6 things to know before investing in a brokerage account

If you’re ready to become an investor, there’s never been a better time to start. Opening a brokerage account is one of the best money moves you can make because it gives you the most flexibility.

Here are six things to know before investing your hard-earned money in a brokerage account.

1. Your brokerage shouldn’t be your emergency fund

Before investing through a brokerage, you should have a healthy savings account for short-term needs, like unexpected expenses or something you plan to buy in a few years, such as a car or home.

Your savings should never be invested; keeping a cash reserve safe in a high-interest savings account is critical so it always retains value. If you experience a hardship like losing your job or business income, having cash can keep you from getting into debt.

A good target for your emergency fund is three to six months’ worth of your living expenses (such as housing, food, utilities and debt payments). For instance, if you spend $3,000 monthly on living expenses, make a goal to keep at least $9,000 in savings.

Once you have emergency savings, consider investing money toward goals you want to reach in at least three to five years. For example, you might dream about paying a child’s education expenses, making a house downpayment or retiring.

Investing means choosing financial instruments, like mutual funds or exchange-traded funds, with the expectation of future growth, which means accepting some risk. The value of investments can fluctuate wildly within short periods and could plummet when you need to spend them. That’s why you should avoid investing money earmarked for short-term goals.

2. You must pay taxes on brokerage gains

Brokerage accounts are taxable, requiring you to pay federal and applicable state income tax annually on capital gains, including profits on sales, interest and dividends. The tax amount depends on how long you own an investment and your tax bracket.

The upside of investing in a taxable brokerage is getting lots of flexibility. Unlike a retirement account, they don’t impose contribution limits, withdrawal penalties or required minimum distributions. Both brokerages and tax-advantaged retirement accounts offer a menu of investments. However, brokerage accounts typically have the broadest range of options.

3. You should invest in a brokerage as early as possible.

No matter how much money you have, it’s better to open a brokerage and invest sooner rather than later. Consider the following example.

Emily began investing in a brokerage at age 25 to buy a home before her 40th birthday. Over those 15 years, she invested $500 a month and received an average return of 8%. When she was ready to choose a home, she’d have nearly $175,000 to put down.

A second investor, Brad, begins investing at age 30 and stops at age 40. He also invests $500 a month and receives the same average return of 8%. But Brad has close to $90,000 after those ten years.

By starting to invest five years earlier, Emily has $85,000 more to spend on a dream home, even though she only invested $30,000 more ($500 x 12 months x 5 years) than Brad. Her brokerage account has a higher balance because it has more time to compound and grow.

So, remember that the sooner you start investing regularly, the more wealth you can build with less effort.

4. You should create a diversified brokerage portfolio.

Since no one can predict the future value of investments, buying and selling individual securities (like stocks and bonds) isn’t wise for average investors. A better strategy is to invest in one or more diversified funds, which bundle investments like stocks, bonds and other securities, making them convenient for investors to purchase.

Investment funds are incredibly diversified because they comprise hundreds or thousands of underlying securities. They may focus on one asset class, such as large domestic companies, or a mix of them.

Diversifying your investments allows you to earn higher average returns while reducing risk. If some securities within a fund lose value, others can hold steady or increase value, minimizing potential losses.

Since the 1920s, the historical average return of the stock market has been approximately 10%. If you have decades to go before spending funds in a brokerage, consider investing primarily in stock funds. Stock prices fluctuate during the short term, but prices will likely increase over the long term.

5. You should understand brokerage investment funds.

In addition to stock funds, there are different types and categories of funds you should be familiar with that a brokerage may offer.

• Mutual funds are a collection of assets managed by a fund professional. Buying and selling shares in a mutual fund are restricted to the end of the trading day when the fund’s net asset value gets calculated.
• Exchange-traded funds (ETFs) are similar to mutual funds in that they are baskets of assets. However, they trade like individual stocks, meaning you can buy or sell ETF shares throughout the day and should expect price fluctuations.
• Index funds are mutual funds that usually come with low fees and may comprise thousands of underlying investments. Index funds aim to match or outperform a specific index, such as the Standard & Poor’s 500 Index or Dow Jones Industrial Average.
• Target date funds are mutual funds that automatically reset the mix of assets in their portfolio according to your set time frame, such as when you plan to retire.

Be aware that funds come with different fees, known as an expense ratio. For example, a 1% expense ratio means that 1% of the fund’s assets will pay yearly expenses, such as management and advertising. Choosing lower-cost funds, such as ETFs and index funds, is an excellent way to get higher returns.

6. Consider your needs when choosing a brokerage.

Choosing the right brokerage can make a huge difference in your investing experience. Consider your investing preferences, such as choosing your own investments, using a robo-advisor or getting help from an advisor. Some brokerages offer free advice, and others charge for assistance.

A robo-advisor manages your portfolio automatically based on features you select, such as your stated risk tolerance, age and goals. It’s an algorithm recommending a diversified portfolio, typically a mix of five to ten exchange-traded funds (ETFs).

It can rebalance the portfolio, ensuring your desired asset allocation gets maintained over time.

Because trading is automated, the robo-advisors typically charge lower fees than human advisors. However, some brokerages offer a hybrid model where you can consult a human professional for more advanced financial planning advice.

You should consider a firm’s investing fees based on the type of advice you want or need. As with any financial decision, do your homework to compare the best brokerage accounts and consider your unique circumstances and preferences.

About the author

Laura Adams is a money expert and spokesperson for Finder. She’s one of the nation’s leading personal finance and business authorities. As an award-winning author and host of the top-rated Money Girl podcast since 2008, millions of readers, listeners and loyal fans benefit from her practical advice. Laura is a trusted source for media and has been featured on most major news outlets, including ABC, Bloomberg, CBS, Consumer Reports, Forbes, Fortune, FOX, Money, MSN, NBC, NPR, NY Times, USA Today, US News, Wall Street Journal, Washington Post and more. She received an MBA from the University of Florida and lives in Vero Beach, Florida. Her mission is to empower consumers to live healthy and rich lives by making the most of what they have, planning for the future and making smart money decisions every day.

This article originally appeared on Finder.com and was syndicated by MediaFeed.org.