Investing Archives | Page 20 of 221

Q: How Safe Are Roth IRAs Considered to Be?

It depends how you define 'safe.' If you’re thinking 100% free from loss, there are no safe investments. That said, Roth IRAs, and many other retirement account types, are generally considered to provide investors with lower risk exposure. They’re generally safer than investing in, say, penny stocks or cryptocurrencies, which are usually referred to as 'speculative' investments.

Feb

2024

Can a Roth IRA Lose Money?

By Austin Kilham | Growing Wealth, Investing, Preparing for Retirement | Comments Off

It is possible to lose money when you invest in a traditional or Roth IRA (Individual Retirement Account), depending on what investments you choose for your Roth. All investments can lose money — including those within any type of retirement account.

That’s why it’s important to invest your Roth in assets that reflect your risk tolerance. If you invest mostly in stocks, you are at a higher risk for losses in your account. If you invest in less volatile assets (e.g. bond funds), you may be at a lower risk for losses.

Are Roth IRAs safe? No investment account is ever 100% safe, but because retirement accounts are generally long-term investments, they offer the possibility of growth over time. Also, the more years you invest in a traditional or Roth IRA, the more time that retirement account may have to recover from any losses.

Key Points

• It is possible to lose money in a Roth IRA depending on the investments chosen.

• Roth IRAs are not 100% safe, but they offer the potential for growth over time.

• Market fluctuations and early withdrawal penalties can cause a Roth IRA to lose money.

• Investing late or contributing too much can also result in potential losses.

• Diversification and considering time horizon can help mitigate risks in a Roth IRA.

Understanding IRAs

An IRA is a type of tax-advantaged account that may help individuals plan and save for retirement. IRAs can offer investors specific tax advantages that could be beneficial when compared with traditional brokerage accounts (which can be taxed as income).

There are also a few types of IRAs, with the most popular or well-known being the traditional IRA and Roth IRA account.

With a traditional IRA your contributions are pre-tax, meaning the amount you deposit in an IRA is deducted from your taxable income and is therefore not taxed until you withdraw the funds.

The key distinction is that contributions to Roth IRAs involve money that’s already been taxed, so it grows tax free, and withdrawals are also tax free. More on the differences between them below.

Can You Lose Money in a Roth IRA?

Now, to the main question: Can a Roth IRA lose money? The answer is yes, it can. This is one of the main differences between a Roth IRA vs. savings: Investing involves risk, whereas parking your money in the bank usually does not (with the exception of inflation risk).

There are several reasons that your Roth IRA may lose money.

Market Fluctuations

Given that the money in retirement accounts, including IRAs, is typically invested, the overall value of the account is subject to the whims of the market. That means that if the market experiences a downturn or correction, your Roth IRA balance is likely to decline as well.

That’s not a certainty, however, as IRAs are generally invested in a range of assets, not all of which may be affected by larger market conditions.

Early Withdrawal Penalties

Your Roth IRA can also lose money if you withdraw funds from it prematurely, and thus, are forced to pay early withdrawal penalties. Roth IRAs are complicated, however, in that your contributions can be withdrawn at any time. But you have to be careful with earnings.

If you withdraw earnings from your Roth IRA before age 59 ½ , you’ll likely be assessed a 10% penalty by the IRS.

Depending on the type of IRA you have, you may also need to pay ordinary income taxes, too.

You may want to consult a tax professional to make sure you understand Roth IRA rules that can trigger penalties.

Investing Late

It’s also possible to “lose money” in the sense that you miss out on market gains over time by investing in your Roth IRA too late. Time is an important factor in investing and saving for retirement, and if you start relatively young, time will work for you as the markets tend to rise over the years.

But if you’re about to hit retirement age and have only been investing in your Roth IRA for, say, a few years, you likely missed out on many years’ of appreciation by investing too late. This is why it’s generally a good idea to start funding an IRA as soon as possible.

Contributing Too Much

It’s possible to contribute too much to your Roth IRA, which may end up costing you. There are limits to how much you can contribute each year. For tax year 2023, the Roth IRA contribution maxes out at $6,500, or $7,500 if you’re over the age of 50. If you blow past that maximum, you must withdraw the excess amount or it can trigger a 6% tax penalty from the IRS.

Note that if your modified adjusted gross income exceeds a certain amount — $138,000 for single filers in tax year 2023, $218,000 for those married and filing jointly — you cannot contribute the maximum amount to a Roth IRA.

Allowable contributions are gradually reduced up to $153,000 in income for single filers, and up to $228,000 for married filing jointly. Above those caps, you cannot contribute to a Roth IRA at all.

Custodial Fees

There are also fees to consider. Someone manages your Roth IRA, and they don’t do it for free. As such, you may incur managerial or custodial fees that can affect your account’s overall balance, in addition to the cost of the investments themselves.

Can You Lose Your Entire Roth IRA?

It’s unlikely that you’d lose your entire Roth IRA’s value. Most fees, penalties, and taxes are levied as a percentage of that value, so they would not be able to fully drain the account. Perhaps the closest you could get to losing all of the money in your Roth IRA is if the market sees an all-out collapse, and most assets see their values reduced to zero.

Again — that’s very unlikely, but not impossible. If it were to happen, too, you’d probably have bigger problems to worry about other than the value of your investments!

With all of this in mind, it’s fair to ask, Are Roth IRAs safe to invest your money in?

The answer is that IRAs in general can provide less risk exposure than, say, day trading, although there are still risks to take into consideration. A Roth IRA that’s 100% invested in equities could be quite risky compared with a Roth invested in other assets (e.g. bonds or bond funds, mutual funds, and so on).

Also, the assets in a Roth IRA are usually long-term investments, which tend to help mitigate the risk of losses over time, as your money may have a chance to recover from any market downturns.

Limiting Risk in IRAs

One thing all of the IRAs above have in common is they offer the individuals who hold them a lot of flexibility in investment choices — including mutual funds, property, stocks, bonds, ETFs, annuities, and more. As a result, IRA investors can have a big say in what their retirement portfolio will look like.

And while it is possible that their portfolio may lose money, there are ways to manage that risk. By contrast, 401(k) retirement plans often offer limited investment options, such as a handful of mutual funds or target date funds.

Diversification

Diversification is chief among an investor’s risk management tools. A diversification strategy means spreading money across multiple asset classes, such as stocks and bonds. A portfolio can be further diversified within each asset class. For example, diverse stock holdings might include stocks from companies of different sizes, sectors, and geographical locations.

