Sep
28
2024
Understanding the Buy Low, Sell High Strategy

Buy Low, Sell High Strategy: An Investor’s Guide

By | Growing Wealth, invest, Investing | Comments Off on Buy Low, Sell High Strategy: An Investor’s Guide

When it comes to investing, there are certain rules of thumb that investors are often encouraged to follow. One of the most-repeated adages in investing is to try and “buy low, sell high.”

Buying low and selling high simply means purchasing securities at one price, then selling them later at a higher price. This bit of investing wisdom offers a relatively straightforward take on how to realize profits in the market. But figuring out how to buy low and sell high — and make this strategy work — is a bit more complicated. Timing the market is not a perfect science, and understanding that implementing a buy low, sell high strategy is more complicated than it sounds is critical to investor success.

Key Points

•   Buy low, sell high is an investment strategy that involves purchasing securities at a lower price and selling them later at a higher price.

•   Timing the market and implementing this strategy can be challenging, as market movements are unpredictable.

•   Understanding stock market cycles and trends can help determine when to buy low and sell high.

•   Technical indicators and moving averages can assist in identifying pricing trends and points of resistance.

•   Investor biases and herd mentality can impact decision-making, so it’s important to make rational choices based on research and analysis.

What Does It Mean to “Buy Low, Sell High”?

“Buy low, sell high” is an investment philosophy that advocates buying stocks or other securities at one price, and then selling them later when they’ve (hopefully) gained value. This is the opposite of buying high and selling low, which effectively results in investors selling stocks at a loss.

When investors buy low and sell high, they may do so to maximize profits. For example, a day trader may purchase shares of XYZ stock at $10 in the morning, then turn around and sell them for $30 per share in the afternoon if the stock’s price increases. The result is a $20 profit per share, less trading fees or commissions. Of course, a price increase of that magnitude within a single day is highly unlikely.

Likewise, a buy and hold investor may purchase stocks, exchange-traded funds (ETFs), or mutual funds and hold onto them for years or even decades. The payoff comes if they sell those securities later for more than what they paid for them.

Recommended: How to Know When to Sell a Stock

4 Tips on How to Buy Low and Sell High

The following tips may help investors develop a buy low, sell high strategy (or avoid the buy high, sell low trap).

1. Investing with the Business Cycle

Understanding stock market cycles and their correlation to the business cycle can help when determining how to buy low and sell high.

The business cycle is the rise and fall in economic activity that an economy experiences over time. If the business cycle is in an expansion phase and the economy is growing, for instance, then stock prices may be on the upswing as well. On the other hand, if it’s become apparent that economic growth has peaked, that could be a signal for stock price drops to come as an economy slows or enters into a recession.

But like most strategies that aim to buy low and sell high, investing with the business cycle can be challenging.

It’s also important to remember that security prices typically don’t move in a straight line up or down in lockstep with a specific phase of the business cycle. Instead, most securities experience a level of volatility, where prices move up or down (or both) in the short term before reverting to the mean.

2. Look at Stock Pricing Trends

Investors who want to buy low may find it helpful to pay attention to pricing trends or technical indicators. Tracking trends for individual securities, for a particular stock market sector, or the market as a whole can help investors get a sense of what kind of momentum is driving prices.

For instance, an investor wondering how low a stock price can go can look at technical indicator trends to identify significant pricing dips or rises in the stock’s history. This could, potentially, help determine when a stock or security has reached its bottom, opening the door for buying opportunities. Conversely, investors may also use trends to evaluate when a stock has likely reached its high point, indicating that it’s prime time to sell.

3. Use Moving Averages

Moving averages are a commonly used indicator for technical analysis. A moving average represents the average price of a security over a set time period. So to find a simple moving average, for example, an investor would choose a time period to measure. Then they’d add up the stock’s closing price each day for that time period and divide it by the number of days.

The moving average formula can help compare stock pricing and determine points of resistance. In other words, they can tell investors where stock prices have topped out or bottomed out over time. Moving averages can smooth out occasional pricing blips that temporarily push stock prices up or down.

Comparing one moving average to another, such as the 50-day moving average to the 200-day moving average, can also help investors to spot sustainable up or down pricing trends. All this can help when deciding when to buy low or sell high.

4. Beware of Investor Bias

An investor bias is a pattern of behavior that influences reactions to a changing market. For example, noise trading happens when an investor makes a trade without considering the state of the market or timing. The investor may follow pricing trends but make trades without considering whether the time is right to buy or sell.

Investors who give in to biases may find themselves following a herd mentality when it comes to making trades. If news of a pending interest rate hike sparks fear in the markets, investors may start panic selling in droves. This can, in turn, cause stock prices to drop. On the other hand, irrational exuberance for a specific stock or type of security can push prices up, causing an unsustainable market bubble.

Investors who can refrain from being influenced by the crowd stand a better chance of making rational decisions about when to buy or when to sell to either maximize profits or minimize losses.

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Pros and Cons of Buy Low, Sell High

A buy low, sell high strategy can work for investors, but while it’s a worthy goal, the implementation can be difficult. Investors who are too focused on timing the stock market can run into difficulties.

Benefits of Buy Low, Sell High

Buying low and selling high can yield these advantages to investors.

•   Potential bargain-buying opportunities. If investor sentiment is causing fear and panic to take over the market and push stock prices down, that could open a door for buy low, sell high investors as they buy the dip. Individuals who ignore market panic could purchase stocks and other securities at a discount, only to benefit later once the market rebounds and prices begin to rise again.

•   Potential for high returns. An investor skilled at spotting trendings and reading the market cycle could reap sizable profits using a buy low, sell high strategy. The wider the gap between a stock’s purchase and sale price, the higher the profit margin.

•   Beat the market. A buy low, sell high approach could also help investors to beat the market if their portfolio performs better than expected. This might be preferable for active traders who forgo a passive or indexing approach to investing.

Disadvantages of Buy Low, Sell High

Attempting to buy low and sell high also holds some risks for investors.

•   Timing the market is imperfect. There’s no way to time the market and which way stock prices will go at any given moment with 100% accuracy. So there’s still some risk for investors who jump the gun on when to buy or sell if stocks have yet to reach their respective lowest or highest points.

•   Being left out of the market. Investors who want to buy low and sell high would not want to buy securities when the market is up. That practice, however, could lead to substantial time out of the market entirely, especially during bull markets.

•   Biases can influence decision-making. Investment biases and herd mentality can wreak havoc in a portfolio if an investor allows it. Instead of buying low and selling at a profit later, investors may find themselves in a buy high, sell low cycle where they lose money on investments.

