When you first open a brokerage account, you will have to sign a “new account agreement.” Do not sign the new account agreement unless you thoroughly understand it and agree to the terms and conditions it imposes on you; there is a lot of legalese in these things, but it is important. Do not rely on statements concerning your account and how your money will be handled that are not in the agreement. Most of this stuff is pretty standard and is required by Uncle Sam. Full-service brokerages will often have more paperwork beyond the minimum federal requirements because they are expected to do a lot more for you.
The broker should ask you about your goals for the account and personal financial situation, including your net worth, income, investment experience, as well as how much risk you are willing to take. This stuff does not mean much if you are using a self-directed account with a low-cost brokerage to enter trades online, but if you are using a full-service brokerage, then it is very important. You are paying a premium for good advice, so be honest. A quality broker will use this information to determine which investments to recommend to you. If a broker tries to sell you an investment before asking you these questions, that is a very bad sign. It tells you that the person is more worried about earning a commission than helping you decide whether an investment is consistent with your financial goals and tolerance for risk.
The agreement requires that you make three important decisions:
Who gets to make the ultimate decision about what securities you buy and sell in your account? Normally, a broker will make recommendations, but the final say is up to you. Some people don’t want that responsibility, so they want to turn it over to their broker. You will have the final say on investment decisions unless you give discretionary authority to your broker. Discretionary authority is an awesome responsibility. It gives your broker the authority to invest your money without talking to you about the price, the type of security, the amount, and when to buy or sell. Obviously, you do not want to give this authority to your broker without considering the implications of turning over control of your account to someone other than yourself.
As a rule, your broker cannot legally accept authority over your account unless she is registered as an investment adviser. You will also want to have a clear investment plan worked out that you both agree will accomplish your investment goals. If you’d rather take a hands-off approach to investing that requires only a periodic rebalancing of your portfolio, you can leave this important task up to your broker. This critical task is essential, and you cannot afford to take on risk through procrastination. If you know you are likely to put it off, then this sort of arrangement with a broker may be ideal.
How will you pay for your investments? Most investors maintain a “cash” account that requires payment in full for each security purchase. If you open a margin account, you can buy securities by borrowing money from your broker for a part of the purchase price. Margin is Wall Street slang for “line of credit,” and you do not want to ever use it (except maybe while you are waiting for old trades to settle).
You may need a margin account to make certain types of trades so you may want to go ahead and set that up when you first open your account. Brokers will take no risk whatsoever on your behalf, so relatively safe bets must be covered by margin even if you are sure you will never actually ever use the margin. Your broker will not let you trade options until you have a certain level of experience so you may want to get the options account process going as soon as possible as well.
Different brokerages deal with cash in different ways, but it is pretty easy to figure you how much cash you have when you log into your account. Any money you haven’t spent on stocks or other securities sits in cash. You can immediately deploy that cash to buy something at any time that the market for your security is open. If you don’t have a margin account, you may have to wait a few days for sold securities to “settle” before the cash is available again. Most investors like to keep at least some of their portfolio in cash as “dry powder.”
Dry powder is an old term that hearkens back to the days of muzzleloading rifles when frontiersmen faced death at the teeth and claws of vicious beasts if they didn’t manage to “keep their powder dry” so that they could protect themselves and hunt for food. If you are a trader, some market conditions dictate that cash is the best place for your money to be. With cash, you can quickly buy stocks during a “flash crash,” and you can hedge by buying options.
There is a sick feeling to see opportunity everywhere, but you don’t have any “dry powder” to take advantage of it. If you are investing in cash as part of your non-emergency savings plan, consider keeping it in your brokerage account. You can buy money market ETFs that will perform like a high-quality savings account, and you can quickly liquidate those if opportunities that are more lucrative present themselves.
To use this strategy, you have to have the discipline not to put the money you need for other obligations, especially short-term ones, at risk. If you are a long-term investor and not a trader, you will want to invest all you can as soon as you can. The opportunity cost risk is just too high to try and “wait for a dip” or wait for “markets to settle down.”
How much risk can you accept and still sleep well at night? In a new account agreement, you must specify your overall investment objective in terms of risk. Categories of risk may have labels such as “income,” “growth,” or “aggressive growth.” Be sure that you understand these terms, and be certain that the risk level you choose truthfully reflects your investment objectives. Be sure that the investments recommended to you reflect the category of risk you have selected. If you have a self-directed account, then your answers to these questions will not matter very much. If you are opening a self-directed account, you will still have to answer the questions, but it is up to you to determine if a security aligns with your standards.