What a brokerage account is
A brokerage account is an investment account opened with a broker or a firm that charges a commission or fee for buying and selling orders for an investor.
Opening an Account
To open a brokerage account, fill out an application either at a brick and mortar brokerage location or, if applicable, online at the firm’s website or by fax. If the broker is able to verify your credit, employment status, and other information, you will be approved. You can then fund the account through ACH, check wire transfer, or other means. Unlike 401(k), IRAs, and other retirement plans, there is no restriction on how much money you can put in a brokerage account, although some accounts may have certain minimum requirements. The caveat is that you as an investor should understand how stable and secure the brokerage is and whether it has SIPC coverage. SIPC coverage is basically insurance that protects investors to a certain limit if the stock brokerage firm for some reason goes under.
Full Service or Discount Broker
The number of services provided varies between brokers. An account at a discount broker would likely be very cost effective (meaning the commissions are low), but may not have much customer service. An account at a full-service brokerage could likely mean more services and access to anticipated IPOs, but the account requirements and fees will be much more demanding if you are a new to trading or only interested in long-term investing.
Margin or Cash Account
In terms of the types of broker accounts, there are generally two main kinds – a cash account and a margin account. For a cash account, an investor has to wait three business days until the transaction settles (a transaction being an order to buy or sell shares of a stock), before doing another transaction with the money garnered from the not-yet-settled transaction. For a margin account, the brokerage loans you money and allows you to do the transaction instantaneously. Because the brokerage firm loans you money, you will have to pay interest on the borrowed money, generally 7 percent or higher for accounts less than $100,000 at most brokerages. Although you can short in a margin account (but not in a cash account) shorting is an extremely risky strategy for even experience traders. To day trade consistently, you generally need to have $25,000 or more, otherwise, you will run into the pattern day trading rule, which limits accounts below $25,000 to just three intraday trades a week.
Different types of securities you can buy
A brokerage account can be used to buy different types of securities, including common stocks, bonds, mutual funds, and more.
- Common stocks are basically just a fractional ownership of a company. If the company makes a profit, and the company’s management decides to share that profit with its owners, the company could pay a quarterly dividend, and you as an investor would collect that dividend. The dividend would go into the brokerage account on the ex-dividend date.
- Bonds include things such as treasury bills, municipal bonds, and corporate bonds. Because the U.S. government backs Treasury bills, short-term Treasury bills are considered the safest securities in the world. Municipal bonds are bonds issued by various municipalities and can be untaxed. Depending on how strong a company is, corporate bonds can be safer than stocks of the same company. Generally, many bonds pay a coupon, or periodic interest payment that continues until the bond matures. That periodic interest payment also goes into your brokerage account.
What a mutual fund is
A mutual fund is similar to a stock you buy, the only difference is that a mutual fund is a managed portfolio of stocks (or bonds) of many companies while a stock is just partial ownership of one company. Given that companies in a mutual fund portfolio are different, a mutual fund can theoretically be lower risk than a stock of a single company due to more diversification in the fund’s structure. If things go wrong in one company, other companies in a mutual fund portfolio might still do well, and the mutual fund’s overall net worth, or net asset value, won’t be as negatively affected.
Typically, mutual funds have a portfolio manager who directs analysts who do market research. Together, the team does their best to pick stocks they think will outperform an index, such as the S&P 500, and include it in their portfolio. Some mutual funds are concentrated in a select sector, such as energy or technology, while others cover the broader market as a whole. Because professional managers make the buy-and-sell decisions, mutual funds are considered ‘active’ funds.
Due to the fact that portfolio managers and analysts bring in salaries, many mutual funds charge a management fee, which is usually between 0.5 percent and 2 percent a year. In addition to the management fees, many mutual funds also charge redemption fees or a purchase fee when an investor exits or enters the fund, respectively.
Although many mutual funds have outperformed the market for long stretches of time, the statistics on active fund performance versus the broader market is rather sobering. According to a Standard & Poor’s research report, 92.2 percent of large cap active funds, 95.4 percent of mid-cap active funds, and 93.2 percent of small cap active funds have lagged behind a simple index fund that just tracks the S&P 500. The data suggests that, although owning a mutual fund is more beneficial in the long run than staying in cash, owning a simple low-cost S&P 500 index fund could be a better choice if you are interested in long term investing. A big reason for many mutual funds lagging the index is due to the mutual fund fees and the fact that some mutual funds make short term buying and selling decisions, and thus create more taxable income than a buy-and-hold strategy.
One generally comes before the other
The biggest distinction between a brokerage account and a mutual fund is that you generally need a brokerage account before you can buy a mutual fund. One exception could be if your place of employment plans your retirement.