•   Pricing doesn’t tell the whole story. While tracking stock pricing trends and moving averages can be useful, they don’t offer a complete picture of what drives pricing changes. For that reason, it’s important for investors also to consider other factors, such as consumer sentiment, the possibility of a merger, or geopolitical events, influencing stock prices.

Alternatives to Buy Low, Sell High

Buying low and selling high is not a foolproof way to match or beat the market’s performance. It’s easy to make mistakes and lose money when attempting to time the market unless, of course, you possess a crystal ball or psychic abilities.

There are, however, other ways to invest without trying to time the market. Take dollar-cost averaging, for example. This strategy involves staying invested in the market continuously through its changing cycles. Instead of trying to time when to buy or sell, investors continue making new investments. Over time, the highs and lows in stock pricing tend to average out.

A dividend reinvestment plan (DRIP) is another option. Investors who own dividend-paying stocks may have the opportunity to enroll in a DRIP. Instead of receiving dividend payouts as cash, they’re reinvesting into additional shares of the same stock. Similar to dollar-cost averaging, this approach could make it easier to ride out the ups and downs of the market over time and eliminate the stress of deciding when to buy or sell.

Investing with SoFi

A buy low, sell high investment strategy is fairly simple, in that it involves buying a security at one price, and selling it after, or if, it appreciates. Obviously, there’s no guarantee that any asset will appreciate, so it’s possible investors could lose money – but they could also see positive returns, too.

Further, the strategy can be challenging to implement. Executing a buy low, sell high plan successfully means researching and doing due diligence to understand how the market works.

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

Is buying low and selling high a good strategy?

Buying low and selling high can generally be a good strategy as it allows you to take advantage of price movements in the market. However, there is no guarantee that this strategy will always be successful, and you may end up losing money if the market conditions are not favorable.

Is it illegal to buy low and sell high?

There is no law against buying low and selling high. Most investors make money by buying a security at a low price and then selling it later at a higher price.

Why do you sell high and buy low?

Many investors sell high and buy low because they want to take advantage of market conditions to realize a positive return. When the market is high, investors may sell an investment they purchased at a lower price to make a profit.

Photo credit: iStock/katleho Seisa

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.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Sep
28
2024
How Does a Block Trade Deal Work?

Guide to Block Trades

By | Growing Wealth, invest, Investing | Comments Off on Guide to Block Trades

Block trades are big under-the-radar trades, generally carried out in private. Because of their size, block trades have the potential to move the markets. For that reason they’re conducted by special groups known as block houses. And while they’re considered legal, block trades are not regulated by the SEC.

As a retail investor, you likely won’t have anything to do with block trades, but it’s a good idea to know what they are, how they work, and how they can affect the overall market.

Key Points

•   Block trades are large-volume purchases or sales of financial assets, often conducted by institutional investors.

•   Block trades can move the market for a security and are executed through block trade facilities, dark pools, or block houses.

•   Block trades are used to avoid market disruption and can be broken down into smaller trades to conceal their size.

•   Retail investors may find it difficult to detect block trades, but they can provide insights into short-term market movements and sentiment.

•   Block trades are legal and not regulated by the SEC, but they can be perceived as unfair by retail investors.

What Are Block Trades?

A block trade is a single purchase or sale of a large volume of financial assets. A block, as defined by the New York Stock Exchange’s Rule 127.10, is a minimum of 10,000 shares of stock. For bonds, a block trade usually involves at least $200,000 worth of a given fixed-income security.

Though 10,000 shares is the operative figure, the number of shares involved in most block trades is far higher. Individuals typically don’t execute block trades. Rather, they most often come from institutional investors, such as mutual funds, hedge funds, or other large-scale investors.

Why Do Block Trades Exist?

Block trades are often so large that they can move the market for a given security. If a pension fund manager, for example, plans to sell one million shares of a particular stock without sparking a broader market selloff, selling all those shares on a public market will take some time.

During that process, the value of the shares the manager is selling will likely go down — the market sees a drop in demand, and values decrease accordingly. Sometimes, the manager will sell even more slowly. But that creates the risk that other traders will identify the institution or the fund behind the sale. Then, those investors might short the stock to take advantage.

Those same risks exist for a fund manager who is buying large blocks of a given security on a public market. The purchase itself can drive up the price, again, as the market sees an increase in demand. And if the trade attracts attention, other traders may front-run the manager’s purchases.

How Block Trades Are Executed

Many large institutions conduct their block trades through block trade facilities, dark pools, or block houses, in an effort to avoid influencing the market. Most of those institutions typically have expertise in both initiating and executing very large trades, without having a major — and costly — effect on the price of a given security.

Every one of these non-public exchange services operates according to its own rules when it comes to block trades, but what they have in common is relationships with hedge funds and others that can buy and sell large blocks of securities. By connecting these large buyers and sellers, blockhouses and dark pools offer the ability to make often enormous trades without roiling the markets.

Investment banks and large brokerages often have a division known as a block house. These block houses run dark pools, which are called such because the public can’t see the trades they’re making until at least a day after they’ve been executed.

Dark pools have been growing in popularity. In 2020, there were more than 50 dark pools registered with the Securities and Exchange Commission (SEC) in the United States. At the end of 2023, dark pools executed about 15% of all U.S. equity trades.

Smaller Trades Are Used to Hide Block Trades

To help institutional traders conceal their block trades and keep the market from shifting, blockhouses may use a series of maneuvers to conceal the size of the trade being executed. At their most basic, these strategies involve breaking up the block into smaller trades. But they can be quite sophisticated, such as “iceberg orders,” in which the block house will break block orders into a large number of limit orders.

By using an automated program to make the smaller limit orders, they can hide the actual number of orders at any given time. That’s where the “iceberg” in the name comes from — the limit orders that other traders can see are just the tip of the iceberg.

Taken together, these networks of traders who make block trades are often referred to as the Upstairs Market, because their trades occur off the trading floor.

Pros and Cons of Block Trades

As with most things in the investment field and markets, block trades have their pros and cons. Read on to see a rundown of each.

Pros of Block Trades

The most obvious advantage of block trades is that they allow for large trades to commence without warping the market. Again, since large trades can have an effect on market values, block trades, done under the radar, can avoid causing undue volatility.

Block trades can be used to conceal information, too, which can also be a “pro” in the eyes of the involved parties. If Company A stock is moving in a block trade for a specific reason, traders outside of the block trade wouldn’t know about it.

