Click to move to each section:
- Brokerage accounts
- Cash and margin accounts
- Is my money safe?
- Order types
- Large price drops and distributions — don't panic
- Dividends and rebalancing
- Fractional shares
- Mutual funds
Most of the asset managers discussed in previous sections do not offer brokerage services, so their products must be purchased through other institutions. The brokers discussed so far are Vanguard, Fidelity, and Schwab. Other brokers in the US include E*Trade, Ally Invest, and Interactive Brokers. Vanguard’s website is inconsistent and can be difficult to use compared to its peers, so even if you decide on Vanguard funds, I would suggest purchasing them as ETFs through Fidelity or Schwab. Those two are the brokers I recommend to most users. Feel free to create an account with each broker to experience the website and mobile app.
Before moving your money into a particular brokerage account, ensure that it is possible to buy shares in all of the funds you’re considering. Find out what fees, if any, the broker charges upon purchase and sale, and whether there is a minimum investment. If you choose a mainstream broker like Schwab or Fidelity, ETF trades will be free (a large ETF sale may cost a few cents due to SEC regulations). In a Schwab account, Schwab mutual funds are free to trade while Fidelity and Vanguard mutual funds carry transaction fees. Fidelity mutual funds are free to trade in a Fidelity account, and the same for Vanguard mutual funds in a Vanguard account. However, you may also be able to purchase shares through another broker: E*Trade, for instance, offers no-fee access to some Vanguard mutual funds. Fidelity and Schwab mutual funds have no investment minimums; Vanguard mutual funds have a minimum of $3,000 or more.
If you want to switch brokers and you've already purchased securities, you can do an account transfer to avoid selling and triggering taxes. Usually, there is no fee to sell shares of another manager's mutual funds (e.g., if you owned Fidelity mutual funds and transferred to a Schwab account). But before transferring mutual funds, you should verify that you can sell those specific funds without fees. Buying more shares will sometimes trigger expensive transaction fees, if you can buy them at all. ETFs have the advantage of making account transfers easier, because you don't have to manage a transition away from the mutual funds you can no longer buy.
Your previous broker may charge a fee to transfer out. You can ask your new broker to compensate you for the fee, which they may be willing to do, especially if you have a large account. If you're transferring cash only, it's likely that a wire transfer would be less expensive than an account transfer.
When you want to move money from investments to your bank account, the funds will not be available to withdraw until two business days after you sell the corresponding shares. So if you sold shares of a bond ETF on a Friday, the soonest you could transfer the money would be Tuesday morning (assuming no federal holidays; the time of day does not matter). This is due to the convention of a two-day settlement period. In contrast to exchange-traded securities like ETFs, stock and bond mutual funds generally have one-day settlement (e.g., a sale is executed on Monday evening and the funds settle on Tuesday).
The US market will switch to a one-day settlement period for stocks and ETFs on May 28, 2024.
This restriction can be lifted: if you enable margin features in your account, you can transfer funds immediately after selling, up to a certain portion of your total account value. With a margin account, you can also sell shares of an ETF and immediately buy shares of a new one, whereas a cash account has more restrictions. For these reasons, I recommend enabling margin in your account. By law, a minimum of $2,000 is required to activate margin features. Margin accounts allow you to borrow funds from your broker (and pay interest), which is not a practice I would suggest for most investors. Margin accounts also allow you to sell short, which is not something the average investor needs to know how to do.
All things considered, a margin account is arguably simpler to use than a cash account. The chief concerns with using each type of account are the following.
Cash account:
- good faith violations
- freeriding violations
- cash liquidation violations
Margin account:
- unwittingly borrowing money
- pattern day trader designation
The cash account violations are described here. Good faith violations are the main hazard. You can still sell and buy on the same day in a cash account, as long as you don't sell again before the first trade settles.
With margin enabled, don't spend more cash than you have in your account (assuming you want to avoid borrowing money). This is straightforward, although different brokers use different words for the same concepts, so you may want to call your broker to clarify terminology. Borrowing money is not legally allowed in a tax-advantaged account, so instead of margin, you'll have access to limited margin in your IRA. This allows you to trade without worrying about settlement periods, but naturally does not permit you to invest with borrowed money. Your broker may require a minimum of $25K in the account. Fidelity offers a user-friendly feature in their brokerage account called "Margin with Debt Protection", which provides the benefits of margin without the possibility of accidentally borrowing money.