Diversification helps minimize the effects market risk can have on an investor’s portfolio. There are two main types: market risk, also called systematic risk, and specific or unsystematic risk.

Systematic risk is caused by factors that have a broad impact on the market as a whole, such as inflation or a global pandemic. Unfortunately, there’s not much an investor can do about this sort of risk, unless you’re an active investor familiar with hedging strategies.

The second type of market risk, unsystematic risk, is limited to individual companies, industries, or geographies. For instance, a workers’ strike at a factory could halt production and drag down an automaker’s stock price.

Diversification helps mitigate unsystematic risk. So, if an individual holds stocks in hundreds of different companies, one poorly performing company may have minimal negative impact on their portfolio’s performance. While diversification cannot prevent the risk of loss entirely, it may help individuals’ portfolios less vulnerable to market volatility.

How Safe Are Roth IRAs Considered to Be?

It depends how you define “safe.” If you’re thinking 100% free from loss, there are no safe investments. That said, Roth IRAs, and many other retirement account types, are generally considered to provide investors with lower risk exposure. They’re generally safer than investing in, say, penny stocks or cryptocurrencies, which are usually referred to as “speculative” investments.

Roth IRAs are usually managed and diversified, and as such, have some degrees of safety built into them to keep investors’ money relatively safe. That said, they aren’t completely risk-free. As mentioned, there are things that can lower a Roth IRA’s overall value — some of which investors can attempt to mitigate.

Time Horizon for Investments

Some investors might want to consider their time horizon in an effort to minimize portfolio losses that can occur at inopportune times. A time horizon is the amount of time an investor anticipates holding an investment until they want the money back.

When an investor is young, they may choose to hold riskier investments, such as stocks in their portfolio. Stocks can offer more opportunity for growth, but — on the flip side — stocks can also suffer big drops in value.

Investors who are many years away from a financial goal, such as retirement, may opt to hold more stocks to take advantage of their growth potential. With many years to go before they need to tap their investments, these investors have time to ride out the market’s swings.

The Takeaway

It’s possible to lose money in a Roth IRA, or any retirement or investment account — it really depends what types of investments are in the Roth.

The market may take a dip, for example, which can have an effect on your Roth IRA’s overall value. You can also see some of that value eaten up by custodial fees or penalties, if you decide to withdraw money. In a broader sense, if you start investing too late, you can miss out on market gains over many years — likewise costing you money.

It’s unlikely you would see your entire Roth IRA’s value fall to zero. But it’s also important to remember that retirement accounts are not risk-free investment vehicles. And depending on the type of IRA you have (traditional or Roth, SEP or SIMPLE), there will be different considerations you’ll need to make about how, when, and why you’re investing.

Ready to make an IRA part of your retirement plan? Learn more about opening an IRA with SoFi Invest®. SoFi doesn’t charge commissions (you can read the full fee schedule here), and members have access to complimentary financial advice from a professional.

Help grow your nest egg with a SoFi IRA.

FAQ

What happens to my Roth IRA if the stock market crashes?

It’s likely that you would see the overall value of your Roth IRA diminish in the event of a stock market crash. That doesn’t mean that it would have no value or you’d lose all of your money, but fluctuations in the market do affect the values of the investments in IRAs.

What are the risks of investing in a Roth IRA?

Risks of investing in a Roth IRA involve potentially incurring penalties for early withdrawals, seeing values decline due to market fluctuations, and even the potential of being assessed tax penalties for contributing too much money during a given year, among other things.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
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Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Feb

2024

What Is Leverage in Finance?

By Samuel Becker | Growing Wealth, invest, Investing, Terminology | Comments Off

Leverage in finance involves using a relatively small amount of capital to make larger trades or investments, increasing the potential of larger returns. In the world of finance, it’s critical to understand leverage if you plan to day trade or make other types of short-term investments, and the additional risks involved.

In general, leverage means doing a lot with a little. Think about how you may use an actual, physical lever to turn a switch, for instance. The switch itself may be small, and require a turn that’s a quarter of an inch to flip from off to on. But by using a lever — which is much bigger, physically, than the switch itself — the work becomes easier.

Key Points

• Leverage in finance involves using a small amount of capital to make larger trades or investments, potentially increasing returns.

• Leverage can be achieved through borrowing money or trading on margin, allowing investors to make increased dollar investments.

• While leverage can amplify gains, it also magnifies losses and comes with additional risks and costs.

• Different types of leverage exist, including financial leverage used by businesses to raise capital and operating leverage used to analyze fixed and variable costs.

• Leverage can be used in personal finance, such as taking out a mortgage, and is also utilized by professional traders to potentially increase profits.

What Is Leverage?

In finance, leverage refers to using a small amount of capital to do a relatively big amount of work — making big investments with a small amount of money. The rest of the money used to make the investment is borrowed, or investors are trading on margin.

In short: Leverage is about borrowing capital to make bigger bets in an effort to increase returns.

How Leverage Works

In leveraged investing, the leverage is debt that investors use as a part of their investing strategy. While it’s easy to think that all debt is bad, in fact it can actually be useful when folded into a specific investing tactic, although it also introduces additional risks and costs.

Leverage typically works like this: A person or company wants to make an outsized investment, but doesn’t have enough capital to do it. So, they use the capital they do have in conjunction with margin (borrowed money) to make a leveraged investment. If they’re successful, the return on their investment is far greater than it would’ve been had they only invested their own capital.

The risk, of course, is that those returns do not materialize, putting the investor in debt. Investors will also need to consider how their overall costs could increase, as they’ll likely pay interest on the money they borrow, too.

Example of Leverage

Here is an example of how leverage could be used:

Let’s say that you found a startup. To get the company off the ground, you take in $10 million from investors, but you want to expand operations fast — hire employees, ramp up research and development efforts, and build out a distribution network.

You can do that with the $10 million, but if you were to borrow another $10 million, you would be able to double your efforts. That would allow you to hire more employees, improve your products faster, and distribute them further and wider, though you’d need to pay interest on the loan, too, factoring into overall costs.

That $10 million you borrowed is allowing you to do more with less. Of course, you run the risk that the company won’t be able to sustain a quick growth pace, in which case you may not be able to pay back the loan, or end up paying additional costs for interest and fees. But if things do work out, you’d be able to grow faster and accrue more value than if you hadn’t taken on any additional debt.

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

Pros and Cons of Leverage

On the surface, leverage can sound like a powerful tool for investors — which it can be. But it’s a tool that can cut both ways: Leverage can add to buying power and potentially increase returns, but it can also magnify losses, and put an investor in the hole.

What’s important to remember is that there are both pros and cons to a tool like leverage.