Block trades are also not regulated by the SEC, meaning there are fewer hoops to jump through.

Cons of Block Trades

While masking a large, market-changing trade may be a good thing for those involved with the trade, it isn’t necessarily a positive thing for everyone else in the market. As such, block trades can veil market movements which may be perceived as unfair by retail investors, who are trading none the wiser.

Block trades can be hard to detect, too, as mentioned. Since they’re designed to be obscure to the greater market, it can be difficult to tell when a block trade is actually occuring.

Block trades are also not regulated by the SEC — it’s a pro, and a con. The SEC doesn’t regulate them, but rather the individual stock exchanges. That may not sit well with some investors.

Block Trade Example

An example of a block trade could be as follows: A large investment bank wants to sell one million shares of Company A stock. If they were to do so all at once, Company A’s stock would drop — if they do it somewhat slowly, the rest of the market may see what’s going on, and sell their shares in Company A, too. That would cause the value of Company A stock to fall before the investment bank is able to sell all of its shares.

To avoid that, the investment bank uses a block house, which breaks the large trade up into smaller trades, which are then traded through different brokerages. The single large trade now appears to be many smaller ones, masking its original origin.

Are Block Trades Legal?

Block trades are legal, but within stock market history they exist in something of a gray area. As mentioned, “blocks” are defined by rules from the New York Stock Exchange. But regulators like the SEC have not issued a legal definition of their own.

Further, while they can move markets, block trades are not considered market manipulation. They’re simply a method used by large investors to adjust their asset allocation with the least market disruption and stock volatility possible.

How Block Trades Impact Individual Investors

Institutional investors wouldn’t go to such lengths to conceal their block trades unless the information offered by a block trade was valuable. A block trade can offer clues about the short-term future movement and liquidity of a given security. Or it can indicate that market sentiment is shifting.

For retail (aka individual) investors, it can also be hard to know what a block trade indicates. A large trade that looks like the turning of the tide for a popular stock may just be a giant mutual fund making a minor adjustment.

But it is possible for retail investors to find information about block trades. There are a host of digital tools, some offered by mainstream online brokerages, that function like block trade indicators. This might be useful for trading stocks online.

Many of these tools use Nasdaq Quotation Dissemination Service (NQDS), Level 2 data. This subscription service offers investors access to the NASDAQ order book in real time. Its data feed includes price quotes from the market makers who are registered to trade every NASDAQ and OTC Bulletin Board security, and is popular among investors who trade using market depth and market momentum.

Even access to tools like that doesn’t mean it’ll be easy to find block trades, though. Some blockhouses design their strategies, such as the aforementioned “iceberg orders,” to make them hard to detect on Level 2. But when combined with software filters, investors have a better chance of glimpsing these major trades before they show up later on the consolidated tape, which records all trades through blockhouses and dark pools — though often well after those trades have been fully executed.

These software tools vary widely in both sophistication and cost, but may be worth considering, depending on how serious of a trader you are. At the very least, using software to scan for block trades is a way to keep track of what large institutional investors and fund managers are buying and selling. Active traders may use the information to spot new trends.

The Takeaway

Block trades are large movements of securities, typically done under-the-radar, involving 10,000 or so shares, and around $200,000 in value. It can be difficult for individual investors to detect block trades — which, again, are giant position shifts by institutional investors — on their own.

But these trades have some benefits for individual investors. The mutual funds and exchange-traded funds (ETFs) that most investors have in their brokerage accounts, IRAs, 401(k)s and 529 plans may take advantage of the lower trading costs and volatility-dampening benefits of block trades, and pass along those savings to their shareholders.

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.

Photo credit: iStock/marchmeena29

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.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Sep
28
2024
financial chart recession bar graph

What Is a Recession?

By | Financial Independence, Growing Wealth, Investing | No Comments

A recession is a period of general economic contraction. Recessions are typically accompanied by falling stock markets, a rise in unemployment, a drop in income and consumer spending, and increased business failures.

Recessions tend to have a wide-ranging economic impact, affecting businesses, jobs, everyday individuals, and investment returns. But defining what, exactly, a recession is, and the long-term repercussions they may have on personal financial situations is tricky.

Different Recession Definitions

A recession is often defined as a drop in gross domestic product (GDP) — which represents the total value of goods and services produced in the country — for at least two quarters in a row. However, this is not an official definition of a recession, and instead, is just a shorthand that some economists and investors use when analyzing the economy.

Recessions are officially defined and declared by the Business Cycle Dating Committee at the National Bureau of Economic Research (NBER). So, when GDP dropped two straight quarters in 2022 (Q1 and Q2), the NBER didn’t declare a recession because other indicators, such as unemployment, didn’t necessarily align with a recessionary environment.

Consumers and workers may believe that the economy is in a recession when unemployment or inflation rises, even though economic output may still be growing. That can affect all sorts of things, including the stock market, and put a damper on investors’ hopes as they trade stocks and other securities.

Recommended: Recession Survival Guide and Help Center

NBER’s Definition

The NBER defines a recession as a significant and widespread decline in economic activity that lasts a few months. The economists at the NBER use a wide range of economic indicators to determine the peaks and troughs of economic activity. The NBER chooses to define a recession in terms of monthly indicators, including:

•   Employment. Job growth or job loss can be used to gauge the likelihood of a recession, and serve as a litmus test of sorts for which way the economy is moving.

•   Personal income. Personal income can play a direct role in influencing recessionary environments. When consumers have more personal income to spend, that can fuel a growing economy. But when personal income declines or purchasing power declines because of rising interest rates, that can be a recession indicator.

•   Industrial production. Industrial production is a measure of manufacturing activity. If manufacturing begins to slow down, that could suggest slumping demand in the economy and, in turn, a shrinking economy.

These indicators are then viewed against the backdrop of quarterly gross domestic product growth to determine if a recession is in progress. Therefore, the NBER doesn’t follow the commonly accepted rule of two consecutive quarters of negative GDP growth, as that alone isn’t considered a reliable indicator of recessionary movements in the economy.

Additionally, the NBER is a backward-looking organization, declaring a recession after one has already begun and announcing the trough of economic activity after it has already bottomed.

