How Does a Stock Exchange Work?

How Does a Stock Exchange Work?

Stock exchanges are platforms that allow investors to buy and sell stocks in a venue that is regulated and transparent. These exchanges enable investors of all stripes to trade stocks, potentially benefiting from a stock’s share price appreciation and dividend payments.

Stock exchanges help the stock market work and are a big part of the overall economy. Understanding stock exchanges and how they work may help you how they affect you and your investments.

What Is a Stock Exchange?

A stock exchange is a marketplace where the shares of publicly-traded companies are bought and sold between investors.

Exchanges are generally organized by an institution or association that hosts the market, like the New York Stock Exchange or Nasdaq. These organizations and government regulators–like the Securities and Exchange Commission (SEC) in the U.S.–set up the rules and regulations of what companies investors can trade on a stock exchange.

If a company is “listed” on an exchange, it means that the company can be traded on that exchange. Not all companies are listed because each exchange regulates which companies meet their requirements. Companies not listed on the exchange are traded over-the-counter, or OTC for short.

Investors who want to buy or sell stocks commonly go through an investment broker, a person or entity licensed to trade on the exchanges. Brokers aim to buy or sell stock at the best price for the investor making the trade, usually earning a commission for the service. Most investors will now use online brokerage firms for this service, paying little to no commissions for trades.

Historically, stock exchanges were physical locations where investors came together on a trading floor to frantically buy and sell stocks, like what you may have seen in the movies or on TV. However, these days, more often than not, stock exchanges operate through an electronic trading platform.

Major Stock Exchanges

10 Largest Stock Exchanges by Market Capitalization of Listed Companies

Exchange

Location

Market capitalization (in trillions)*

New York Stock Exchange (NYSE) U.S. $24.68
Nasdaq U.S. $19.5
Shanghai Stock Exchange China $7.05
Euronext Europe $5.90
Tokyo Stock Exchange Japan $5.31
Shenzhen Stock Exchange China $5.15
Hong Kong Exchanges Hong Kong $4.57
National Stock Exchange of India India $3.32
London Stock Exchange U.K. $3.17
Saudi Stock Exchange Saudi Arabia $3.15
*As of July 2022; Source: Statista

Why Do We Have Stock Exchanges?

Stock exchanges exist because they provide a place for buyers and sellers to come together and trade stocks. Stock exchanges are also important because they provide a way for businesses to raise money. When companies issue stock to raise capital, investors will then trade the company’s shares on the stock exchange in which it is listed.

The stock exchanges set the rules for how stocks are traded. Stock exchanges are also regulated markets, which means that a government agency oversees the activity on the exchange. These rules and regulations provide a level of safety for investors and help to ensure that the market is fair, transparent, and liquid.

💡 Not sure what a stock is? Here we explain what stocks are and how they work.

What Is the Stock Market?

The stock market is made up of a network of different stock exchanges, including OTC markets, and the companies that are traded on these exchanges.

When you hear mentions of the stock market and its performance, it is usually in reference to a particular stock market index, like the S&P 500 or Dow Jones Industrial Average. However, the stock market is more than the specific companies that make up these stock market indices.

Generally, stock markets facilitate the buying and selling of shares between companies and institutional investors through initial public offerings (IPOs) in the primary market. Once a company has an IPO, the company’s shares are traded in secondary markets, like stock exchanges.

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Stock Market Volatility

Volatility in the stock market occurs when there are big swings in share prices. Share prices can change for various reasons, like a new product launch or the most recent earnings report. And while volatility in the stock market usually describes significant declines in share prices, volatility can also happen to the upside.

Pros of the Stock Market

As mentioned above, the stock market allows companies to raise capital by issuing shares to investors. Raising money was one of the main reasons why stock issuances and trading began. It allows businesses to raise money to expand a business without taking out a loan or issuing bonds.

And because investors can own shares of companies, they can benefit from the growth and earnings of a business. Investors can profit from a company’s dividend payments, realize a return when the stock’s price appreciates, or benefit from both. This helps investors build wealth.

The relationship between stock markets, companies, and investors has arguably led to more economic efficiency, allowing money to be allocated in more productive ways.