Pros of Leverage	Cons of Leverage
Adds buying power	Increased risks and costs
Potential to earn greater returns	Leveraged losses are magnified
For investors, it’s generally easy to access	It can be more complex than meets the eye

Leverage vs Margin

Margin is a type of leverage that is specifically tied to use in the financial markets by investors. It is basically like a line of credit for a brokerage or investment account.

Here’s how margin works: An investor has a cash balance, which acts as collateral, and there are interest rates at play, like any other type of loan. With a margin account, investors can tradesome, but not all stocks or other assets on margin.

Using margin, an investor can effectively supercharge their potential gains or losses. It’s also important to note — and it’s worth repeating over and over — that using margin as an investor can increase overall costs and risks. Not every investor will be comfortable assuming those risks and costs (such as interest charges), so you’ll want to know what you’re doing before using margin.

Margin and leverage are related, and it’s easy to confuse the two. Even if you know what margin trading is and how margin accounts work, it’s important to make sure you know what the differences are. This chart should help.

Leverage vs Margin
Leverage	Margin
A loan from a bank for a specific purpose	A loan from a brokerage for investing in financial instruments
May involve a cash injection to be used for a specific purpose	No cash is exchanged; acts as a line of credit
Can be used by businesses or individuals; May take the form of a mortgage or to expand inventory	Can be used to create leverage and increase investment buying power

Types of Leverage

So far, we’ve mostly discussed leverage as it relates to the financial markets for investors. But there are other types of leverage, too.

Financial Leverage

Financial leverage is used by businesses and organizations as a way to raise money or access additional capital without having to issue additional shares or sell equity. For instance, if a company wants to expand operations, it can take on debt to finance that expansion.

The main ways that a company may do so is by either issuing bonds or by taking out loans. Much like in the leverage example above, this capital injection gives the company more spending power to do what it needs to do, with the expectation that the profits reaped will outweigh the costs of borrowing in the long run.

Operating Leverage

Operating leverage is an accounting measure used by businesses to get an idea of their fixed versus variable costs.

When discussing financial leverage, math needs to be done to figure out whether a company’s borrowing is profitable (called the debt-to-equity ratio). When calculating operating leverage, a company looks at its fixed costs as compared to variable costs to get a sense of how the costs of borrowing are affecting its profitability.

Leverage Investing

Leverage trading is the use of borrowed money to try and increase profits or returns. A company can use leverage investing by purchasing a new factory, allowing it to expand its ability to create products, and as such, increase profitability. An individual investor can borrow money to buy more stocks, increasing their potential returns.

It’s important to keep in mind, though, that leverage trading, or the use of borrowed money to invest, increases overall costs for investors, as they will need to pay interest on the money they borrow, and may be subject to other fees, too.

With that in mind, there are a few ways that leverage can be used in investing, either by individuals, or organizations.

Buying on Margin

Margin is a form of leverage, and trading on margin means that an investor is using money borrowed from their brokerage to execute a trade. In other words, an investor is borrowing money from their trading platform or brokerage — paying an applicable interest rate to do so, which can vary and should be considered as a part of overall trading costs — and making trades with it. It’s similar to using a credit card for investing, in some ways.

Given that margin concerns interest charges and additional costs, using it to trade or invest involves additional risks, particularly for inexperienced investors.

Leveraged ETFs

ETFs, or exchange-traded funds, can also have leverage baked into them. Leveraged ETFs are tradable funds that allow investors to potentially increase their returns by using borrowed money to invest in an underlying index, rather than a single company or stock. Leveraged ETFs utilize derivatives to increase potential returns for investors.

Using Borrowed Money to Invest

While many investors utilize margin, it’s also possible to borrow money from an outside source (not your broker or brokerage) to invest with. This may be appealing to some investors who don’t have high enough account balances to meet the thresholds some brokerages have in place to trade on margin. For example, a platform may require an investor to have a minimum balance of $25,000 in their account before they’ll offer the investor margin trading.

If an investor doesn’t have that much, looking for an outside loan — a personal loan, a home equity loan, etc.— to meet that threshold may be an appealing option.

But, as mentioned when discussing margin, borrowing money to invest can rope in additional risk, and investors will need to consider the additional costs associated with borrowing funds, such as applicable interest rates. So, before doing so, it may be a good idea to consult a financial professional.

Leverage in Personal Finance

The use of leverage also exists in personal finances — not merely in investing. People often leverage their money to make big purchases like cars or homes with auto loans and mortgages.

A mortgage is a fairly simple example of how an individual may use leverage. They’re using their own money for a down payment to buy a home, and then taking out a loan to pay for the rest. The assumption is that the home will accrue value over time, growing their investment.

Leverage in Professional Trading

Professional traders tend to be more aggressive in trying to boost returns, and as such, many consider leverage an incredibly important and potent tool. While the degree to which professional traders use leverage varies from market to market (the stock market versus the foreign exchange market, for example), in general most pro traders are well-versed in leveraging their trades.

This may allow them to significantly increase returns on a given trade. And professionals are given more leeway with margin than the average investor, so they can potentially borrow significantly more than the typical person to trade. Of course, they also have to stomach the risks of doing so, too — because while it may increase returns on a given trade, there is always the possibility that it will not.

Leveraged Products

There are numerous financial products and instruments that investors can use to gain greater exposure to the market, all without increasing their investments, like leveraged ETFs.

Volatility and Leverage Ratio

A leverage ratio measures a company’s debt situation, and gives a snapshot of how much debt a company currently has versus its cash flows. Companies can use leverage to increase their profitability by expanding operations, etc., but it’s a gamble because that profitability may not materialize as planned.

Knowing the leverage ratio helps company leaders understand just how much debt they’ve taken on, and can even help investors understand whether a company is a potentially risky investment given its debt obligations.

The leverage ratio formula is: total debt / total equity.

Volatility is another element in the mix, and it can be added into the equation to figure out just how volatile an investment may be. That’s important, given how leverage can significantly amplify risk.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

The Takeaway

Leverage can help investors, buyers, corporations and others do more with less cash on hand in their accounts at a given time. But there are some important considerations to keep in mind when it comes to leverage. In terms of leveraged investing, it has the potential to magnify gains — but also to magnify losses, and increase total costs.

Utilizing leverage and margin as a part of an investing or trading strategy has its pros and cons. But investors should give the risks some serious consideration before getting in over their heads. It may be a good idea to speak with a financial professional accordingly.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

What is leverage in simple terms?

In simple terms, the concept of leverage means to do a lot with a little. As it relates to finance or investing, this can mean using a small amount of capital to make large or outsized trades or investments.