Julius Shiskin Definition

The shorthand of using two negative quarters of GDP growth can be traced back to a definition of a recession that first originated in the 1970s with Julius Shiskin, once commissioner of the Bureau of Labor Statistics. Shiskin defined recession as meaning:

•   Two consecutive quarters of negative gross national product (GNP) growth

•   1.5% decline in real GNP

•   15% decline in non-farm payroll employment

•   Unemployment reaching at least 6%

•   Six months or more of job losses in more than 75% of industries

•   Six months or more of decline in industrial production

It’s important to note that Shiskin’s recession definition used GNP, whereas modern definitions of recession use GDP instead. GNP, or gross national product, measures the value of goods and services produced by a country both domestically and internationally. Gross domestic product only measures the value of goods and services produced within the country itself.

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How Often Do Recessions Occur?

Economic recessions are a normal part of the business cycle. According to the NBER, the U.S. experienced 33 recessions prior to the coronavirus pandemic. The first documented recession occurred in 1857, and the most recent was caused by the Covid-19 pandemic, which started in February 2020 and ended in April 2020.

Since World War II, a recession has occurred, on average, every six years, though the actual timing can and has varied.

U.S. Recessions Since World War II
Start of Recession

 End of Recession

 Number of Months
November 1948 October 1949 11
July 1953 May 1954 10
August 1957 April 1958 8
April 1960 February 1961 10
December 1969 November 1970 11
November 1973 March 1975 16
January 1980 July 1980 6
July 1981 November 1982 16
July 1990 March 1991 8
March 2001 November 2001 8
December 2007 June 2009 18
February 2020 April 2020 2
Source: NBER

How Long Do Recessions Last?

According to the NBER, the shortest recession occurred following the onset of the Covid-19 pandemic and lasted two months, while the longest went from 1873 to 1879, lasting 65 months. The Great Recession lasted 18 months between December 2007 and June 2009 and was the longest recession since World War II.

If you consider the other 12 recessions following World War II, they have lasted, on average, about ten months.
Periods of economic expansion tend to last longer than periods of recession. From 1945 to 2020, the average expansion lasted 64 months, while the average recession lasted ten months.

Between the 1850s and World War II, economic expansions lasted an average of 26 months, while recessions lasted an average of 21 months.

The Great Recession between 2007 and 2009 was the most severe economic drawdown since the Great Depression of the 1930s. This recession was considered particularly damaging due to its duration, unemployment levels that peaked at around 10%, and the widespread impact on the housing market.

6 Common Causes of Recessions

The causes of recessions can vary greatly. Generally speaking, recessions happen when something causes a loss of confidence among businesses and consumers.

The mechanics behind a typical recession work like this: consumers lose confidence and stop spending, driving down demand for goods and services. As a result, the economy shifts from growth to contraction. This can, in turn, lead to job losses, a slowdown in borrowing, and a continued decline in consumer spending.

Here are some common characteristics of recessions:

1. High Interest Rates

High interest rates make borrowing money more expensive, limiting the amount of money available to spend and invest. In the past, the Federal Reserve has raised interest rates to protect the value of the dollar or prevent the economy from overheating, which has, at times, resulted in a recession.

For example, the 1970s saw a period of stagnant growth and inflation that came to be known as “stagflation.” To fight it, the Fed raised interest rates throughout the decade, which created the recessions between 1980 and 1982.

2. Falling Housing Prices

If housing demand falls, so does the value of people’s homes. Homeowners may no longer be able to tap their house’s equity. As a result, homeowners may have less money in their pockets to spend, reducing consumption in the economy.

3. Stock Market Crash

A stock market crash occurs when a stock market index drops severely. If it falls by at least 20%, it enters what is known as a “bear market.” Stock market crashes can result in a recession since individual investors’ net worth declines, causing them to reduce spending because of a negative wealth effect. It can also cut into confidence among businesses, causing them to spend and hire less.

As stock prices drop, businesses may also face less access to capital and may produce less. They may have to lay off workers, whose ability to spend is curtailed. As this pattern continues, the economy may contract into recession.

4. Reduction in Real Wages

Real wages describe how much income an individual makes when adjusted for inflation. In other words, it represents how far consumer income can go in terms of the goods and services it can purchase.

When real wages shrink, a recession can begin. Consumers can lose confidence when they realize their income isn’t keeping up with inflation, leading to less spending and economic slowdown.

5. Bursting Bubbles

Asset bubbles are to blame for some of the most significant recessions in U.S. history, including the stock market bubble in the 1920s, the tech bubble in the 1990s, and the housing bubble in the 2000s.

An asset bubble occurs when the price of an asset, such as stock, bonds, commodities, and real estate, quickly rises without actual value in the asset to justify the rise.

As prices rise, new investors jump in, hoping to take advantage of the rapidly growing market. Yet, when the bubble bursts — for example, if demand runs out — the market can collapse, eventually leading to recession.

6. Deflation

Deflation is a widespread drop in prices, which an oversupply of goods and services can cause. This oversupply can result in consumers and businesses saving money rather than spending it. This is because consumers and businesses would rather wait to purchase goods and services that may be lower in price in the future. As demand falls and people spend less, a recession can follow due to the contraction in consumption and economic activity.

How Do Recessions Affect You?

Businesses may have fewer customers when the economy begins to slow down because consumers have less real income to spend. So they institute layoffs as a cost-cutting measure, which means unemployment rates rise.

As more people lose their jobs, they have less to spend on discretionary items, which means fewer sales and lower revenue for businesses. Individuals who can keep their jobs may choose to save their money rather than spend it, leading to less revenue for businesses.

Investors may see the value of their portfolios shrink if a recession triggers stock market volatility. Homeowners may also see a decline in their home’s equity if home values drop because of a recession.

When consumer spending declines, corporate earnings start to shrink. If a business doesn’t have enough resources to weather the storm, it may have to file for bankruptcy.

Recommended: How to Invest During a Recession

Governments and central banks will often do what they can to head off recession through monetary or fiscal stimulus to boost employment and spending.

Central banks, like the Federal Reserve, can provide monetary policy stimulus. The Fed can lower interest rates, which reduces the cost of borrowing. As more people borrow, there’s more money in circulation and more incentive to spend and invest.

Fiscal stimulus can come from tax breaks or incentives that increase outputs and incomes in the short term. Governments may put together stimulus packages to boost economic growth, as the U.S. government did in 2009 and in 2020.

For example, stock market volatility increased wildly amid fears of the coronavirus pandemic and its economic fallout. To ward off recession, the U.S. government put together trillions in Covid-19 stimulus packages that included direct payments to citizens, suspended student loan payments, a boost to unemployment benefits, and a lending program for businesses and state and local governments.

Recessions vs Depressions and Bear Markets

Though recessions, depressions, and bear markets may all feel or seem similar, there are some differences investors should be aware of.

