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In recent years, selecting a brokerage has become a lot simpler. There is no need to visit a physical location or mail documents. All you need is your computer and you are ready to go.
However, with literally hundreds if not thousands of brokerages available across the internet, it can be difficult to find the right one for yourself. Here, we will explain everything that you need to know before you opt for a broker. This guide will help you determine the key factors to watch for before you select a broker and begin trading.
We will begin by looking at the various brokerage account types.
There are various ways through which you can classify brokerage accounts. In general, there are 4 different kinds of brokerage accounts:
Let’s look at each of them and compare them against one another.
This account is your average run of the mill account that allows you to access a wide variety of investments. You can either open it individually or with someone.
As an individual, you will solely be responsible for paying taxes on the account, whereas the burden will rest on two or more people in a joint account. Joint accounts are usually created by spouses, but that is not necessary. You can, in fact, open it with anyone.
When opening a standard account, you have the option of choosing either a cash account or a margin account. We explore the differences between them later. Simply put, however, novice traders should opt for a cash account as margin accounts carry a lot of risk.
Remember that if you want to trade advanced assets such as options and other derivatives, you will need to sign an agreement. This agreement will protect the broker from any legal action provided you suffer huge losses.
An education account is an account that is used to fund educational expenses. In most cases, this account comes in the form of a 529 savings plan and is operated by a specific state. However, brokerages can also open this account for you through a particular state.
The only restriction is that the money withdrawn from the account must be used for qualified educational expenses. Anyone can be the beneficiary, and anyone can contribute to the fund on behalf of the beneficiary.
The biggest advantage of an education plan is that you do not need to pay any income taxes (both federal and state) on the income from these funds.
An Individual Retirement Account (IRA) is an account dedicated to saving for retirement. There are many types of IRAs, each offering various benefits and limitations.
In general, IRAs offer you tax breaks on the money that you invest. On top of that, certain retirement accounts also require your employer to match your contributions. However, there is usually a limit on how much you can invest in an IRA ($6000 in 2021 if you’re under 50 years of age, $7000 for individuals over 50).
Other limitations of IRAs include prohibition on margin trading, options trading, and short positions among other things.
With the rising cost of living, there is a pressure to save more for retirement. This is reflected in the average value of retirement accounts by family. As you can see in the following chart using FED Survey of Consumer Finances data, in 2001, the average was $151,000, but this has increased steadily over time to an average of $255,000 in 2019. However, the median figures have not seen such a dramatic increase, growing from $42,000 to $65,000 in the same period.
There are various types of Custodial accounts. The most common ones are based on the Uniform Gift to Minors Act and the Uniform Transfer to Minors Act. The major difference between the two is that UTMAs are also able to hold real estate.
It is also possible to open a custodial IRA account on behalf of a minor if the said minor has earned income. You cannot transfer money in a custodial account to any other beneficiary, but you can use it for purposes other than tuition.
Before you can select a stockbroker, you must know how to decide between the right ones. Here are a few main ways through which you can compare different brokers:
Let’s look at each of the aforementioned ways in a bit more detail.
It is best to look for any hidden fees that the brokerage may have. Before you sign up with a service, go through the entire fee structure multiple times to make sure you haven’t missed anything.
Remember that just because a broker is expensive doesn’t mean you should ignore it. It may provide you more features and better services.
Ideally, you want a broker that can help you learn as you trade. Most top-notch brokers have a portal where you can learn about trading and get better at it.
Also, you should read the reviews of brokerages to see how they treat their customers. A brokerage that can quickly address problems is vastly superior to one who can’t.
This is something that most people do not think of when choosing a broker. It is more than probable that you will need to move your funds at some point. Some brokers try to prevent this from happening.
Look for a broker that not only approves all withdrawal requests but processes them quickly as well. There is no point in receiving funds three days after you needed them, is there?
Similarly, your broker should also allow you to withdraw and deposit money in multiple ways. This way, you can choose whichever one you find the most convenient.
Always look for a broker that has a trading platform that covers all of your needs. As long as it has all the features necessary, choose a platform that is simple and easy to understand.
