To become an investor in financial instruments such as stocks, commodities, futures and bonds, etc., you’ll almost certainly need to set up a relationship with a broker (which can be an individual or a brokerage firm). The broker will buy and sell securities for you for a commission (plus other fees will likely also come into play). The broker will also provide recordkeeping and, unless requested otherwise, hold your securities for you in your brokerage account. Many other services are available and will be discussed below.
Is a broker always required? No, there are some companies that facilitate direct (i.e., no broker needed) purchases of their stock and/or have dividend reinvestment programs, but for all practical purposes you’ll need a broker to invest in stocks.
For simplicity’s sake, this How-To discusses brokers from the viewpoint of those who are primarily interested in stocks. Most of the concepts presented here apply to investors in other securities, and many, if not most, “stockbrokers” will trade other instruments such as bonds and options for you. But in this article we make no attempt to identify or discuss issues peculiar to investments other than stocks.
A key part of your relationship with a broker will be a “brokerage account”. A brokerage account allows you to deposit funds with the broker, who will use those funds to buy on your behalf. Securities purchased will then be kept in the account, and when they are sold the proceeds will be deposited there. Unused cash sitting in the brokerage account will normally earn interest. Once your brokerage account is open and funded, you will be able to execute buys and sells almost instantly.
A margin account is a brokerage account that allows you to buy “on margin”. That is, you can borrow from the broker and buy stock worth than the amount the cash you have in the account. Buying on margin can magnify your gains, but will also magnify your losses. It is a riskier way to invest, but used by many investors to leverage their own assets.
Nowadays brokerage accounts often offer many other services such as banking. Many of these will be discussed below. In fact, the availability of these extra services may be key factors in your choice of a broker
Choosing a Broker
The most important part of the process is research. There are many, many options to choose from and investors have different needs and preferences.
Types of Brokers
Distinctions between different types of brokers are becoming increasingly blurred, with many “cheap” online brokers offering a fairly extensive and sophisticated array of services, and traditional full service brokers offering discounted online trading. Still, some of the distinctions remain valid, and for a newcomer a simple categorization may be helpful when wading through the available alternatives.
For our purposes here, we will classify brokers as:
Discount brokers with assistance
Full service brokers
In its purest form, this kind of broker is simply an order-taker. Since there is no physical office to visit, no licensed stockbrokers available to advise you personally and relatively little overhead, online/discount brokers generally provide the least expensive way to buy and sell securities.
If you feel you are knowledgeable enough to take on the responsibilities of directing your own investments, or if you want to learn how to invest without making a large financial commitment, this could be the way to go.
Also, if you plan to trade frequently, minimizing transaction costs will be will be important to your success. This may lead you to choose an online/discount broker, but remember that speed of trade execution and the potential for other hidden costs are also important things to consider.
With an online/discount broker, you can normally open an account with relatively little money and trade execution costs are usually calculated purely on a per transaction basis.
As noted above, in the real world online/discount brokers may actually offer many more services, either themselves or through links with affiliated firms or to third party investment-related sites, resource and research sites.
Discount brokers with assistance:
Discount brokers with assistance will offer a bit more than a non-assisted online broker. How much more varies considerably, so you will have determine what is available from any broker that you are evaluating.
Conceptually, this type of broker doesn’t leave you completely on your own but doesn’t provide full service either. Their websites will usually have more information, and they may offer more ways for you to get in contact with a real person and/or receive investing assistance. They will typically provide you with general information, but not specific buying or selling recommendations.
Full service brokers:
Full service brokers are the traditional stockbrokers that work out of an office, and normally has a specific person who is “your” broker. This individual will be available to you for consultations, including face-to-face meetings. The general idea is for them to take the time to understand you personally and financially.
The “full service” in full service brokers means that they will work with you to develop a financial plan best suited to your investment goals and objectives. They can also often assist with estate planning, tax advice, retirement planning, budgeting and other types of financial advice.
Full service brokers are for those who want everything in one package and/or value personal contact. In terms of fees, they are generally a lot more expensive than discount brokers.
And as we’ve already noted, many, if not most, now offer discount and online trading options too.
These days, most investors question the need for full service brokers given the range of investment advice and financial information readily available from the internet, books, and online and discount brokers. Plus many full service brokers are little more than glorified salespeople.
Still, for someone who plans to buy and hold for relatively long periods and invest in relatively large amounts, the high full service commissions may not be that important. Investors should, however, be very alert for other costs such as account maintenance fees which can significantly reduce an investor’s profits.