Before describing the pattern day trader rule, we should define a day trade. A day trade means that you opened and closed a given position on the same day. Here's a day trade: you buy shares of XY on Wednesday and sell some or all of the shares on Wednesday. This is not a day trade: you buy shares of XY on Wednesday, sell them on Thursday, buy more shares of XY later on Thursday, and sell them on Friday. On Thursday you closed a position then opened another; you didn't open and close a given position on the same day. The pattern day trader rule dictates that a broker must label you a pattern day trader (PDT) if you execute at least four day trades within a rolling period of five business days. Why does it matter? After this designation, you'll be required to maintain an account value of at least $25K at all times. For many people, this would be an issue. Your broker is likely willing to remove the designation once or even a few times, but you need to know how to avoid it if your account is worth less than $25K or might fall below that threshold during a downturn.
Margin is an account feature that you need to apply for, because brokers are legally required to ensure that the investments they offer their clients are suitable. It's also a risk management tactic on their part to ensure their clients aren't putting themselves in debt by signing up for margin without any understanding. Your broker will ask very simple questions about your knowledge of and experience with investing. Without suggesting anything, it's not unheard of to exaggerate one's income, net worth, or years of investing experience in order to ensure that you'll be approved for margin. The application is automated and you'll likely be approved instantly.
Many people are aware that bank accounts in the US are insured by the FDIC up to $250K per depositor, per insured bank, for each account type. Client assets at US brokerage firms are also insured, but there are many regulations intended to protect client assets before insurance is ever needed. As FINRA stated here:
In virtually all cases, when a brokerage firm ceases to operate, customer assets are safe and typically are transferred in an orderly fashion to another registered brokerage firm. Multiple layers of protection safeguard investor assets. For example, registered brokerage firms must keep their customers' securities and cash segregated from their own so that, even if a firm fails, its customers' assets will be safe. Brokerage firms are also required to meet minimum net capital requirements to reduce the likelihood of insolvency, and to be members of the Securities Investor Protection Corp (SIPC), which protects customer securities accounts up to $500,000. SIPC protection comes into play in those rare cases of firm failure where customer assets are missing because of theft or fraud.
Note that securities in each account are insured up to $500K. So a client's taxable account, Roth IRA, and traditional IRA at the same firm are each covered up to $500K. Some brokers purchase private insurance for account values far above the SIPC threshold. Splitting assets between different firms is not necessary even for those with more than the insured amount. Brokerage firms are not subject to the same "bank run" vulnerabilities as banks and credit unions, because brokers have no claim on your securities. Only a firm's insolvency paired with pervasive theft or fraud triggers a need for SIPC insurance.
If an asset manager like BlackRock were to fail, and you were invested in one of their funds, either the fund would be transferred to another manager or the assets would be liquidated and returned to shareholders.
Your money is safe.
There are two basic order types everyone needs to know: market order and limit order. A market order means you'll buy or sell shares immediately, at the best price your broker can arrange. A limit order does the same, but only if the available price is at least as good as the limit you specified. So when you're buying shares, the order will execute only when the price is at your limit or lower. When you're selling shares, it will execute only when the price is at your limit or higher.
Ensure that you understand the bid-ask spread before you submit any orders. If an ETF has a bid price of $80.14 and an ask price of $80.16, a market order to buy shares will likely execute at $80.16. If you set a limit order for $80.11, there are two possibilities: (a) your order will execute when the ask price falls to $80.11, or (b) your order will never execute because the ask price never fell to $80.11. One way of using a limit order is to set the limit at the current ask price (if you're buying) or bid price (if you're selling), to avoid any surprises about the price at which your trade is executed. The ETFs recommended here are usually not highly volatile, so a market order is harmless.
If you place an order to buy or sell while the market is closed, it will be submitted at 9:30am when the market opens on the next business day (all times are Eastern time). If it's a market order, it will execute at whatever the day's opening price is. This price can occasionally be very different than the closing price on the prior trading day. But if you only have the chance to invest your money in the evenings or on weekends, submitting a market order is fine as long as you understand that the execution price could surprise you in either direction.