Also, try to determine the reliability of the platform. Since your trades will mostly be done online, make sure the platform is not susceptible to downtime.
Once again, reading reviews and using ‘demo trading accounts’ can be of huge help here.
The account that you choose depends on your needs. For most people, a standard brokerage account is adequate. It provides you the most freedom and allows you to invest in the widest variety of asset classes.
You should only deviate from the standard account if you are investing towards a particular goal. A retirement account will not let traders grow their capital in a rapidly fast manner. Instead, it will only be suited to those that want to slowly build wealth over the next few decades.
Similarly, an education account can be used to rapidly increase your capital, but it will be useless unless you need to withdraw money for educational expenses. And a custodial account may allow you to use your earnings on anything you wish, but it must benefit the beneficiary.
Contrary to popular belief, you don’t need a lot of money to start trading.
There are a lot of advantages of having a significant amount of capital. For example, it’s much easier to diversify your holdings across various asset classes. However, we explore options to diversify even with little money later.
As long as you have a few hundred dollars at your disposal, you can open a brokerage account.
One tip that you must remember is that you should always keep the fees in mind when trading. If you do not have a lot of capital, excessively entering and exiting positions may cause you to lose money even if the trades were not at a loss.
There are brokers out there that offer zero-commission trades. If you do not have a lot of capital, then going for one of them is ideal. However, just be aware of any hidden fees.
Members of the two aforementioned bodies have to adhere to strict rules when it comes to operating procedures. Being a member will protect your brokerage account from theft and unauthorized trading.
Most important of all, however, is the protection you get in case your broker becomes insolvent. Prior to the advent of FINRA and SIPC, a bankrupt broker usually ended in the loss of funds for all its clients. However, SIPC can provide limited protection. In general, SIPC has you covered for a total of $500,000.
Just keep in mind that the protection does not extend to all securities. The most notable securities not covered by SIPC are currencies, commodity options, commodity futures, and unregistered contracts.
We have touched on this before. While you should go for a cheap broker, going for the cheapest is not always the best option.
This is because a broker that isn’t cheap may offer additional services. For example, they may be able to provide top-notch customer support. Or, they may have an expansive educational platform that you can use to better your skills.
We have already mentioned how brokers often have hidden fees. On top of this, many brokers make use of the cash in your account by investing it in high-yielding funds and providing you low-yields.
The best thing you can do is to look at a few cheap brokers and compare their services. If a broker is obviously better than another, then a slightly higher fee is justified. Simply put, pick the cheapest broker that provides you all the services you need.
This is by far one of the most important decisions that you need to make. Almost every broker will offer you the choice between margin and cash trading.
Margin trading allows you to borrow money from the broker and ‘leverage’ your trades. Leverage amplifies both your profits as well as your losses.
Here is how the two compare:
Unless you are an advanced trader that fully understands the risk of margin trading, you should opt for a cash account.
A margin account carries a lot of risk. It is not uncommon to see novice investors losing all of their capital over a single trading session because they do not understand how leverage works. As such, beginner (and most intermediate) investors should stick with cash trading.
The best way to diversify when you have little money is to invest in Exchange Traded Funds (ETFs). You can purchase as little as one share of an ETF and gain exposure to all of its investments.
Another tool that you may want to consider is an Index Fund. An Index Fund tracks the performance of an index, thereby getting you results consistent with the market.
Even though you will only be invested in a single fund, the fund will be invested in multiple securities. Furthermore, you will be able to diversify even more by investing in multiple funds.
For example, you may split your capital between a Gold ETF and an S&P 500 Index Fund. This way, you will be exposed to 500 of the best stocks as well as numerous gold-based assets.
Just remember to thoroughly vet the fund that you invest in. Investing in a fund that loses you money makes diversification pointless.
With the introduction of low cost brokerage firms, more people are gaining access to investments. However, as this chart showing the value of directly held stocks shows, these values have remained fairly stable.
The data from FED Survey of Consumer Finances shows that in 2001, the average by family value of directly held stocks was $277,000. This dropped slightly in 2004, but apart from 2010, there has been a general upward trend.
