If you’re looking to get skin into the investment game, you’re probably wondering, “What is a brokerage account?” The term is thrown around pretty loosely, so you might have come across the phrase in some fine print disclosure, or maybe you noticed it in big, bold lettering that begged your attention.
Either way, it’s your money and you should know where it’s going. To complement our guide to investing, we’re here to explain what a brokerage account is in full detail so you can feel confidently informed about your future financial decisions. If you find that this type of investment vehicle makes sense for your circumstances, we’ll go over how to open a brokerage account, as well as the different types of brokerage accounts you can choose from to get your money moving.
What is a brokerage account?
A brokerage account is similar to a savings account, but for investing. A regular bank might offer an account with a high annual percentage yield (APY) that earns interest on the money you deposit, allowing you to stretch those dollars a little further. A brokerage account, on the other hand, opens the door to a wide range of investment opportunities, such as stocks, bonds, and mutual funds that can make your money work much harder over time.
Sometimes, a brokerage account is defined as a securities account because it holds financial assets (such as securities) on behalf of an investor with a broker, bank, or custodian. Basically, your average Joe Schmoe can’t walk up to the Stock Exchange floor and begin executing trades; they must be performed through a licensed brokerage firm that acts as a middleman between you and your money moves.
How do brokerage accounts work?
There are many types of brokerage accounts, and each works a little differently depending on how it’s set up. Let’s start with a simplified brokerage account definition: a means for investors to participate in the stock market. The broker holds your account and acts as an intermediary between you and your investment purchases.
Now, Investor.gov breaks down this brokerage account definition further by categorizing them as either “cash” or “margin” accounts.
How do cash brokerage accounts work?
In this type of brokerage account, investors deposit cash that’s used to pay for the shares or securities purchased. They don’t require a lot of money to open—many brokerage firms will allow you to create one with no initial deposit required. However, before you can buy any investments, you’ll first need to add funds to the account for purchasing power.
How do margin brokerage accounts work?
A margin account lets investors borrow money from the brokerage firm to buy shares and securities, with the assets in the portfolio serving as collateral on the loan. Buying investments on margin can dramatically increase your purchasing power, but it can involve a high level of risk.
For example, if the market crashes and the value of your assets decline, a “margin call” may force you to deposit funds into the account immediately—or, the brokerage firm may sell any of your securities to cover the shortfall without even informing you in advance. You also must first be approved by a brokerage firm to add margin to your account before you can even being trading on margin.
What types of investments are in a brokerage account?
Curious about the investment opportunities you can gain access to by opening a brokerage account? The golden rule of portfolio diversification suggests adding a mix of assets to your account in order to offset risk of volatility. Below are some of the most popular investments you can purchase on your own or through a broker with your brokerage account—but you’re by no means limited to these options.
As the name might imply, these stocks are very common and represent shares of ownership in a business organization. You can earn money off them by collecting dividend payments or by selling the stock in your brokerage account when the price is higher than what you paid for it.
Shareholders of preferred stocks typically receive higher dividend payments than common stocks but are more sensitive to changes in interest rates.
A mutual fund refers to a pool of money collected by investors who mutually purchase stocks, bonds, and various assets.
These lower-risk investment vehicles (such as U.S. Treasury securities) are more stable than stocks but usually offer a lower yield over time.
Real estate investment trusts (REITs)
You can also open a brokerage account to purchase REITs, or pools of real estate-related assets.
Money market and certificates of deposit
A money market account offers higher interest rates than a standard savings account, and certificates of deposits (CDs) loan money to banks for a fixed time at a fixed rate.
Exchange-traded funds (ETFs)
Exchanged-traded funds are baskets of securities that are traded like stocks and purchased through your brokerage account on the exchange.
Master limited partnerships
These investments are publicly traded entities that may offer investors high yields.
How to open a brokerage account?
Now that you know a thing or two about investment terms and how a brokerage account works, you might feel ready to open one of your own to start purchasing securities. The good news is that it’s usually very easy to open a brokerage account, and you have plenty of choices to choose from.
Download an app
In today’s world of digital banking, mobile apps like Robinhood have become increasingly popular among a new generation of do-it-yourself investors looking to learn the ropes with zero-fee trading. The platform does not charge a commission on trades nor does it enforce minimum account requirements (with the exception of its margin accounts). However, they do make a profit off of margin lending as well as subscription fees for margin trading or your cash holdings.
The drawback? Robinhood only supports some types of securities, and they do not offer investment advice regarding which types of assets to purchase through their brokerage account.
Create an online account
Many brokerage firms, such as E*TRADE and Charles Schwab or TDAmeritrade, took note of Robinhood’s success and adopted similar zero-commission models for most stock trades. You can easily hop online, choose between cash or margin trading, and open a self-directed brokerage account within minutes.
This also spurred the development of robo-advisors, or automated software platforms that handle nearly all investment decisions on your behalf for one low, affordable price—but with no guarantee backing the success of their decisions.
Select a discount broker
Discount brokerage firms—including Fidelity, Vanguard, and Charles Schwab—became big by offering their brokerage services at a significantly cheaper price than most full-service firms. They can facilitate the sale of a wider assortment of securities than most online and mobile platforms, and some may offer technical support to get you started for a more personalized approach.
Choose a full-service firm
If it’s within your budget to afford a full-service brokerage firm—like Morgan Stanley, Merrill Lynch, and Wells Fargo Advisors—it may be in your interest to do so. These types of brokers help their clients develop investment plans and then execute transactions accordingly… but they get paid to do so.
Some may charge brokerage investment fees with a commission on every investment that’s bought or sold (regardless of whether the trade is profitable to the investor), while others may charge flat advisory fees ranging from 0.5 – 1.5% of the total account balance every year.
While many advisors hold a fiduciary responsibility to their investors—meaning they must act in their clients’ best interests—plenty of advisors do not. They can work on either a non-discretionary or discretionary basis, the latter of which does not require client approval.
This can present an obvious conflict of interest if you open a brokerage account with an advisor who’s more interested in profiting off of your investments than making you money in the long run.
If you’re wondering how brokerage accounts work, the most important thing to know is that all investments involve some degree of risk. There is no singular “right” answer regarding which type of brokerage account you should open to start building an investment portfolio; it all depends on your experience and knowledge of trading on the stock market, how much risk you’re willing to take on, and what your budget can afford.
You should always do your research and be sure to avoid investment mistakes common to new-comers on the market. You can also take advantage of Mint’s investment calculator to estimate an asset’s growth, create goals, develop a strategy, and search for opportunities to boost your portfolio’s success.