Trading is most active after the market opens at 9:30am and as the close approaches at 4pm. If you buy new ETF shares between 11:30am and 1:30pm, it's likely that price movement will be relatively low. This doesn't mean it's a mistake to trade near market open or close, but some people might find it mentally easier to execute trades when prices are stable. If you want to make it easy, feel free to just submit market orders for everything.
When you submit an order, it will either expire at the end of the day (a day order) or will be Good 'Til Canceled (GTC). Most of the time this distinction will not matter, because your orders should execute quickly. I don't recommend trying to wait multiple days for price improvement by using a limit order: just submit your orders and keep it simple.
None of this applies to mutual funds: there is no bid-ask spread and trades can occur only once per day at 4pm.
Some funds may have large distributions at the end of the year, triggering unusually large price drops. (If you need a refresher on dividends and price drops, click here.) Take Vanguard's total international bond fund (BNDX) as an example. Throughout 2021, monthly dividends ranged from 3-4 cents per share. The price changes due to these distributions were barely noticeable. On December 22, the closing price was $57.10. Then on the morning of December 23, the price opened at $55.35, falling 3%. These drops can be a source of dismay for new investors who think they rapidly lost this money in what they considered a safe bond fund. On December 29, shareholders saw a large distribution land in their account. Following a dividend of three cents per share at the beginning of December, the fund's end of year distribution was composed of a dividend of $1.25 per share, long-term capital gains of 36 cents per share, and short-term capital gains of half a cent per share (totaling about $1.62 per share).
This section is simply meant to warn you about a price drop you may (or may not!) observe in some of your funds at the end of each year. You can always check the ex-dividend date and payment date ahead of time, which you can find on a fund's webpage. Schwab and Fidelity have a great interface for viewing this information by typing the ticker symbol in their website's search bar. (You need an account to use this feature, though it need not be funded.) You can check distributions from previous years, because a fund's schedule of distributions tends to be very uniform over time.
It's advisable to select the option to reinvest dividends and capital gains distributions in your settings. For some people with small portfolios, each round of dividends will be so small that their sum may not even be enough to purchase a single share of an ETF. In that case, keep it simple and adjust your settings so that all dividends are automatically reinvested.
Alternatively, you could refrain from automatically reinvesting and use each dividend as an opportunity to partially rebalance your portfolio. You would buy shares in the most underweighted fund, and avoid reinvesting dividends in overweighted funds. You can use the same approach when investing your earned income (i.e., salary or wages) to add to underweighted funds. Rebalancing through dividends and earned income is advantageous because you can do so without selling any shares. Being able to hold shares for more than a year without selling is ideal in taxable accounts, because you'll pay lower taxes on long-term capital gains. Depending on how much earned income flows into your portfolio, you may be able to keep it balanced according to your preferences with dividends and earned income. All rebalancing actions should be conducted with tax implications in mind.
Either way, most people are best served by not treating dividends as a form of immediate income, but rather as a portion of their shares which they were forced to sell. (See this video on the irrelevance of dividends.)
Time-based rebalancing may occur on a quarterly, semi-annual, or annual schedule. You might also rebalance if your allocation drifts past a threshold (e.g., when a fund strays by more than 5 percentage points from its intended proportion). According to a Vanguard paper, the specific method does not much matter if you remain consistent:
What’s remarkable is that starkly different strategies were equally successful in controlling risk. At one extreme is a monthly 0% threshold strategy. If portfolio allocations differ at all from their target at month-end, the portfolio is rebalanced. Over the past 92 years, this strategy would have rebalanced a portfolio more than 1,100 times to produce an annualized return of 8.20%. At the other extreme is an annual 10% threshold strategy. The portfolio is evaluated yearly and rebalanced only if allocations differ from their target by more than 10 percentage points. This strategy led to only 14 rebalancing events, also producing an annualized return of 8.20%. We see that most rebalancing strategies have historically produced similar returns and Sharpe ratios on an after-tax basis.
Based on research like this, I would suggest a restrained approach to rebalancing, rather than trying to keep your portfolio perfectly weighted at all times.
