How does a brokerage account work?
A brokerage account is one of the most important things in personal finance. It is an account which allows an individual to make investments in stocks, bonds, REITS, mutual funds, ETFs, and certificates of deposit. For financial planning or wealth creation, such investments are critical.
A brokerage account is a taxable account that is opened with a brokerage firm. Once the account is opened, the account holder has to transfer money into the account. This can be done either through cheque, wire transfer, or electronic transfer from a linked bank account.
Most brokerage firms these days link your primary bank account to the newly opened brokerage account so that transferring money to and from that account to your bank account becomes easy.
Different types of brokerage accounts
There are two types of brokerage accounts that you can choose from. One is a cash account which basically works on the basis of the amount of cash that is deposited in the account.
Trades are done only when there is sufficient cash in the account. If settlement takes 2 or 3 days, new trades are not executed until that amount has been cleared and fully transferred to the cash brokerage account.
This concept is important and must be understood because whenever an account holder sells his/her investment, the proceeds from that sale might show up immediately in the account but the settlement of that transaction may take a few hours or days.
The second type of brokerage account is a margin brokerage account. With a margin account, you can borrow money with your investments in the brokerage account acting as collateral.
So, against those investments, the brokerage firm basically lends you money at a low rate of interest. You can then use that borrowed money to make new investments. This type of account makes it possible for you to avoid waiting for the transaction to reach settlement.
You can also engage in what is known as margin trading, where you use leverage (borrowed money) to earn higher returns.
There are some disadvantages to using a margin account. First of all, an account holder of a margin account may not qualify for a lower dividend tax rate which can be almost half of the regular tax rate. Secondly, margin trading is highly risky.
One can lose a lot more than imagined by trading on borrowed money. A positive and healthy net worth can easily turn into negative net worth if a decision goes wrong. If you are going to be a serious and long-term investor, then it may be best to keep away from a margin brokerage account.
Different types of brokerages
Besides the type of brokerage account, you also have to think about the type of brokerage firm that you will work with. There are two types of brokerages, a full-service brokerage and a discount brokerage.
A full-service brokerage is a traditional service where you as a client are assigned a specific broker. This broker is a real person that you can talk to whenever you want, that you can meet in person at the office, and who knows you and your family well.
There is a “personal attention” factor with this option. Your broker will probably work with you for many years and will have a very good understanding of your financial situation.
The personal attention and service do come at a price. You could pay a high $50 to $150 per transaction fee with a full-service brokerage account.
These high fees mean that you probably will be less inclined to make frequent trades. That could be a good thing, as you will be a serious long-term investor who is not moved by emotional swings and market reactions.
Full-service brokerage accounts have two types of fee structures, one is the commission structure which was highlighted above where a fee is charged every time a trade is made. The second is an advisory structure where a flat annual fee (usually a percentage of total account balance) is charged and then no individual trade fees are charged. The most cost-effective option will depend on a case-to-case basis.
A discount broker is like a no-frills option. There is no personal attention as most of these brokerage firms tend to be online only.
The entire focus of a discount brokerage is cost. They provide you the service of making and selling investments at the lowest cost possible. Your per trade transactions could be as low as $5 to $10. You are expected to have all the knowledge of which investments to make. You are expected to execute your own trades.
There is no hand-holding with a discount brokerage. The most you could get is customer service on phone or through an online chat.
Discount brokerages may have a more dedicated option of a financial advisor, but that would cost you more as well. Discount brokerage firms these days have plenty of research data on their websites.
So, if you are confident of sifting through information, reading, and analyzing financial data, then a discount brokerage would work great in your case. With this option, you basically have to know what you are doing.
Some other aspects about brokerage accounts
Unless specified, there are generally no deposit or holding limits to a brokerage account. This is different from a 401k or a Roth IRA account which does have specific limits associated with it.
The one thing that you should look for when evaluating different brokerage firms is an account which has SIPC coverage. SIPC is like insurance that is helpful in the case the brokerage firm goes bankrupt. SIPC coverage is $500,000 per customer (for all accounts) in which $250,000 is the cash limit.
This is as important as FDIC coverage at a bank account. Different asset types in your brokerage account will have different levels of SIPC coverage. If you cannot get SIPC coverage, then you may want to consider an arrangement with a brokerage firm where the firm only executes your trades while you hold all investments through the DRS or direct registration system.
Can I have multiple brokerage accounts?
You may be wondering if it is possible to have multiple brokerage accounts. The answer is yes. You can have as many brokerage accounts as you want (and are willing to pay the fees for).
You can have multiple accounts either with the same brokerage firm or with multiple firms. In fact, having multiple accounts might actually be a good strategy. You can diversify your risks by not depending on one brokerage firm to transact your investments.
Sometimes, investors like to have one brokerage firm for buying stocks/investments and another for selling those investments. Doing so will keep your conversations with the brokers short and allow you to make your own decisions without any unnecessary objections from a broker.
Remember to set financial goals before you begin to invest. Investment is not about getting rich quickly or making a killer trade. It is ultimately about building wealth and fulfilling life goals. These could be buying a house, paying for education, or getting married. Whatever it is, set a goal and work towards it through disciplined investing.
Also, make sure that your finances are strong before you begin investing. Do not abandon your 401k or Roth IRA account. Keep enough emergency cash on hand. Ideally, 6 months of expenses should be in your bank account as liquid money, ready to go whenever needed. Once you have a solid foundation, then think of investing any surplus amounts.