The role of the financial intermediary is to join together separate entities that are looking to raise capital with people and organizations that have extra money to invest. Brokerage accounts are held by the institution, on the behalf of its clientele, in order to trade securities and hold them for safekeeping. It is important to understand the role of the broker-dealer firm prior to selecting the right type of account to suit your needs.
Broker-dealer firms take orders to buy and sell investments for clients. Brokers never actually own these securities. Dealers, however, trade for their own account and carry “inventory” that may be sold off to customers at a later point in time. Broker-dealer firms carry a fiduciary responsibility to act within your best interests and are regulated by the Securities and Exchange Commission.
Discount brokers are transactional and take orders without offering recommendations. The traditional discount broker has now become associated with online trading, where you may execute trades through the computer interface.
Brokers that compile your personal financial data to recommend particular investments may be referred to as advisers. Of course, the amount of fees that you must pay are comparable to the level of service rendered, and you will still need to set up an account to easily buy, sell and hold the investments.
The cash account is the most basic brokerage account. You deposit cash into the account and use the cash balance to buy investments. Cash that is not being actively invested typically earns money-market interest rates.
Margin accounts allow you to borrow against the balance of your account to buy investments. The broker-dealer extends the loan and charges margin interest for these debts. The Federal Reserve Board sets margin requirements, which detail the percentages of ownership capital that are required to buy particular securities.
After buying the investment, you must keep a set ratio of your own money in the account in proportion to the margin loan. These ratios are defined as maintenance requirements. The broker-dealer submits a margin call when the account’s equity drops beneath a certain level to demand that you put enough money in your account to meet maintenance.
Margin accounts are related to leverage. Borrowed money allows you to commit more capital to particular investments and increase returns. Conversely, poor investment decisions may be disastrous because of the interest payments, leveraged positions and the risk that you will be forced to repay part of the margin loan when stocks fall and equity drops beneath maintenance levels.
Discretionary accounts grant money managers the authority to invest money on your behalf at their discretion. The adviser makes decisions pertaining to the type and amount of investments bought for the account--without you receiving any formal notification prior to his short-term trades.
Money managers often charge wrap fees, which are set according to a percentage of the total assets managed within these discretionary accounts.
Choosing the Right Brokerage Account
Selecting the right brokerage account is contingent upon your specific financial goals and sophistication as an investor. Experienced investors, or those who are not relying upon a particular sum of money to fund expenses, will prefer discount brokerage accounts that charge minimal fees. Those that have the money to invest, but lack the time to research the stock market, should pay for advisory services.
Meanwhile, discretionary accounts are reserved for competent money managers that have established trust. Discretionary accounts may be best for the wealthy because of the larger fees that come with access to quality service.