Recessions vs Depressions

When a recession occurs, it could stir up uneasy feelings that perhaps the economy will enter a depression. However, there are significant differences between recessions and depression. While recessions are a normal part of the business cycle that last less than a year, depressions are a severe decline in economic output that can last for years. Consider that the Great Recession lasted 18 months, while the Great Depression lasted about ten years.

Recessions vs Bear Markets

A recession is also different from a bear market, even though many think the two events go hand-in-hand.

A bear market begins when the stock market drops 20% from its recent high. If you look at the benchmark S&P 500 index, there have been 14 bear markets since 1945.

Yet, not all bear markets result in recession. During 1987’s infamous Black Monday stock market crash, the S&P 500 lost 34%, and the resulting bear market lasted four months. However, the economy did not dissolve into recession.
That’s happened three other times since 1947. Bear markets have lasted 14 months on average since World War II, and the most significant decline since then was the bear market of 2007–2009.

That’s why it’s important to keep in mind that the stock market is not the same as the economy, though they are related. Investors react to changes in economic conditions because what’s happening in the economy can affect the companies in which investors own stock.

So, if investors think the economy is growing, they may be more willing to put money in the stock market. They will likely pull money out of the stock market if they believe it is contracting. These reactions can function as a sort of prediction of recession.

Recommended: Bear Market Investing Strategies

Is It Possible to Predict a Recession?

Economists and investors try to predict recession, but it’s difficult to do, and they often end up wrong. Economists usually frame the possibility of a recession as a probability. For example, they may say there’s a 35% chance of a recession in the next year.

There are several methods economists use to try to predict recessions. Some of the most common include analyzing economic indicators, such as employment and inflation, as well as consumer and business confidence surveys. Economists build models with these economic indicators as inputs, hoping the data will help them determine the path of economic growth. While these methods can indicate whether a recession might be on the horizon, they are far from perfect.

One issue in predicting a recession is that a lot of data analysts use to forecast the economy are backward looking indicators. These data, like the unemployment rate or GDP, present a picture of the economy as it was a month or more prior. Using this data to paint a picture of the present economy becomes difficult and adds to the complexity of predicting a recession.

However, many analysts believe the yield curve is the best indicator to help predict a recession. When the yield curve inverts, meaning that the interest rate on short-term Treasuries is higher than on long-term Treasuries, it is a warning sign that the economy is heading to a recession. An inverted yield curve has occurred before all 10 U.S. recessions since 1955. Notably, however, the yield curve inverted in 2022, and a recession did not subsequently occur (yet).

The Takeaway

Recessions are periods of economic contraction, and are usually accompanied by rising unemployment and a falling stock market – though that’s not always the case.

The possibility of a recession can be unsettling, causing you to think of economic hardships and spark fears of personal financial troubles. However, recessions are a regular part of the business cycle, so you should be prepared for one if and when it comes. When it comes to investing, this means building and maintaining a portfolio to meet long-term goals.

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.

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.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Guide to Options Trading for Beginners

By | Growing Wealth, invest, Investing | Comments Off on Guide to Options Trading for Beginners

Editor's Note: Options are not suitable for all investors. 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. Please see the Characteristics and Risks of Standardized Options.

An option is a financial instrument whose value is tied to an underlying asset; this is known as a derivative. Instead of buying an asset, such as company stock, outright, an options contract allows the investor to potentially profit from price changes in the underlying asset without actually owning it.

Because options contracts may be much cheaper to come by than the underlying asset, trading options can offer investors leverage that may result in significant gains if the market moves in the right direction. But options are very risky, and also can result in steep losses. That’s why investors must meet certain criteria with their brokerage firm before being able to trade options.

What Is Options Trading?

Knowing how options trading works requires understanding what an option is, and what the advantages, disadvantages, and risks of options trading may be.

What Are Options?

Buying an option is simply purchasing a contract that represents the right but not the obligation to buy or sell a security at a fixed price by a specified date.

•   The options buyer (or holder) has the right, but not the obligation to buy or sell a certain asset, like shares of stock, at a certain price by a specific date (the expiration date of the contract). Buyers pay a premium for each options contract; this is the total price of the option.

•   The options seller (or writer), who is on the opposite side of the trade, has the obligation to buy or sell the underlying asset at the agreed-upon price, aka the strike price, if the options holder exercises their contract.

Options buyers and sellers may use options if they think an asset’s price will go up (or down), to offset risk elsewhere in their portfolio, or to increase the profitability of existing positions. There are many different options-trading strategies.


💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.

Why Are Options Called Derivatives?

An option is considered a derivative instrument because it is based on the underlying asset: An options holder doesn’t purchase the asset, just the options contract. That way, they can make trades based on anticipated price movements of the underlying asset, without having to own the asset itself.

In stock options, one options contract typically represents 100 shares.

Other types of derivatives include futures, swaps, and forwards. Options that exist for futures contracts, such as the S&P 500 index or oil futures, are also popular derivatives.

What is the difference between trading using margin vs. options? Having a margin account does offer investors leverage for other trades (e.g. trading stocks). But while a brokerage may require you to have a margin account in order to trade options, you can’t purchase options contracts using margin. That said, an options seller (writer) might be able to use margin to sell options contracts.

Recommended: What Are Derivatives?

What Are Puts and Calls?

There are two main types of options: calls vs. puts.

Call Options 101

When purchased, call options give the options holder the right to buy an asset.

Here’s how a call option might work. The options buyer purchases a call option tied to Stock A with a strike price of $40 and expiration three months from now. Stock A is currently trading at $35 per share.

If Stock A appreciates to a value higher than $40 per share, the option holder may choose to exercise the contract, or sell their option for a premium. If the value of Stock A goes up, the value of the call option should, all else being equal, also go up.

The opposite would also be true. If shares of Stock A go down, the value of the call should, all else being equal, go down.

If the options holder wanted to exercise their call option, with American-style options they have until the expiration date to do so (with European-style options, the option must be exercised on the expiration date). When they exercise, they can buy 100 shares at the strike price.

Put Options 101

Meanwhile, put options give holders the right to sell an asset at a specified price by a certain date.

Here’s how a put trade might work. A trader buys a put option tied to Stock B with a strike price of $45 and expiration three months from now. Stock B is currently trading at $50 per share.

If the price of Stock B falls to $44, below the strike price, the options holder can exercise the put. Alternatively, the value of the option would likely also rise in this scenario, as owners of Stock B might look to lock in profits and sell shares before the stock falls further. A scenario like that may give the option holder the choice of selling the option itself for a profit.