What is an example of leverage?

An example of leverage could be a mortgage, or home loan, in which a borrower makes a relatively small down payment and borrows money to purchase a home. They’re making a big financial move with a fraction of the funds necessary to facilitate the transaction, borrowing the remainder.

Why do people want leverage?

Leverage allows investors or traders to make bigger moves or take larger positions in the market with only a relatively small amount of capital. This could lead to larger returns — or larger losses.

Photo credit: iStock/StockRocket

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
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For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Feb

2024

The Black-Scholes Model, Explained

By Brian Nibley | Financial Independence, Growing Wealth, invest, Investing | Comments Off

The Black-Scholes option pricing model is a mathematical formula used to calculate the theoretical price of an option. It’s a commonly-used formula for determining the price of contracts, and as such, can be useful for investors in the options market to know and have in their pocket for use.

But there are some important things to know about it, such as the fact that the model only applies to European options, and more.

Key Points

• The Black-Scholes model is a mathematical formula used to calculate the theoretical price of an option.

• It is commonly used for pricing options contracts and helps investors determine the value of options they’re considering trading.

• The model takes into account factors like the option’s strike price, time until expiration, underlying stock price, interest rates, and volatility.

• The Black-Scholes model was created by Myron Scholes and Fischer Black in 1973 and is also known as the Black-Scholes-Merton model.

• While the model has some assumptions and limitations, it is considered an important tool for European options traders.

What Is the Black-Scholes Model?

As mentioned, the Black-Scholes model is one of the most commonly used formulas for pricing options contracts. The model, also known as the Black-Scholes formula, allows investors to determine the value of options they’re considering trading.

The formula takes into account several important factors affecting options in an attempt to arrive at a fair market price for the derivative. The Black-Scholes options pricing model only applies to European options.

💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.

The History of the Black-Scholes Model

The Black-Scholes model gets its name from Myron Scholes and Fischer Black, who created the model in 1973. The model is sometimes called the Black-Scholes-Merton model, as Robert Merton also contributed to the model’s development. These three men were professors at the Massachusetts Institute of Technology (MIT) and University of Chicago.

The model functions as a differential equation that requires five inputs:

• The option’s strike price

• The amount of time until the option expires

• The price of its underlying stock

• Interest rates

• Volatility

Modern computing power has made it easier to use this formula and made it more popular among those interested in stock options trading.

The model only works for European options, since American options allow contract holders to exercise at any time between the time of purchase and the expiration date. By contrast, European options come at cheaper prices and only allow the owner to exercise the option on the expiration date. So, while European options only offer a single opportunity to earn profits, American options offer multiple opportunities.

What Does the Black-Scholes Model Tell?

The main goal of the Black-Scholes Formula is to determine the chances that an option will expire in the money. To this end, the model goes deeper than simply looking at the fact that a call option will increase when its underlying stock price rises and incorporates the impact of stock volatility.

The model looks at several variables, each of which impact the value of that option. Greater volatility, for example, could increase the odds the options will wind up being in the money before its expiration. The more time the investor has to exercise the option also increases the likelihood of it winding up in the money and lowers the present value of the exercise price. Interest rates also influence the price of the option, as higher rates make the option more expensive by decreasing the present value of the exercise price.

The Black-Scholes Formula

The Black-Scholes formula expresses the value of a call option by taking the current stock prices multiplied by a probability factor (D1) and subtracting the discounted exercise payment times a second probability factor (D2).

Explaining in exact detail what D1 and D2 represent can be difficult because the original research papers by Black and Scholes didn’t explain or interpret D1 and D2, and neither did the papers published by Merton. Entire research papers have been written on the subject of D1 and D2 alone.

💡 Quick Tip: If you’re an experienced investor and bullish about a stock, buying call options (rather than the stock itself) can allow you to take the same position, with less cash outlay. It is possible to lose money trading options, if the price moves against you.

Why Is the Black-Scholes Model Important?

The Black-Scholes option pricing model is so important that it once won the Nobel Prize in economics. Some even claim that this model is among the most important ideas in financial history.

Some traders consider the Black-Scholes Model one of the best methods for figuring out fair prices of European call options. Since its creation, many scholars have elaborated on and improved this formula. In this sense, Black and Scholes made a significant contribution to the academic world when it comes to math and finance.

Some claim that the Black-Scholes model has made a significant contribution to the efficiency of the options and stock markets. While designed for European options, the Black-Scholes Model can still help investors understand how an option’s price might react to its underlying stock price movements and improve their overall options trading strategies.

This allows investors to optimize their portfolios by hedging accordingly, making the overall markets more efficient. However, others assert that the model has increased volatility in the markets, as more investors constantly try to fine tune their trades according to the formula.

How Accurate Is the Black-Scholes Model?

Some studies have shown the Black-Scholes model to be highly predictive of options prices. This doesn’t mean the formula has no flaws, though.

The model tends to undervalue calls that are deeply in the money and overvalue calls that are deeply out of the money.

That means the model might assign an artificially low value to options that are much higher than the price of their underlying stock, while it may overvalue options that are far beneath the stock’s current value. Options that deal with stocks yielding a high dividend also tend to get mispriced by the model.

Assumptions of the Black-Scholes Model

There are also a few assumptions made by the model that can lead to less-than-perfect predictions. Some of these include:

• The assumption that volatility and the risk- free rate within a stock remain constant

• The assumption that stock prices are stable and large price swings don’t happen

• The assumption that a stock doesn’t pay dividends until after an option expires

Recommended: How Do Dividends Work?

Such assumptions are necessary, even if they may negatively impact results. Relying on assumptions like these make the task possible, as only so many variables can reasonably be calculated.

Over the years, math scholars have elaborated on the work of Black and Scholes and made efforts to compensate for some of the gaps created by the original assumptions.

This leads to another flaw of the Black-Scholes model, unlike other inputs in the model, volatility must be an estimate rather than an objective fact. Interest rates and the amount of time left until the option expires are concrete numbers, while volatility has no direct numerical value.

The best a financial analyst can do is calculate an estimation of volatility by using something like the formula for variance. Variance is a measurement of the variability of an asset, or how much prices change from time to time. One common measurement of volatility is the standard deviation, which is equivalent to the square root of variance.

The Takeaway

The Black-Scholes option-pricing model is among the most influential mathematical formulas in modern financial history, and it may be the most accurate way to determine the value of a European call option. It’s a complicated formula that has some drawbacks that traders must understand, but it’s a useful tool for European options traders.