Fidelity offers fractional shares for all ETFs (as well as stocks). Vanguard allows fractional shares for Vanguard ETFs only. Schwab offers fractional shares only for S&P 500 stocks, so it's not currently possible to purchase fractional ETF shares through Schwab.
While fractional shares are convenient for small investors, I think they usually don't make a significant difference. But they do serve as a great way for brokers to attract (a) beginners who want to dip a toe into investing with small amounts, and (b) people who are extremely bothered by not being able to invest every cent. There are some stocks like NVR with very high share prices that could certainly merit fractional shares, but ETF shares don't reach such extremes, so fractional shares are not as important.
If you decide to use fractional shares, you should be aware of a few details. Dealing in fractional shares may mean that your trade cannot be executed instantly in full, because the broker purchases your whole shares immediately but needs to combine your fractional share with those owned by others. The Plain Bagel's video on this is a great explanation. Since mainstream ETFs are rarely volatile, this will not matter in the vast majority of cases, but you should be aware of it. No matter how many ETFs are in an allocation plan, it is necessary to buy only one fractional share, and this is wise even if it means that the proportions will not be perfect.
It is easiest to buy a fractional share of the fund with the most assets under management, because this is likely to be the most liquid (i.e., quickly tradable at minimal cost). The 30-day median bid-ask spread is a more direct way of assessing liquidity than assets under management, because the bid-ask spread is the cost you pay to trade. Lower is better. In the most liquid ETFs, the median spread will be .01% or may even round down to .00%. Selecting a large ETF with a very low bid-ask spread is likely to lead to an immediate execution of the fractional trade. After your initial allocation you will eventually need to invest more money into your funds, because you've earned income or received dividends. You may want to always use the money left over after purchasing whole shares to purchase a fractional share of the most liquid fund, but this is not essential, as long as you understand that the trade may not execute instantly and that the price can change in the intervening seconds. However, you can use a limit order instead of a market order to prevent any surprises about the share price.
For logistical and financial reasons, some mutual funds prohibit frequent trading. Before you start using your employer-sponsored retirement plan, you should find out whether your plan provider has restrictions against frequent trading. There are no such restrictions on ETF trading (although ETFs are rarely offered by employer-sponsored plans).
In contrast to stocks and ETFs, mutual funds are not traded during market hours. Instead, once you submit an order to buy or sell shares of a mutual fund, the order will not execute until the conclusion of market hours. The order cutoff time is usually 4pm ET. Remember: if you submit a buy or sell order after 4pm, it will not execute that day. Another day of trading will occur before the order is executed after market hours. An order can be cancelled until 4pm on the day it will be executed.
At 4:05pm on (say) a Friday, even though the market is closed, you won't be able to see the day's updated price (also known as the NAV). It will still show the price from the end of day on Thursday. The new price will be published between 5pm and 6pm. You can check it in your brokerage account, on the fund webpage, or on a third-party website like Yahoo! Finance.
Before buying any mutual fund you should ensure that there are no extra conditions, like a short-term redemption fee. Such fees may depend on which broker you use. Yet another advantage of ETFs is that you don't have to worry about potentially surprising fees. For example, Vanguard's fixed income mutual funds VGAVX and VBLAX have purchase fees to disincentivize rapid trading — even if you trade in a Vanguard account — but their ETF counterparts VWOB and BLV have no such fees.
If you want to move money from one mutual fund to another, it's not ideal to sell shares and then buy shares after the sell order has executed. If you sell on a Monday, your order will execute after hours and you'll have cash on Tuesday. Once you buy shares on Tuesday, your order will execute after hours and you'll have missed the entire day's movement. Since the movement tends to be upward, we want to avoid this. Instead of selling, we can select "exchange". This will allow us to sell and buy shares after hours on Monday without missing Tuesday. Schwab phrases this option clearly: select "sell and buy another" to perform an exchange in a Schwab account.
Click here for the next section — Taxes
All sections:
- Cover page
- Introduction to index funds
- Thinking about risk
- Tax-advantaged accounts
- Your psychology
- Investing for retirement
- Guidelines for personal finance
- Building a stock portfolio
- Fund proposals
- Advice
- Practical information for execution
- Taxes
- Vocabulary and further resources
- Advanced topics