open a brokerage account, you'll be asked to choose between a cash-only or margin account type. A cash-brokerage account is one that requires you to deposit cash and securities, in full, by the time your trades settle, 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 the three-day settlement period. A margin account, on the other hand, allows you to borrow against certain assets in the brokerage account to buy investments, with the broker giving you what amounts to a low-interest rate loan.
You might consider investing through a cash-only brokerage account for several reasons:
- Margin brokerage accounts add more complexity to the way you collect dividends on your stocks. If things don't work out exactly right, you might not qualify for the lower dividend tax rates and, instead, be forced to pay ordinary tax rates which can be roughly double the amount, percentage-wise.
- Using margin can end in a huge financial disaster, no matter how well you think you've thought a position through. As an extreme example, a guy who went to bed with tens of thousands of dollars in net equity in his brokerage account that he got through trading using margin, woke up to find he owed his broker $106,445.56 because of a poor short-sale decision and a volatile market. 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 the same company on margin.
If you want to perform a particular method, such as value investing, dividend investing, and passive investing, these practices don't lend themselves to borrowed money and work well for more risk-averse investors.
Deposit and Holding Limits 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.
Take note of the financial strength of your broker and the extent of its SIPC coverage. This is the insurance that compensates investors if 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 while holding your securities through the Direct Registration System (DRS).
Limits on the Number of Brokerage Accounts
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 through as many institutions as will permit you to open those accounts. 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.
Discount Brokers vs. Full-Service Brokers
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, or walk into his or her office and regularly have meetings to discuss your portfolio.
Part of the compensation for these types of arrangement 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, some 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 as to which approach works better for your temperament and investing level.
A discount broker, in contrast, is generally online-only, 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.
You can find out more information on stockbrokers and brokerage firms by reading this guide to stockbrokers and brokerage firms, which contains a wealth of resources for new investors trying to understand how to choose a stockbroker, how to read a trade confirmation, and much more.