What Is the Put-Call Ratio?

A stock’s put-call ratio is the number of put options traded in the market relative to calls. It is one measure that investors look at to determine sentiment toward the shares. A high put-call ratio indicates bearish market sentiment, whereas a low one signals more bullish views.


💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.

Options Trading Terminology

•   The strike price is the price at which the option holder can exercise the contract. If the holder decides to exercise the option, the seller is obligated to fulfill the contract.

•   With American-style options the expiration is the date by which the contract needs to be exercised. The closer an option is to its expiration, the lower the value of the contract. That is what’s called the time value.

•   Premiums reflect the value of an option; it’s the current market price for that option contract.

•   Call options are considered in the money, when the shares of the underlying stock trade above the strike price. Put options are in the money when the underlying shares are trading below the strike price.

•   Options are at the money when the strike price is equal to the price of the asset in the market. Contracts that are at the money tend to see more volume or trading activity, as holders look to exercise the options.

•   Options are out of the money when the underlying security’s price is below the strike price of a call option, or above the strike price of a put option. For example, if shares of Stock C are trading at $50 each and the call option’s strike price is $60, the contracts are out of the money.

For an out-of-the-money put option, the shares of Stock C may be trading at $60, while the put’s strike price is $50, so therefore, not yet exercisable.

Recommended: Popular Options Trading Terminology to Know

“The Greeks” in Options Trading

Traders use a range of Greek letters to gauge the value of options. Here are some of the Greeks to know:

•   Delta measures the impact of the price of the underlying asset on the option’s value.

•   Beta measures how much a single stock moves relative to the overall stock market.

•   Gamma tracks the sensitivity of an option’s Delta.

•   Theta is the sensitivity of the option to time.

•   Vega is the sensitivity of the option to implied volatility.

•   Rho is the sensitivity of the option to interest rates.

Get up to $1,000 in stock when you fund a new Active Invest account.*

Access stock trading, options, auto investing, IRAs, and more. Get started in just a few minutes.

*Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

How to Trade Options

The market for stock options is typically open from 9:30am to 4pm ET, Monday through Friday, while futures options can usually be traded almost 24 hours.

This is how you may get started trading options:

1. Pick a Platform

Log into your investment account with your chosen brokerage.

2. Get Approved

Your brokerage may base your approval on your trading experience. Trading options is riskier than trading stocks because losses can be steeper. That’s why not all investors should trade options.

3. Place Your Trade

Decide on an underlying asset and options strategy and place your trade.

4. Manage Your Position

Monitor your position to know whether your options are in, at or out of the money.

Basic Options Trading Strategies

Options offer a way for holders to express their views of an asset’s price through a trade. But traders may also use options to hedge or offset risk from other assets that they own. Here are some important options trading strategies to know:

Long Put, Long Call

In simple terms, if the buyer purchases an option — be it a put or a call — they are ‘long’. A long put or long call position means the holder owns a put or call option.

•   A holder with a long call strategy effectively locks in a lower purchase price for the underlying asset in case it increases in value.

•   A holder with a long put strategy effectively locks in a higher sales price for the underlying asset in case it decreases in value.

Covered and Uncovered Calls

If an options writer sells call options on a stock or other underlying security they also own outright, the options are referred to as covered calls. The selling of options helps the writer generate an additional stream of income while committing to sell the shares they own for the predetermined price if the option is exercised.

Uncovered calls, or naked calls, also exist, when options writers sell call options without owning the underlying asset. However, this is a much riskier trade since the exercising of the option would oblige the options seller to buy the underlying asset in the open market, in order to sell the stock to the option buyer.

Note that the seller wants the option to stay out of the money so that they can keep the premium (which is how the seller makes money).

Spreads

Option spread trades involve buying and selling an equal number of options for the same underlying asset but at different strikes or expirations.

A bull spread is a strategy in which a trader expects the price of the underlying asset to appreciate.

A bearish spread is a strategy in which a trader expects a decline in the price of the underlying asset.

Horizontal spreads involve buying and selling options with the same strike prices but different expiration dates. Vertical spreads are created through the simultaneous buying and selling of options with the same expiration dates but different strike prices.

Straddles and Strangles

Strangles and straddles in options trading allow traders to profit from a move in the price of the underlying asset, rather than the direction of the move.

In a straddle, a trader buys both calls and puts with the same strike prices and expiration dates. The options buyer would pocket a profit if the asset price posts a big move, regardless of whether it rises or falls.

In a strangle, the holder also buys both calls and puts but with different strike prices.

Pros & Cons of Options Trading

Like any other type of investment, or investment strategy, trading options comes with certain advantages and disadvantages that investors should consider before going down this road.

Pros of Options Trading

•   Options trading is complex and involves risks, but for experienced investors who understand the fundamentals of the contracts and how to trade them, options can be a useful tool to make investments while putting up a smaller amount of money upfront.

•   The practice of selling options to collect income can also be a way for writers who are seeking income to collect premiums consistently. This was a popular strategy particularly in the years leading up to 2020 as the stock market tended to be quiet and interest rates were low.

•   Options can also be a useful way to protect a portfolio. Some investors offset risk with options. For instance, buying a put option while also owning the underlying stock allows the options holder to lock in a selling price, for a specified period of time, in case the security declines in value, thereby limiting potential losses.

Cons of Options Trading

•   A key risk in trading options is that losses can be outsized relative to the cost of the contract. When an option is exercised, the seller of the option is obligated to buy or sell the underlying asset, even if the market is moving against them.

•   While premium costs are generally low, they can still add up. The cost of options premiums can eat away at an investor’s profits. For instance, while an investor may net a profit from a stock holding, if they used options to purchase the shares, they’d have to subtract the cost of the premiums when calculating the stock profit.

•   Because options expire within a specific time window, there is only a short period of time for an investor’s thesis to play out. Securities like stocks don’t have expiration dates.

Advantages and Disadvantages of Options Trading
Pros

 Cons
Additional income Potential outsized losses
Hedging portfolio risk Premiums can add up
Less money upfront than owning an asset outright Limited time for trades to play out

The Takeaway

Options are derivative contracts on an underlying asset (an options contract for a certain stock is typically worth 100 shares). Options are complex, high-risk instruments, and investors need to understand how they work in order to avoid steep losses.

When an investor buys a call option, it gives them the right but not the obligation to buy the underlying asset by the expiration date. When an investor buys a put option, it gives them the right but not the obligation to sell the underlying asset by the expiration date.