Things to Consider
Yourself: While it’s beyond the scope of this How-To to cover investment strategy, a key consideration in the choice of a broker is you. You must analyze yourself, your personality, your financial needs and goals, the types of things you want to invest in, how actively you want to trade, your confidence level, and so on. Hopefully you’ve already done this as part of developing an investment strategy. Apart from your investment strategy, your personal preferences such as the importance of being able to talk to a real person by phone or even face-to-face should be considered.
Cost is obviously very important. The most visible cost – commissions on trades – is generally easy to determine and, as noted elsewhere, is more important to some investors than others. But other costs such as account maintenance fees; extra commissions and hidden costs for trading penny stocks, if that’s one of your interests, and even limit orders; and the costs of other services you plan to use such as banking can add up and have a significant impact on investor wealth considering the compounding effect over many years. Particularly look out for fees that don’t make any sense such as custodial and safe-keeping fees. These are often sham fees designed to siphon off extra dollars from the unwary. Don’t be afraid to ask why a fee is being charged
You must also consider the impact of interest paid on cash balances, which is an offset to costs.
Related to cost is the type of investor you plan to be:
Short-term vs. Long-term: Short-term investors should look for low transaction costs. Extremely short-term day traders should also focus on trade execution time. For long-term investors, transaction fees are less important than account maintenance or other fees based on time or account balance.
Do-it-yourself vs. want/need advice, help with research and/or direct access to a real person: Obviously extra service levels generally cost more.
Use of Margin Accounts: Obviously investors planning to trade on margin should check offerings and costs. But even those not planning to trade on margin right now might want to think about the future.
Can the broker accommodate your trading plans? Does the firm restrict or charge extra for trading in OTC and penny stocks (some firms officially facilitate penny stock trading, but are quick to stop trading in especially hot penny stocks)? Do they offer trading in the non-stock types of investments you plan to make, such as derivatives? For day traders, do they promise exceptionally quick trade executions? If you want to invest in mutual funds or Exchange-Traded Funds (ETFs), do they have a roster of attractive funds you can buy commission free? Investors planning to engage in short-selling need to check availability and whether or not a firm has special margin requirements over and above the SEC minimum.
Minimum Balance Requirements are critical for small investors. A brokerage firm with a $10,000 or $50,000 minimum balance requirement just isn’t an alternative for many investors. Also what happens when an account falls below the minimum? All firms have minimum “Opening” balance requirements but don’t penalize investors when an account falls below this amount. But others charge account maintenance fees in such cases which can be significant – particularly, especially in percentage terms, for small investors.
Other Services and Features: Some firms offer credit cards, checking, retirement plans and even mortgages, allowing you to combine checking, investing and credit. Some firms offer trading and even check depositing over smartphones. New services are being offered all the time
Retirement plan offerings such as IRAs can be attractive, and convenient when handled by your stock brokerage firm. Many brokers offer no-commission mutual funds and ETFs. Mutual funds and ETFs offer investors, particularly beginning and small investors, immediate portfolio diversification. ETFs are gaining in popularity because they have lower management fees than actively managed mutual funds – which often don’t actually perform any better, or even as well as, indexed funds.
Restrictions: Some firms make it hard and/or expensive to take money out of your account. Other restrictions or special requirements might apply to specific areas of interest to you.
Customer Service: Customer service – which online generally includes website design, performance and interface – is important even when using online/discount brokers. So as you narrow down your choices, give customer service a workout. Are websites quick and easy to understand and navigate? Can you find what you’re looking for? Whether online or offline – do you get prompt and relevant responses to questions and requests for materials? If phone service is important to you, are calls answered promptly and by someone who can help you or immediately direct you to the right place?
Before you sign up with a broker be sure to test customer service, particularly at peak times.
Alternative Trading Options: Particularly if you plan to trade frequently and/or in highly volatile stocks, you need to know your options for trading and other services when you are away from your computer or if your internet access is interrupted.
Other: As with other commitments and purchases, see what current and former customers are saying. The internet is a good tool for this. If an introductory offer is a factor in your decision, make sure you qualify to receive it. Read the fine print.
Setting Up A Brokerage Account
Once you’ve done your research and decided on a broker and the services you want to use, the rest should be relatively quick and easy. Each broker has their own forms and procedure, so account setup is simply following instructions and then funding your new account.