Cons of the Stock Market

For companies, issuing shares on the stock market may be onerous and expensive due to rules and regulations from the stock exchanges and government regulators. Because of these difficulties, companies may be wary of going through the IPO process. Instead, they are more comfortable raising money in the private markets.

💡 Recommended: How Many Companies IPO Per Year?

There are several potential risks associated with investing in the stock market. For example, the stock market is subject to market volatility, resulting in losses. Investors must be willing to take on the risks of losing money for the possibility of gains in the future.

Additionally, there is the potential for stock market fraud and manipulation by companies and investors, which harms individual investors, companies, and the economy.

The Takeaway

Knowing the ins and outs of stock exchanges and how they influence the broader stock market can help you become a better investor. By learning about stock exchanges, their different rules, and their advantages and disadvantages, you may better understand the stock market as a whole. This may allow you to invest confidently and prepare for future stock market volatility.

At SoFi, members have access to financial planners who can offer personalized advice. If you’re ready to start investing, SoFi Invest® offers an online brokerage account, where investors can buy stocks, exchange-traded funds (ETFs), fractional shares, or invest in IPOs. For a limited time, funding an account gives you the opportunity to win up to $1,000 in the stock of your choice. All you have to do is open and fund a SoFi Invest account.

Download the SoFi Invest mobile app today.

FAQ

What is the stock market?

The stock market is a collection of markets where stocks are traded between investors. It usually refers to the exchanges where stocks and other securities are bought and sold.

What are the benefits of investing in the stock market?

Some benefits of investing in the stock market include the potential for earning income through dividend payments, experiencing share price appreciation, and diversifying one’s financial portfolio beyond cash.


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The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A., or SoFi Lending Corp.
Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.

New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.

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External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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What Is Automated Investing?

What Is Automated Investing?

Automated investing is a type of investing that uses computer algorithms to generate tailored financial planning or retirement advice to individuals. Automated investing, also known as robo advisors, tends to feature low fees, lower minimum balances, digital applications, and a more hands-off approach to investing.

Because automated investing can be done with little or no direct human effort, it can be an ideal option for investors just starting their wealth-building journey. Automated investing may reduce the learning curve for some investors entering the financial markets, helping them start building and managing a portfolio to achieve their financial goals.

Automated Investing 101

Automated investing uses computer algorithms to select and trade stocks, exchange-traded funds (ETFs), or other assets without the need for oversight by a human financial advisor.

Automated investing has changed the financial advisory game in fundamental ways. Like so much else that has happened during the digital revolution, automated investing has eliminated the middle man and is delivering a service directly to the client – you, the investor.

Investors who sign up for an automated investing platform usually take an online survey. This survey collects information about the investor’s financial situation, risk tolerance, and goals. The automated investing advisor then uses this data to recommend investments to the client that may help them meet their financial goals. The automated investing platform will build and manage a portfolio for the investor using computer algorithms and other data.

Automated investing advisors may also handle portfolio rebalancing and tax-loss harvesting if the client chooses these services.

Most automated advisors use Modern Portfolio Theory (MPT) to create and manage a portfolio’s asset allocation. The idea is to decrease risk by diversifying a portfolio into many assets; the idea is “not put all your eggs in one basket.”

The automated investing industry is growing fast; client assets managed by automated advisors are estimated to be $1.66 trillion by the end of 2022, up from $300 billion in 2017, according to data from Statista .

Of course, the automated investing phenomenon is relatively new; its direct-to-investor service has only occurred over the last decade, so it’s difficult to report a long-term industry-wide track record.

Automated Investing vs Robo Advisors

Automated investing tools are sometimes referred to as robo advisors. Investors may see the terms automated investing and robo advisors used interchangeably to describe digital tools that use computer algorithms to create and manage a financial portfolio.

💡 Recommended: Robo Advisor vs. Financial Advisor: Which Should You Choose?

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Why People Choose an Automated Invested Strategy

There are several reasons why investors choose automated investing tools to build and manage a financial portfolio to build wealth.

Low Cost Process

Automated investing advising generally costs less than traditional financial advisors. The reason the cost of automated advising is lower: less human labor. Human advisors require salaries and benefits.