The contracts work differently for options sellers/writers.

The seller or writer of a call option has the obligation to sell the underlying asset at the agreed strike price to the options holder, if the holder chooses to exercise the option on or before the expiration.

The seller of a put option has the obligation to buy the shares of the underlying asset from the put option holder at the agreed strike price.

Qualified investors who are ready to try their hand at options trading, despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors.

Invest with as little as $5 with a SoFi Active Investing account.

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.

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.
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.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

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

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Guide to Environmental, Social, and Governance (ESG) Investing

By | Growing Wealth, invest, Investing, Terminology | Comments Off on Guide to Environmental, Social, and Governance (ESG) Investing

What Is ESG?

ESG, which stands for environmental, social, and governance factors, refers to non-financial criteria that investors can use to determine whether companies are socially and environmentally responsible.

ESG investing is considered a form of sustainable or impact investing, but the term itself is more specific to emphasize that companies must focus on positive results in these three areas.

There is, however, no universally shared set of ESG criteria used by all investors or financial firms to evaluate a company’s soundness or risk along these lines. Rather, investors must learn which standards a certain fund or stock adheres to before choosing to invest.

Even so, there has been growing interest in ESG strategies in the last decade, as many of these funds have shown themselves to offer competitive returns vs. traditional strategies.

What Is ESG Investing?

As discussed, investors use ESG criteria to screen potential investments; if a business’s operations don’t follow ESG standards, investors may avoid putting money into the company. In that sense, ESG investing can be seen as a type of socially responsible investing.

But, as mentioned above, there is no universal set of standards for what makes a company ESG friendly. Companies committed to ESG operations may publish sustainability reports to give investors some insights into the firm. Additionally, third-party organizations have stepped in to create ESG scores for companies and funds based on their adherence to various ESG factors.

The following are some of the common factors that investors consider when evaluating the three different ESG areas.

Environmental

The environmental component of ESG criteria might include metrics on a company’s energy emissions, waste, and water usage. Investors may also focus on the risks and opportunities associated with the impacts of climate change on the company and its industry.

Some company information that environmentally conscious investors may evaluate include:

•   Pollution and carbon footprint

•   Water usage and conservation

•   Renewable energy integration (such as solar and wind)

•   Climate change policies

💡 Recommended: How to Invest in EV Stocks

Social

The social component of ESG generally describes the impact of a company’s relationships with people and society. Factors as varied as corporate culture, commitment to diversity, and how much a company invests in local organizations or communities can impact socially conscious investors’ decisions on buying into a specific corporation.

Some other social factors can include:

•   Employee pay, benefits, and perks

•   Diversity, equity, and inclusion

•   Commitment to social justice causes

•   Ethical supply chains (e.g., no sweatshops, conflict-free minerals, etc.)

Governance

The governance component of ESG generally focuses on how the company is run. Investors want to know how the board of directors, company, and shareholders relate to one another.

Some additional governance factors that investors evaluate include:

•   Executive compensation, bonuses, and perks

•   Diversity of the board of directors and management team

•   Transparency in communications with shareholders

•   Rights and roles guaranteed to shareholders

How ESG Scores Work

ESG scores — sometimes called ESG ratings — are designed to measure a company’s performance based on specific environmental, social, and governance criteria. Investors can use them to assess a company’s success, risks, and opportunities concerning these three areas.

An ESG score is typically calculated by analyzing a company’s available data on environmental, social, and governance policies and practices using various sources, like SEC filings, government databases, and media reports.

A high ESG score means a company manages ESG risks better than its peers, while a low ESG score means the company has more unmanaged ESG risks. Evaluating a company’s ESG score, along with financial analysis, can give investors a better idea of the company’s long-term prospects.

Some of the most prominent ESG score providers are MSCI, Morningstar Sustainalytics, and S&P Global. But some financial firms conduct their own ESG evaluations and provide proprietary scores. Transparency into how the scores are calculated can vary.

ESG vs SRI vs Impact Investing

ESG investing is sometimes called sustainable investing, impact investing, or socially responsible investing (SRI). However, impact investing and socially responsible investing are often viewed differently than ESG investing.

Some of the differences between the three investment strategies are:

•   ESG investing focuses on a company or fund’s environmental, social, and governance practices and traditional financial analysis.

•   Socially responsible investing eliminates or selects investments according to specific ethical guidelines. Investors following an SRI strategy may avoid investing in companies related to gambling and other sin stocks, or they may avoid companies that cause damage to the natural environment — or both.

•   Impact investing is generally done by institutional investors and foundations. Impact investing focuses on making investments in companies or projects specifically designed to generate positive social or environmental impact.

In addition there is another designation investors may want to know, green investing refers to strategies that are purely focused on benefiting the environment.

Last, corporate social responsibility initiatives, or CSR refers to programs and initiatives that organizations may establish on their own. Often, these business decisions support socially responsible movements, like environmental sustainability, ethical labor practices, and social justice initiatives.

Get up to $1,000 in stock when you fund a new Active Invest account.*

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*Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

Why Is ESG Investing Important?

ESG investing is important because it offers investors a way of putting their money into causes that are significant to them, with the hope of having a genuine impact via their investments in certain companies or funds. This is why ESG is often called impact investing, although true impact investing is a broader term, and refers to a range of companies that may or may not be focused on sustainable issues.

Whether or not companies or funds that embrace ESG strategies deliver on the promised goals is a matter for investors to decide via due diligence. As noted above, without a commonly agreed-upon set of standards and some form of accountability, it’s difficult to ascertain which companies are truly having an impact.

Are ESG Strategies Profitable?

Nonetheless, investors have continued to be interested in ESG strategies. In 2021, socially responsible U.S. mutual funds saw record inflows of some $70 billion — a 36% increase over 2020. ESG funds saw substantial outflows through 2021 and most of 2022. But sustainable funds still managed to outperform non-sustainable funds through Q3 of 2022, despite challenging market conditions, according to Morningstar research as of September 30, 2022.

During the third quarter of 2022, sustainable large-cap funds netted $525 million, versus their unsustainable equity peers, who lost $25 billion that period.

Two other studies from Morningstar added to the evidence that funds which embrace socially responsible investing strategies tend to outperform conventional mutual funds.

Their “Sustainable Funds U.S. Landscape Report” from February 2022 found that “two thirds of sustainable offerings in the large-blend category topped the U.S. market index last year compared with 54% of all funds in the category.”

According to the report: “There are 5 times as many sustainable funds in the U.S. today than a decade ago, and 3 times more than five years ago.”