Given the Black-Scholes model’s complexity, it’s likely that many investors will never use it. That doesn’t mean it isn’t important to know or understand, of course, but many investors may not get much practical use out of it unless they delve deeper into the world of options trading.

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SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Feb

2024

Asset Allocation by Age, Explained

By Rebecca Lake | Growing Wealth, invest, Investing | Comments Off

Asset allocation is an investment strategy that helps you decide the ratio of different asset classes in your portfolio to ensure that your investments align with your risk tolerance, time horizon, and goals.

In other words, the way you allocate, or divide up the assets in your portfolio helps to balance risk, while aiming for the highest return within the time period you have to achieve your investment goals.

How do you set your portfolio to get the best asset allocation by age? Here’s what you need to know about asset-based asset allocation.

Key Points

• Asset allocation is the process of dividing investments among different asset classes based on factors like age, risk tolerance, and financial goals.

• Younger investors can typically afford to take more risks and allocate a higher percentage of their portfolio to stocks.

• As investors approach retirement, they may shift towards a more conservative asset allocation, with a higher percentage allocated to bonds and cash.

• Regularly reviewing and rebalancing your asset allocation is important to ensure it aligns with your changing financial circumstances and goals.

• Asset allocation is a personal decision and should be based on individual factors such as risk tolerance, time horizon, and investment objectives.

What Is Age-Based Asset Allocation?

The mix of assets you hold will likely shift with age. When you’re younger and have a longer time horizon, you might want to hold more stocks, which offer the most growth potential. Also, that longer time horizon gives you plenty of years to help ride out volatility in the market.

You will likely want to shift your asset allocation as you get older, though. As retirement age approaches, and the point at which you’ll need to tap your savings draws near, you may want to shift your retirement asset allocation into less risky assets like bonds and cash equivalents to help protect your money from downturns.

In the past, investment advisors recommended a rule of thumb whereby an investor would subtract their age from 100 to know how much of their portfolio to hold in stocks. What is an asset allocation that follows that rule? A 30-year-old might allocate 70% of their portfolio to stocks, while a 60-year-old would allocate 40%.

However, as life expectancy continues to increase — especially for women — and people rely on their retirement savings to cover the cost of longer lifespans (and potential healthcare expenses), some industry experts and advisors now recommend that investors keep a more aggressive asset allocation for a longer period.

The new thinking has shifted the formula to subtracting your age from 110 or 120 to maintain a more aggressive allocation to stocks.

In that case, a 30-year-old might allocate 80% of their portfolio to stocks (110 – 30 = 80), and a 60-year-old might have a portfolio allocation that’s 50% stocks (110 – 60 = 50) — which is a bit more aggressive than the previous 40% allocation.

These are not hard-and-fast rules, but general guidelines for thinking about your own asset allocation strategy. Each person’s financial situation is different, so each portfolio allocation will vary.

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

Asset Allocation Models by Age

As stated, age is a very important consideration when it comes to strategic asset allocation. Here are some asset allocation examples for different age groups.

Asset Allocation in Your 20s and 30s

For younger investors, the conventional wisdom suggests they may want to hold most of their portfolio in stocks to help save for long-term financial goals like retirement.

That said, when you’re young, your financial footing may not be very secure. You probably haven’t built much of a nest egg, you may change jobs relatively frequently, and you may have debt, such as student loans, to worry about. Setting up a potentially volatile, stock-focused allocation might feel nerve-wracking.

If you have a 401(k) at work, this might be your primary investment vehicle — or you may have set up an IRA. In either account you can invest in mutual funds or exchange-traded funds (ETFs) that hold a mix of stocks, providing some low-cost diversification without sacrificing the potential for long-term growth.

You could also invest in a target date fund, which is designed to help to manage your asset allocation over time (more on these funds below).

When choosing funds, it’s important to consider both potential performance and fees. Index funds, which simply mirror the performance of a certain market index, may carry lower expense ratios but they may generate lower returns compared to, say, a growth fund that’s more expensive.

Remember that the younger you are, the longer you have to recover from market downturns or losses. So allocating a bigger chunk of your investments to growth funds or funds that use an active management strategy could make sense if you feel their fees are justified by the potential for higher returns — and the higher risk that comes along with it.

And of course, you can counterbalance higher-risk/higher-reward investments with bonds or bond funds (as a cushion against volatility), index funds (to help manage costs) or target date funds (which can do a bit of both). Just be aware that the holdings within some funds can overlap, which could hamper your diversification strategy and require you to choose investment carefully.

Asset Allocation in Your 40s and 50s

As you enter middle age you are potentially entering your peak earning years. You may also have more financial obligations, such as mortgage payments, and bigger savings goals, such as sending your kids to college, than you did when you were younger. On the upside, you may also have 20 years or more before you’re thinking about retiring.

In the early part of these decades, one approach is to consider keeping a hefty portion of your portfolio still allocated to stocks. This may be useful if you haven’t yet been able to save much for your retirement because you’d be able to add potential growth to your portfolio, and still have some years to ride out any volatility.

Depending on when you plan to retire, adding stability to your portfolio with bonds as you approach the latter part of these decades might be a wise choice. For example, you may want to begin by shifting more of your IRA assets to bonds or bond funds at this stage. These investments may produce lower returns in the short term compared to mutual funds or ETFs. But they can be useful for generating income once you’re ready to begin making withdrawals from your accounts in retirement.

Asset Allocation in Your 60s

Once you hit your 60s and you’re nearing retirement age, your allocation will likely shift toward fixed-income assets like bonds, and maybe even cash. A shift like this can help prepare you for the possibility that markets may be down when you retire.

If that’s the case, you might be able to use these fixed-income investments to provide income during the downturn, so you can avoid selling stocks while the markets are down since doing so would lock in losses and might curtail future growth in your portfolio. Thus, leaning on the fixed-income portion of your portfolio allows time for the market to recover before you need to tap into stocks.

If you haven’t retired yet, you can continue making contributions to your 401(k) to grow your nest egg and take advantage of any employer match.

If you chose to invest in a target date fund within your retirement account when you were younger, it’s likely that fund’s allocation would now be tilting toward fixed-income assets as well.

Retirement Asset Allocation

Once you’ve retired it may seem like you can kick back and relax with all of your asset allocation worries behind you. Yet, your portfolio allocation is as important to consider now as it was in your 20s.

When you retire, you’ll likely be on a fixed income — and you won’t be adding to your savings with earned wages. Your retirement could last 20 to 30 years or more, so consider holding a mix of assets that includes stocks that might provide some growth. Keeping a modest stock allocation might help you avoid outliving your savings and preserve your spending power.