Automated investment fees are usually a percentage of the assets under management (AUM). Typical fees are less than 0.5% of AUM annually. So if an investor puts $1,000 into an automated investing service, they generally pay less than $5 per year. Some automated investing services even have no management fee.

By comparison, a reasonable rate for a human financial advisor would be a 1% investment fee. Investors may also have to pay fees on their investments and commissions for products the financial advisor sells.

However, automated investing services may have additional fees as well. Some robo advisors may have a set-up fee, and the investment of ETFs could also generate management fees and costs for which the consumer is responsible.

💡 Recommended: How Much Does a Financial Advisor Cost?

More Affordable Initial Investment

Many automated investing platforms have low minimum account requirements. And some platforms have no minimum initial investment requirements.

In contrast, some human financial advisors won’t take on a client unless they have more than $100,000. At the high end, private wealth managers could require minimums of $5 million.

Because of the lower initial investment required, younger consumers have turned to automated investing in planning for their financial future. Previously, high minimum balances had been headwinds to younger investors, preventing them from getting financial advice.

As younger investors, like Generation Z and millennials, start hitting life milestones like getting married and saving for a house, automated investing may be a good option for them to begin building wealth.

Efficient & Convenient Access

With traditional financial advisors, clients had limited access and had to work around the human advisor’s schedule. Automated advisors use digital platforms. This allows clients to ask questions and access help 24 hours, seven days a week, if needed.

Need to make a trade or a change? There is no need to call to schedule an appointment, fill out a physical form, meet with an advisor in person, or wait for office hours. Usually, a few button pushes can do the trick.

Lower fees and minimum balances have attracted younger investors to the automated investing industry. But the digital and mobile platforms these services offer have also made younger users turn to such automated services more.

What to Look for in an Automated Investment Platform

If you’re interested in opening an automated investing account, there are several factors you may want to consider before deciding if automating investing is right for you.

Automated Investing Fees

As mentioned above, automated investing fees are generally lower than traditional financial advisors. However, you still want to compare the fees of the various automated investing platforms on the market.

Some platforms charge a flat fee, while others charge a percentage of your assets under management. In addition, some platforms charge fees for specific services, such as tax preparation or additional investment advice.

Affordability

Some automated investment platforms require a minimum investment to open an account. You’ll want to understand any minimum investment requirements before opening an account. For example, some automated investing platforms may offer a $0 account minimum, but that might not include certain robo advisory services you’re looking for.

Investment Options

The investment options offered by automated investment platforms vary. Some platforms offer a limited selection of investment options, while others offer a wide range of investments. You want to ensure the automated investing platform you choose offers investment options that meet your needs.

Usually, robo advisors only invest in ETFs and mutual funds, so you’ll want to see if the services offer a range of funds, from international equities to domestic corporate bonds. Knowing what investment options a robo advisor provides may help you ensure that you may end up with a diversified portfolio that aligns with your goals.

Investment Rebalancing

Generally, a robo advisor will make automated investments based on your risk tolerance and financial goals. These services will create a portfolio of a certain percentage of stock ETFs and bonds ETFs based on risk tolerance. But you want to check that the automated investing services will rebalance your portfolio to maintain that percentage of stocks and bonds.

For example, an investor with a more aggressive risk tolerance may have a portfolio with an asset allocation of 80 percent stocks and 20 percent bonds. With time, the portfolio may change and knock that ratio off balance — too much of one and not enough of the other. An automated investor can automatically rebalance your account to its original 80/20 ratio. No human interaction is needed; the rebalance happens through the automated investing algorithm.

Human Interaction

Some automated investing services may give investors access to human financial professionals, which can be helpful for investors who need to ask questions, discuss goals, and plan for the future. Automated investing services might charge for this service, but it could be helpful to have this option.

Who Is Auto Investing Best for?

Automated investing may be a good option for people who want to invest for the long term but do not want to manage their own portfolios or pay high fees for a traditional financial advisor. It is also a good option for people who want to invest in various assets but do not have the time or expertise to do so themselves.