Online brokerage promotions are one of the best ways to get into investing. These promotions can give you a lot of perks when you are starting.
Since the online brokerage business is extremely competitive, it is not difficult to find promotional offers that can get you up and running.
Remember that regardless of the promotion, it is imperative that you pick a broker that offers you a valuable service. If you sign on with an average broker just because of a promotion, you will stand to suffer later on.
When it comes to switching brokers, it is best to weigh the pros and cons against each other of the move. If the broker is as good as your current one (or better), then switching is a good idea.
Remember to never make the mistake of switching to a brokerage that you are not comfortable with just for the short-term benefits.
Here are a few examples of promotions that you should keep an eye out for:
It is best to regularly visit brokerage websites to see if there are any promotions available. As long as the brokerage itself is trusted and cheap, going for the one with the best promotion is a good idea.
We discussed how important it is that your brokerage is a member of FINRA and SIPC. This is precisely because they can help protect against losses.
In case the brokerage fails, the SIPC will cover each account for up to $500,000, including $250,000 for cash balances.
Just remember that this limit applies to the total of all of your accounts with the brokerage. For example, opening two accounts will not increase your coverage to $1,000,000. It is best to take an in-depth look at what the SIPC insures you against.
The best way to avoid losing your capital is to opt for a reliable brokerage with a trusted history. Taking a look at the financial statements of your brokerage (if available) will also inform you about the financials of the company.
Lastly, remember that brokerages must prove to regulators on a weekly basis that your assets are separated from their own. As such, the chances of losing your money are minuscule.
Since the advent of online brokers, you can start trading almost instantly after you register. Once the funds have been deposited into your account, they are usually available to be used after a few minutes.
Due to regulatory restrictions, brokerages will require you to comply with their Know Your Customer (KYC) procedures. As such, you may need to wait a small amount of time so that the broker can verify your identity.
Once that is done, you will instantly be able to log in to the platform and begin trading.
Brokerage fees mainly depend on the model that is used. For example, a broker may charge a percentage of the trade, a flat fee/trade, or use a mix of the two.
Certain brokers also offer additional services such as estate planning and retirement advice. These brokers usually charge a higher fee. The fee usually ranges between 1-2% of each trade.
Discount brokerages, on the other hand, provide limited products and services. As such, their fees are much lower. Online brokerages can achieve an even lower fee as they only provide you the tools to trade and not much else.
Most brokers also charge an account maintenance fee. The fee is usually charged annually and can vary among brokers. Discount brokers tend to charge around 0.5%, whereas online brokerages charge a fixed amount (mostly less than $50/account).
The first thing that you need to do is to consider the fee structure of the broker. There are 4 kinds of costs that you need to be aware of:
The first thing that you should do is consider your fixed costs. These include the maintenance fee and any service charges that will be deducted monthly/yearly. After that, consider whether there are any equity fee (fee that is a percentage of your capital).
Lastly, consider the trade fee.
For example, if the broker charges a 0.5% commission and you purchase stocks worth $1000, then the actual cost of the trade is $1005.
Try to calculate how many trades you expect to make and the average value of each trade. This will help you get a rough idea of the total fee that the broker will charge.
We have explained in detail all of the things that you need to be aware of before you select a brokerage firm.
Here is a summary of everything that you should check before you pull the trigger and get started with a brokerage.
We touched on this earlier. Opening a retirement account is a great idea if you have a source of steady income and want to save up for the future.
However, a retirement account will limit you by not allowing you to invest in certain risky assets such as derivative instruments. This makes retirement funds not as ideal as standard accounts for traders that want to experience huge returns on their capital.
On top of that, while it is possible to withdraw money out of retirement accounts at an early date, you will need to pay a penalty (usually 10%) along with all applicable taxes.
The main advantage of retirement accounts is that most of them allow your employer to match your contribution. This increases your effective salary (up to a certain point). As such, those that hold steady jobs stand to benefit a fair bit from their retirement accounts.
Do remember that you do not have to feel constrained. It is possible to have both a 401(k) or a similar retirement account as well as a standard brokerage account. If you have enough funds at your disposal to take advantage of both, go ahead and do it!