While that may sound contrary to the suggestion above for pre-retirees to keep more of their assets allocated to fixed-income, the difference is the level of protection you might want just prior to retirement. Now as an official retiree, and thinking about the potential decades ahead, you may want to inject a little growth potential into your portfolio.

It might also make sense to hold assets that grow faster than the rate of inflation or are inflation-protected, such as Treasury Inflation-Protected Securities, or TIPS, which can help your nest egg hold its value.

These are highly personal decisions that, again, go back to the three intersecting factors that drive asset allocation: your goals, risk tolerance, and time horizon. There’s no right answer; the task is arriving at the right answer for you.

Understanding Assets and Asset Classes

At its heart, a financial asset is anything of value that you own, whether that’s a piece of property or a single stock. When you invest, you’re typically looking to buy an asset that will increase in value.

The three broad groups, or asset classes, that are generally held in investment accounts are stocks, bonds, and cash. When you invest, you will likely hold different proportions of these asset classes.

Asset Allocation Examples

What are some asset allocation examples? Well, your portfolio might hold 60% stocks, 40% bonds, and no cash — or 70% stocks, 20% bonds, and 10% in cash or cash equivalents. But how you decide that ratio gets into the nuts and bolts of your actual asset allocation strategy, because each of these asset types behaves differently over time and has a different level of risk and return associated with it.

• Stocks. Stocks typically offer the highest rates of return. However, with the potential for greater reward comes higher risk. Typically, stocks are the most volatile of these three categories, especially in the short term. But over the long term, the return on equities (aka stocks) has generally been positive. In fact, the S&P 500 index, a proxy for the U.S. stock market, has historically returned an average of 10% annually.

• Bonds. Bonds are traditionally less risky than stocks and offer steadier returns. A general rule of thumb is that bond prices move in the opposite direction of stocks.

When you buy a bond, you are essentially loaning money to a company or a government. You receive regular interest on the money you loan, and the principal you paid for the bond is returned to you when the bond’s term is up. When buying bonds, investors generally accept smaller returns in exchange for the security they offer.

• Cash. Cash, or cash equivalents, such as certificates of deposit (CDs) or money market accounts, are the least volatile investments. But they typically offer very low returns.

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

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How Do Diversification and Rebalancing Fit In?

The old adage, “Don’t put all your eggs in one basket,” is apt for a number of concepts in investing.

Putting all of your money in one investment may expose you to too much risk. When it comes to asset allocation, you can help manage risk by spreading money out over different asset classes that are then weighted differently within a portfolio.

Here is a possible asset allocation example: If your stock allocation was 100%, and the stock market hit a speed bump, your entire portfolio could lose value. But if your allocation were divided among stocks, bonds, and cash, a drop in the value of your stock allocation wouldn’t have the same impact. It would be mitigated to a degree, because the bonds and cash allocation of your portfolio likely wouldn’t suffer similar losses (remember: bond prices generally move in the opposite direction of stocks, and cash/cash equivalents rarely react to market turmoil).

Diversification

Portfolio diversification is a separate, yet related, concept. Simple diversification can be achieved with the broader asset classes of stocks, bonds, and cash. But within each asset class you could also consider holding many different assets for additional diversification and risk protection.

For example, allocating the stock portion of your portfolio to a single stock may not be a great idea, as noted above. Instead, you might invest in a basket of stocks. If you hold a single stock and it drops, your whole stock portfolio falls with it. But if you hold 25 different stocks — when one stock falls, the effect on your overall portfolio is relatively small.

On an even deeper level, you may want to diversify across many types of stock — for example, varying by company size, geography, or sector. One way some investors choose to diversify is by holding mutual funds, index funds, or ETFs that themselves hold a diverse basket of stocks.

Rebalancing

What is rebalancing? As assets gain and lose value, the proportion of your portfolio they represent also changes. For example, say you have a portfolio allocation that includes 60% stocks and the stock market ticks upward. The stocks you hold might have appreciated and now represent 70% or even 80% of your overall portfolio.

In order to realign your portfolio to your desired 60% allocation, you might rebalance it by selling some stocks and buying bonds. Why sell securities that are gaining value? Again, it’s with an eye toward managing the potential risk of future losses.

If your equity allocation was 60%, but has grown to 70% or 80% in a bull market, you’re exposed to more volatility. Rebalancing back to 60% helps to mitigate that risk.

The idea of rebalancing works on the level of asset allocation and on the level of asset classes. For example, if your domestic stocks do really well, you may sell a portion to rebalance your dometic allocation and buy international stocks.

You can rebalance your portfolio at any time, but you may want to set regular check-ins, whether quarterly or annually. There may be no need to rebalance if your asset allocation hasn’t really shifted. One general rule to consider is the suggestion that you rebalance your portfolio whenever an asset allocation changes by 5% or more.

What’s the Deal with Target Date Funds?

One tool that some investors find useful to help them set appropriate allocations is a target date fund. These funds, which were described briefly above, are primarily for retirement, and they are typically geared toward a specific retirement year (such as 2030, 2045, 2050, and so on).

Target funds hold a diverse mix of stocks and fixed-income investments. As the fund’s target date approaches, the mix of stocks and bonds the fund automatically adjusts to a more conservative allocation — aka the fund’s “glide path.”

For example, if you’re 35 and plan to retire at 65, you could purchase shares in a target-date fund with a target date 30 years in the future. While the fund’s stock allocation may be fairly substantial at the outset, as you approach retirement the fund will gradually increase the proportion of fixed-income assets that it holds.

Target-date funds theoretically offer investors a way to set it and forget it. However, they also present some limitations. For one, you don’t have control over the assets in the fund, nor do you control how the fund’s allocation adjusts over time.

Target funds are typically one-size-fits-all, and that doesn’t always work with an individual’s unique retirement goals. For example, someone aggressively trying to save may want to hold more stocks for longer than a particular target date fund offers. Also, as actively managed funds, they often come with fees that can take a bite out of how much you are ultimately able to save.

The Takeaway

While many investors spend time researching complex issues like bond yields and options trading, understanding and executing a successful asset allocation strategy — one that works for you now, and that you can adjust over the long term — can be more challenging than it seems.

Although asset allocation is a fairly simple idea — it’s basically how you divide up different asset classes in your portfolio to help manage risk — it has enormous strategic implications for your investments as a whole. The three main factors that influence your asset allocation (goals, risk tolerance, and time horizon) seem straightforward enough as separate ideas, yet there is an art and a science to combining them into an asset allocation that makes sense for you. Like so many other things, arriving at the right asset allocation is a learning process.

