A brokerage account is an investment account in the form of an agreement between an investor and a broker, opened with a brokerage company. Funds are deposited via bank transfer, issuing a check, or by linking a brokerage account with a checking or savings account. Brokerage account has no restrictions on the amount of funds contributed and is subject to capital gains tax.
After the money is deposited into a brokerage account, investors can buy and sell various types of investment instruments in the exchange and OTC markets through an intermediary in the form of a broker. For the execution of brokerage orders for the buy or sell of assets, the broker charges a fee.
Investors can open and use many brokerage accounts. For example, several brokerage accounts in one institution, diversifying assets by investment strategies. Alternatively, several brokerage accounts in different institutions, diversifying assets also by the brokers themselves.
Reliable brokers are necessarily regulated by government regulators and are non-profit associations that insure investors in bankruptcy of a brokerage company. For example, in the United States, the state-owned SEC and non-state FINRA act as a regulator, and SIPC acts as an investor protection association. Different types of assets may have different amounts of insurance compensation.
Types of brokerage accounts
When opening an account, brokers offer to choose between cash or margin types of accounts.
- Does not use borrowed funds, therefore, if you deposited $10,000, then the maximum that you can lose is $10,000;
- You can only buy securities and sell existing ones. It is impossible to make short sales when missing securities is borrowed from a broker and sold;
- Requires the introduction of cash and securities in full by the date of the settlement of the transaction. For example, if the settlement term of a transaction is 2 business days (T + 2), then when selling stocks today, cash will be available for other purchases only after 2 days. Despite the fact that cash may appear on the account immediately after the sale of stocks;
- Can use the direct registration system (DRS), in which purchased securities are written in the name of the investor, not the broker. This protects the investor from any problems arising from the bankruptcy of a brokerage company.
- Uses borrowed funds, allowing you to buy securities worth more than equity. This is called the leverage effect;
- Allows you to make short sales, borrowing the missing securities from a broker and selling them on the market. This method allows you to earn on falling securities, selling borrowed securities at one price and buying back at a cheaper price;
- Does not require the expiration of the settlement of the transaction. You can immediately borrow funds or securities and make another transaction, without waiting for the settlement of the previous transaction;
- Complicate the receipt of dividends on shares. If not everything work correctly, you may not qualify for lower dividend tax rates and instead have to pay at regular tax rates;
- You cannot get dividends at all. With a short sale of stocks, the true owner of the stocks will receive dividends, and not the one who borrowed them from the broker for sale;
- Using margins can lead to financial catastrophe, no matter how smart you are. For example, the leverage of your margin account is 5 to 1. With your own capital of $10,000, you bought shares at $50,000 and went to bed, and when you woke up in the morning, you found out that the loss is $45,000. You not only lost your money, but also owe the broker $35,000. Many people lost huge shares of their savings and in many cases more than their own capital. Some committed suicide because of the heavy losses incurred due to the use of leverage.
When using value, dividend or passive investment, the margin account is categorically inappropriate. Use only your personal funds, without attracting borrowed money. Therefore, you will significantly improve your financial survival.
For experienced investors, the use of margin is justified if the cost of margin is low (low interest rates), the margin itself does not exceed 50% of its own funds and there is additional free money in case of force majeure losses.
Types of brokers
Broker services are distinguished by various factors, one of which is price. Experienced investors try to minimize costs, because this is one of the few that can be controlled in financial markets. By price segment, brokers are divided into 2 types.
Full service brokers
This broker provides many services for clients. He knows you and your financial goals. You can call him or go to his office to discuss your investment portfolio and get investment advice from him. Such a broker has excellent support; you can always contact and ask any questions about opening an account, taxation, setting up a trading platform, choosing securities, etc.
The disadvantage of this broker is expensiveness. For each transaction, you will have to pay 8–15 times more expensive than that of a discounter. On the other hand, such a broker is able to give valuable investment ideas and even be a financial psychologist, encouraging investors to keep calm during market crashes and make profitable deals.
A distinctive feature of discount brokers in their cheapness and savings. These brokers have low fees and other costs due to minimal office expenses, reduced support, etc. There are no personal advisers here who will explain how to open an account and help you in choosing an investment. All have to do it yourself. Orders to buy or sell are sent only via the Internet using the trading brokerage platform. Telephone communication is not used.
These brokers are great for experienced investors, because they do not need advisers, support and visits to offices. An experienced investor wants one thing – low commissions and high-quality execution of orders through the Internet platform. Discount brokers meet these requirements.