Before you start investing, you’ll have to nail down some key terms and concepts – including the differences between a brokerage account and a mutual fund. Read on to learn the difference and how each plays a part in your investing strategy.
What’s a Brokerage Account?
A brokerage account is an account you open at a broker or a firm that charges you a commission or fee for buying and selling securities. You’d use a brokerage account to buy and sell individual stocks or other securities.
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You can find more on our picks for the Best Online Brokerages.
Full service vs. discount broker
A number of services you have at a broker depends on what type of broker you have signed up with.
An account at a discount broker would likely be very cost effective (meaning the commissions are low) but not have much customer service.
An account at a full-service brokerage offers more services, and could potentially give you access to anticipated IPOs if you have a big account or use their service a lot.
Choosing a margin or cash account
In terms of the types of broker accounts, there are generally two – 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 a buy or sell order), 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, and that interest is generally 7% 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 considered dangerous and should not be done.
To day trade consistently, you generally need to have $25,000 or more, or otherwise, you will run into the pattern day trading rule, where you cannot make more than 3 round trip trades in one 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 dividend quarterly, 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 tax-free.
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.
Opening a brokerage account
To open a brokerage account, you apply by filling out an application either at a physical brick and mortar broker or online.
Once the broker checks your credit, job, and other information and you are approved, you 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.
The caveat is that you as an investor should check how strong 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.
What’s a Mutual Fund?
A mutual fund is similar to a stock you buy, the only difference being that a mutual fund is a managed portfolio of stocks (or bonds) of many companies.
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.
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% and 2% a year.
In addition to the management fees, many mutual funds also charge redemption fees or a purchase fee, for when an investor exits and enters into the fund, respectively.
Although many mutual funds have outperformed the market for long stretches of the time, the statistics on broader active fund performance versus the broader market is rather sobering.
According to a Standard & Poor’s research report, 92.2% of large-cap active funds, 95.4% of mid-cap active funds, and 93.2% 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.
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.
In Essence, One Generally Comes Before the Other
The difference between a brokerage account and a mutual fund is that you generally need a brokerage account before you can buy a mutual fund unless your place of employment plans your retirement.