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You may also be interested in:

What Is Asset Allocation? A Beginner’s Guide

How Often Should You Rebalance Your Portfolio?

How to Rebalance Your 401(k)

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

SOIN0723103

Feb

2024

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How to Analyze Stocks: 4 Ways

By Laurel Tincher | Growing Wealth, invest, Investing | Comments Off

When it comes to investing in stocks, there’s no single way to analyze stocks to find a sure winner. That being said, there are many methods that ordinary investors can use to find stocks that are trading at a discount to their underlying value.

The first step in how to analyze a stock before buying is reviewing financial statements. From there, investors can use various methods of analysis to assess investment opportunities and potentially identify worthwhile investments.

Key Points

• There are four common methods of analyzing stocks: technical analysis, qualitative analysis, quantitative analysis, and fundamental analysis.

• Technical analysis focuses on supply and demand patterns in stock charts to make investment decisions.

• Qualitative analysis examines factors like a company’s leadership, product, and industry to evaluate investment opportunities.

• Quantitative analysis uses data and numerical figures to predict price movements in stocks.

• Fundamental analysis looks at a company’s financial health and value to determine if its stock is underor overvalued.

Why Analyzing Stocks Is Important

The process of stock analysis can reveal important information about a company and its history, allowing investors to make more informed decisions about buying or selling stocks. Analyzing stocks can help investors identify which investment opportunities they believe will deliver strong returns. Further, stock analysis can assist investors in spotting potentially bad investments.

Whether you’re strategy involves short vs. long term investing, or day trading, analyzing stocks is going to be important.

💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

Understanding Financial Statements

The first step in understanding stock analysis is knowing the basics of business reporting. There are three main types of financial statements that an investor may need to look at when doing analysis:

• Income statement: This statement shows a company’s profits, which are calculated by subtracting expenses from revenue.

• Balance sheet: The balance sheet compares a company’s assets, liabilities, and stockholder equity.

• Statement of cash flows: This statement outlines how a company is spending and earning its money.

In addition to these statements, a company’s earnings report contains information that can be useful for doing qualitative analysis. The annual report includes the company’s plans for the future and stock value predictions.

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4 Ways to Analyze a Stock

The next step in stock evaluation is deciding which type of analysis to do. Here’s a look at some of the different methods for how to analyze a stock.

1. Technical Analysis

Technical analysis is a method for analyzing stocks that looks directly at a stock’s supply and demand in order to make investing decisions. This form of analysis takes the stance that all information needed is present within stock charts and the analysis of history and trends.

Some key focal points of technical analysis are:

• Stock prices move in trends.

• History repeats itself.

• Stock price history can be used to make price predictions.

• Stock price contains all relevant information for making investing decisions.

• Technical analysis does not consider intrinsic value.

Trend indicators are one of the most important parts of technical analysis. These indicators attempt to show traders whether a stock will go up or down in value. Uptrends mean higher highs and higher lowers, whereas downtrends mean lower lows and lower highs. Some common trend tools include linear regression, parabolic SAR, MACD, and moving averages.

Technical analysis also uses leading indicators and lagging indicators. Leading indicators signal before new trends occur, while lagging indicators signal after a trend has ended. These indicators look at information such as volume, price, price movement, open, and close.

There can be some pros and cons to using technical analysis, however, which can be important to consider when factoring in your risk tolerance.

Day traders tend to focus on technical analysis to try to capitalize on short-term price fluctuations. But because technical analysis generally focuses on short-term fluctuations in price, it’s not as often used for finding long-term investment opportunities.

Further, while technical analysis relies on objective and consistent data, it can produce false signals, particularly during trading conditions that aren’t ideal. This method of analysis also fails to take into consideration key fundamentals about individual shares or the stock market.

2. Qualitative Stock Analysis

When considering how to analyze a stock, it’s also a good idea to look at whether the company behind the stock is really a good business. Qualitative analysis looks into factors like a company’s leadership team, product, and the overall industry it’s a part of.

A few key qualitative metrics to look at are:

• Competitive advantage: Does the company have a unique edge that will help it be successful in the long term? If a company has patents, a unique manufacturing method, or broad distribution, these can be positive competitive advantages.

• Business model: Analyzing a business model includes looking at products, services, brand identity, and customers to get a sense of what the company is offering.

• Strong leadership: Even a great idea and product can fail with poor management. Looking into the credentials of the CEO and top executives of a company can help in evaluating whether it’s a good investment.

• Industry trends: If an industry is struggling, or looks like it may in the future, an investor may decide not to invest in companies in that industry. On the other hand, new and growing industries may be better investments. This is not always the case, as there are strong companies in weak industries, and vice versa.

3. Quantitative Analysis

Similar to technical analysis, quantitative analysis looks at data and numbers in an attempt to predict future price movements. Specifically, quantitative analysis evaluates data, such as a company’s revenues, price-to-earnings ratio, and earnings-per-share ratio, and uses statistical modeling and mathematical techniques to predict a stock’s value.

The upside is that this financial data is publicly available, and it creates an objective, consistent starting point. It can help with identifying patterns, and it can be useful in assessing risk. However, it requires sifting through a lot of data. Further, there’s no certainty when it comes to patterns, which can change.

4. Fundamental Analysis

Fundamental analysis looks at a company from a basic financial standpoint. This gives investors a sense of the company’s financial health and whether its stock may be under- or overvalued. Fundamental analysis takes the stance that a company’s stock price doesn’t necessarily equate to its value.

There are a number of key tools for fundamental analysis that investors might want to familiarize themselves with and use to get a fuller picture of a stock.

Earnings Per Share (EPS)

One of the main goals for many investors is to buy into profitable companies. Earnings per share, or EPS, tells investors how much profit a company earns per each share of stock, and how much investors are benefiting from those earnings. Companies report EPS quarterly, and the figure is calculated by dividing a company’s net income, minus dividend payouts, by the number of outstanding shares.

Understanding earnings per share can give investors guidance on a stock’s potential movement. On a basic level, a high EPS is a good sign, but it’s especially important that a company shows a high or growing EPS over time. The reason for this is that a company might have a temporarily high EPS if they cut some expenses or sell off assets, but that wouldn’t be a good indicator of the actual profitability of their business.

Likewise, a negative EPS over time is an indicator that an investor may not want to buy a stock.

Revenue

While EPS relates directly to a company’s stock, revenue can show investors how well a company is doing outside the markets. Positive and increasing revenues are an indicator that a company is growing and expanding.