Types of ESG Investments

Investors can make ESG investments in the stocks and bonds of companies that adhere to ESG criteria or have high ESG scores. Other potential investment vehicles are mutual funds and exchange-traded funds (ETFs) with an ESG strategy.

Stocks

Buying stocks of companies with environmental, social, and governance commitments can be one way to start ESG investing. However, investors will often need to research companies that have ESG credibility or rely on third-party agencies that release ESG scores.

💡 Recommended: How to Analyze a Stock

Bonds

The bonds of corporations involved in ESG-friendly business practices can be a good option for investors interested in fixed-income securities. Green and climate bonds are bonds issued by companies to finance various environmentally-friendly projects and business operations.

Additionally, government bonds used to fund green energy projects can be an option for fixed-income investors. These bonds may come with tax incentives, making them a more attractive investment than traditional bonds.

💡 Recommended: How to Buy Bonds: A Guide for Beginners

Mutual Funds and ETFs

Investors who don’t want to pick individual stocks to invest in can always look to mutual funds and exchange-traded funds (ETFs) that provide exposure to ESG companies and investments.

A growing number of index funds invest in a basket of sustainable stocks and bonds. These funds allow investors to diversify their holdings by investing in one security.

However, not all ESG funds follow the same criteria and may focus on different aspects of environmental, social, and governance issues. Interested investors would do well to look under the hood of specific funds to evaluate their holdings and other criteria.

💡 Recommended: A Beginner’s Guide to Investing in Index Funds

Identifying ESG Companies

What is the best way to find an ESG company? There are a number of resources available for ESG investors, including proprietary tools that allow investors to search and/or evaluate different stocks based on specific criteria.

There are also a number of lists published by financial media companies that evaluate companies and funds according to ESG criteria.

Financial ratings firms like Morningstar publish regular research reports on different aspects of the ESG sector.

In addition, many industry firms and fund-providers have their own proprietary evaluation methods that investors might consider. Here are five of the biggest companies that provide ESG ratings, according to Fortune.com.

•   FTSE Russell: Publishes ESG ratings on 7,200 securities

•   ISS ESG: Provides ratings on 11,800 issuers and 25,000 funds

•   MSCI: Publishes ESG ratings for over 8,000 companies worldwide

•   Refinitiv: Calculates ESG scores on 11,800 companies

•   Sustainalytics: Publishes ESG ratings on more than 13,000 companies

Benefits of ESG Investing

ESG investing has several benefits, including:

•   Improving long-term financial performance: A growing body of evidence suggests that companies with solid ESG ratings may be good investments. They tend to outperform those with weaker ratings, both in share price performance and earnings growth.

•   Mitigating risk: ESG factors can help identify companies with poor governance practices or exposure to environmental and social risks, leading to financial losses.

•   Creating social and environmental impact: By investing in companies that are leading the way on environmental, social, and governance issues, investors can help drive positive change and make a positive impact on society.

These potential benefits are increasing the popularity of ESG investing. According to Bloomberg, global ESG assets may surpass $41 trillion by the end of 2022 and reach $50 trillion by 2025, up from $22.8 trillion in 2016.

Risks of ESG Investing

The main disadvantage of ESG strategies is that they limit the number of investments that people can consider. Thus, some investors may end up trading potential returns for the ability to invest according to their values.

In addition, ESG investments can sometimes come with higher costs, for example an ESG fund may have a higher expense ration vs. a traditional counterpart.

While there is a growing body of data regarding the performance of ESG indices and securities, it’s still a relatively new sector relative to more traditional investments.

Starting an ESG Investment Portfolio

If you’re interested in creating an ESG portfolio, you can start by contacting a financial advisor who can help you shape your investment strategy.

However, if you are ready to start investing and want to build a portfolio on your own, you can follow these steps:

•   Open a brokerage account: You will need to open a brokerage account and deposit money into it. Once your account is funded, you will be able to buy and sell stocks, mutual funds, and other securities.

•   Pick your assets: Decide what type of investment you want to make, whether in a stock of a company, an ESG-focused ETF or mutual fund, or bonds.

•   Do your research: It’s important to research the different companies and funds and find a diversified selection that fits your desires and priorities.

•   Invest: Once you’re ready, make your investment and then monitor your portfolio to ensure that the assets in your portfolio have a positive social and financial impact.

It is important to remember that you should diversify your portfolio by investing in various asset classes. Diversification will help to reduce your risk and maximize your returns.

ESG Investing Strategies

ESG investing can be different based on values and financial goals. It’s therefore essential to start with your investment goals and objectives when crafting an ESG investing strategy. Consider how ESG factors can help you achieve these goals.

It’s also crucial to understand the data and information available on ESG factors; this will vary by company and industry. When researching potential ESG investments, you want to make sure a company has a clear and publicly-available ESG policy and regularly discloses its ESG performance. Additionally, it can be helpful to look at third-party scores to determine a company’s ESG performance.

The Takeaway

In recent years, investor interest in sustainable investing strategies like ESG has grown. In addition, there is some data that suggests that ESG strategies may be just as effective as traditional strategies in terms of performance.

This is despite the fact that ESG criteria are inconsistent throughout the industry. There are a myriad different ways that companies can provide ESG-centered investments, but there aren’t industry-wide benchmarks for different criteria or success metrics.

Thus, it’s fair to say that there is no “right” way to invest in ESG companies. What matters most is that you have done your own research; you are comfortable with the companies you are investing in; and you believe in their ability to create long-term value.

Investors interested in making ESG investments can use the SoFi app to help. When you open an Active Invest account with SoFi Invest®, you can trade stocks and ETFs to build an ESG portfolio. SoFi doesn’t charge commissions (although operating expense ratios and other fees may apply to exchange-traded funds), and SoFi members have access to complimentary advice from financial professionals.

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 are the three pillars of ESG?

ESG stands for three areas that some companies strive to embrace by being proactive about the environment, supportive of social structures, and transparent and ethical in corporate leadership.

What are some examples of ESG investing?

There are countless ways to add ESG strategies to your portfolio: You can consider investing in green bonds, in companies that focus on environmentally supportive technologies, in funds that invest in a multitude of renewable energy companies, clean water initiatives, carbon sequestration, and more.

What is the difference between ESG and sustainability?

Sustainability is a broader term. Environmental, social, and governance factors may support sustainability in different ways: by limiting air or water pollution, by supporting fair labor practices, by insisting on transparency in corporate governance.

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Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

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