Cash Account

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A cash account is the more popular. It's certainly the safest one to keep you, as a new investor, out of trouble while learning your way through the stock market. In simplest terms, a cash account enables you to buy and sell stock in direct proportion to what is in your account. This means that if you have $1,000 in your account, you can buy only $993 worth of stock in XYZ Company. Wait, what happened to the other $7? It went to pay the brokerage for placing the purchase, remember?

Plain English

A cash account is a brokerage account in which the investor can purchase stock only in an amount equivalent to the amount of money being maintained within the account.

It is exactly this type of example that shows the advantage of a cash account, and new investors should strongly consider having one. With a cash account, if you had tried to place an order for $1,000 worth of stock, the brokerage would have informed you that you didn't have sufficient money in your account, or they simply wouldn't have placed the order.

In the worst-case scenario, the brokerage would simply either freeze your account until such time as you coughed up the $7, cancel the purchase, or otherwise deal with the situation. Many brokerages will still allow you to make trades, as long as you put up the cash, and will freeze only the amount in question. In any event, you would definitely be aware of what was going on or what had already happened, and nothing would have happened that could get you into financial trouble.

Safeguarding Your Trades

Another way in which the cash account covers you from debt trouble in the market (never a good thing) is by prohibiting you from purchasing stock from the subsequent proceeds of a sale. That means you can't buy stock now with money you think you're going to make later.

For example, say you invest $100 in XYZ Company stock today, and tomorrow that stock is worth $200, so you sell it. You can't get the $200 you would have made unless you initially had $100 in your account to have made the first trade. "Wait a second," you say. "If you were to have given me the $200 first, and then I were to pay back that initial $100 as if you had loaned it to me, we would all still have come out happy, right?" Let's say for a moment that you bought the $100 worth of XYZ Company stock with borrowed money or a credit line, thinking the value was going to go up, and tomorrow the market tanks and your stock is worth $10. But you've already made a second purchase for ABC Company stock with borrowed money or a credit line, thinking you'll pay it back with the money you're bound to get from the XYZ purchase. Since the original investment never paid off, you're in way over your head.

TIP

Beginning investors should seriously consider opening a cash account that limits any type of financial damage from a bad investment to nothing more than the initial amount invested. While it's not a great idea to purchase stock on credit at any time, it's especially bad for new investors with limited experience.

It's this kind of reasoning that led to the original stock market crash. When the panic forced all stock prices to drop, people were responsible for the amounts of their original trades. Since they didn't actually have that kind of money, they lost their homes , savings, and anything else of value.

If you're convinced that you're a good enough (or lucky enough) investor to avoid these kinds of problems and pitfalls, perhaps you should consider a margin account.

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