Some large companies, especially tech companies, have increasing revenues over time with a negative EPS because they continue to feed profits back into the growing business. These companies can see significant stock value increases despite their lack of profit.

One can also look at revenue growth, which tracks changes in revenue over time.

Price-to-earnings (P/E) Ratio

One of the most common methods of analyzing stocks is to look at the P/E ratio, which compares a company’s current stock price to its earnings per share. P/E is found by dividing the price of one share of a stock by its EPS. Generally, a lower P/E ratio is a good sign.

Using this ratio is a good way to compare different stocks. One can also compare an individual company’s P/E ratio with an index like the S&P 500 Index to get a sense of how the company is doing relative to the overall market.

The downside of P/E is that it doesn’t include growth.

Price-Earnings-Growth (PEG) Ratio

Since P/E doesn’t include growth, the PEG ratio is another popular tool for analyzing stocks and evaluating stock performance. To look at EPS and revenue together, investors can use the price-earnings-growth ratio, or PEG.

PEG is calculated by dividing a stock’s P/E by its projected 12-month forward revenue growth rate. In general, a PEG lower than 1 is a good sign, and a PEG higher than 2 indicates that a stock may be overpriced.

PEG can also be used to make predictions about the future. By looking at PEG for different time periods in the past, investors can make a more informed guess about what the stock may do next.

Price-to-Sales Ratio (P/S)

The P/S ratio compares a company’s stock price to its revenues. It’s found by dividing stock price by revenues. This can be useful when comparing competitors — if the P/S is low, it might be more advantageous to buy.

Debt-Equity Ratio

Although profits and revenue are important to look at, so is a company’s debt and its ability to pay it back. If a company goes into more and more debt in order to continue growing, and they’re unable to pay it back, it’s not a good sign.

Debt-equity ratio is found by dividing a company’s total liabilities (debt) by its shareholder equity. In general, a debt-equity ratio under 0.1 is a good sign, while a debt-equity ratio higher than 0.5 can be a red flag for the future.

Debt-to-EBITDA

Similar to debt-to-equity, debt-to-EBITDA measures the ability a company has to pay off its debts. EBITDA stands for earnings before interest, tax, depreciation, and amortization.

A high debt-to-EBITDA ratio indicates that a company has a high amount of debt that it may not be able to pay off.

Dividend Yield

While a stock’s price can vary significantly from day to day, dividend payments are a way that investors can earn a consistent amount of money each quarter or year. Not every company pays out dividends, but large, established companies sometimes pay out some of their earnings to shareholders rather than reinvesting the money into their business.

Dividend yield is calculated by dividing a company’s annual dividend payment by its share price. The average dividend yield for S&P 500 companies is around 2%.

One thing to note is that dividends are not guaranteed — companies can change their dividend amounts at any time. So if a company has a particularly high dividend yield, it may not stay that way.

Price-to-Book Ratio (P/B)

Price-to-book ratio, or P/B, compares a company’s stock market value to its book value. This is a useful tool for finding companies that are currently undervalued, meaning those that have a significant amount of growth but still relatively low stock prices.

P/B ratio is found by dividing the market price of a stock by the company’s book value of equity. The book value of equity is found by subtracting the company’s total liabilities from its assets.

Company Reports and Projections

When companies release quarterly and annual earnings reports, many of them include projections for upcoming revenue and EPS. These reports are a useful tool for investors to get a sense of a stock’s future. They can also affect stock price as other shareholders and investors will react to the news in the report.

Professional Analysis

Wall Street analysts regularly release reports about the overall stock market as well as individual companies and stocks. These reports include information such as 12-month targets, stock ratings, company comparisons, and financial projections. By reading multiple reports, investors may start to see common trends.

While analysts aren’t always correct and can’t predict global events that affect the markets, these reports can be a useful tool for investors. They can keep them up-to-date on any key happenings that may be on the horizon for particular companies. The information in the reports also can result in stock prices going up or down, since investors will react to the predictions.

Quantitative vs Qualitative Analysis

Here’s a quick rundown looking at the key differences between quantitative and qualitative analysis. Again, this can be important when weighing your risk need to knows as an investor.

Quantitative vs. Qualitative Analysis
Quantitative Analysis	Qualitative Analysis
Looks at data and numerical figures to predict price movements	Looks at business factors such as leadership, product, and industry
May require sifting through a lot of data, and may be difficult for some investors	Metrics include business models, competitive advantage, and industry trends
Concerned more with the “quantity” and hard data a business produces	Concerned more with the “quality” of a business

Pros and Cons of Doing Your Own Stock Analysis

If you feel like you can do a little stock analysis on your own, there are some pros and cons to it.

Pros

Perhaps the most obvious pro to doing your own stock analysis is that you don’t need to pay someone else to do it, you can do it on your own schedule, and learn as you go. You can develop knowledge that’ll likely help you as you continue to invest in the future. There are also numerous tools out there that you can use to analyze stocks which may not have been around in years or decades past.

Cons

Stock analysis can be an involved process, which can require a lot of investment in and of itself — both monetarily (if you’re using paid tools) and in terms of time. Depending on how deep you want to go, too, it can be a complex process. You may get frustrated or burnt out, or even make a mistake that leads to a bad investment decision.

💡 Quick Tip: Are self directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

Buying Stocks With SoFi

There are a number of ways to analyze stocks, including technical, fundamental, quantitative, and qualitative analysis. The more an investor gets comfortable with terms like P/E ratio and earnings reports, the more informed they can be before making any decisions. Stock analysis is an involved process, however, and may be above the typical investors’ head and ability.

It is important to do your research and homework in relation to your investments, however. If you feel like you could use some guidance or a helping hand, speaking with a financial professional is never really a bad idea.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

What is the best way to analyze a stock?

There’s no “best” way to analyze stocks. The right option for an investor will depend on their personal preferences and investing objectives. And remember, there’s no need to just use one method to analyze a stock — often, analysts will combine different methods of analysis to generate a more robust stock analysis.

What are key indicators to look for when analyzing a stock?

There are a ton of potential indicators that investors can look at, but some broad indicators that investors can start with include stock price history, moving averages, a company’s competitive advantages, business models, and industry trends.

What is an example of stock analysis?

A very, very basic example of stock analysis would include looking at a stock’s share price, comparing it to its historical averages and moving averages, overall market conditions, and looking at the company’s financial statements to try and gauge where it might move next.

You may also be interested in:

How to Pick Stocks: Essential Steps for Investors

How To Know When to Buy a Stock

Using Fundamental Analysis to Choose Stocks

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