As noted above, many younger investors have begun using robo advisors to create portfolios and make automated investment decisions. It may allow these younger investors to build up experience in the financial markets while investing with a hands-off approach. As they build wealth and expertise, these investors may decide to make investment decisions on their own or hire a traditional financial advisor to help manage their financial goals.

Whatever an investor decides, automated investing may be a good strategy for any investor looking to build and manage a portfolio.

The Takeaway

An automated investing platform can be ideal for many investors, particularly regarding affordability, convenience, and avoiding potential human errors. This investment tool allows investors to use a hands-off approach, which many people may prefer over the time-consuming research and management required for picking and choosing stocks, bonds, and other assets to build and manage a portfolio.

If you’re interested in opening an automated investing account, SoFi can help. With SoFi Invest® automated investing, we recommend a portfolio of stock and bond funds for you based on your goals and risk tolerance. We’ll rebalance your investments quarterly, so your money is always invested how you want it to be. And SoFi doesn’t charge a management fee.

Ready to get started with investing? Check out SoFi Invest automated investing platform.


SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A., or SoFi Lending Corp.
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.
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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Stocks: What They Are and How They Work

A stock is a fraction of ownership in a company. Stockowners, also called shareholders, are entitled to a proportional cut of the company’s earnings and assets (and sometimes dividends).

That means, if you own stock in a company, as the company grows and expands you stand to earn a return on your investment. But you also risk losing all or part of your investment if the company doesn’t prosper. (More on that below.)

If you’re interested in investing in stocks, this stocks 101 guide will provide a basic overview of the different types of stocks, the pros and cons of investing in stocks, and more.

What Is a Stock?

Let’s start with a basic stock definition: Stocks are simply shares in a company, and they are primarily bought and sold on publicly traded stock exchanges. That means you can open a brokerage account and become a partial owner of whatever company you choose when you buy shares in that company.

How to Talk About Stocks

What is the difference between a stock vs. a share? A share of stock is the unit you purchase. “Stock” is a shorthand way of referring to the company that is selling its shares.

So: You might buy 100 shares of a company. If you owned 100 stocks, however, that means you own shares of 100 different companies.

Is trading equities the same as trading stocks? Yes. Equities or equity shares, is another way of talking about stocks as an asset class. You’re not likely to say you bought equity in a company. But your portfolio may have different asset classes that include equities, fixed income, commodities, and so on.

These days, it’s possible to own a fraction of a share of stock, for those who can’t afford to buy a single share (which can happen with very large or popular companies).

Main Types of Stock

Stocks come in two varieties: common stock and preferred stock.

•   Common stocks are, as you might guess, the most common. Along with proportional ownership of the company, common stocks also give stockholders voting rights, allowing them voice when it comes to things like management elections or structural business changes.

•   Preferred stocks don’t come with voting rights, but they are given “preferred” status in that earnings are paid to preferred stockholders first. That makes this kind of stock a slightly less risky asset. If the company goes under and its assets are liquidated to repay investors, the preferred stockholders are less likely to lose everything, since they’ll be paid their share before common stockholders.
Most individual investors own common stock.

What Is the History of Stocks?

What are stocks and how did they originate? Historically speaking, all types of assets — property, livestock, precious metals, commodities — have been traded since time immemorial. There are records going back nearly a millennium in the West alone, showing that people traded debt as well as futures and government securities.

Investing in stocks began in Europe in 1602 with the founding of the Dutch East India Company, a so-called “joint stock” company where investors could buy shares. Joint-stock companies helped fund the exploration of the New World, as Europeans then called it.

By 1610, the practice of short-selling had not only taken hold in Amsterdam, it had become such a problem that it was banned by Dutch authorities!

The Trouble With Trading

Stock trading, especially in its infancy in the 17th and 18th centuries, was not the highly regulated industry we know today. Stock markets were rife with scams and schemes and outright fraud. The South Sea Company in England was responsible for one of the most notorious incidents in early finance. The company, which hoped to profit from the slave trade, infamously sold shares to countless investors, and promised them big returns — that never materialized.

As a result, the South Sea bubble burst in 1720, and the company crashed with terrible consequences for the nascent markets abroad. The practice of issuing securities was banned in England for nearly a century — until 1825.

How Stock Exchanges Fuel Economic Growth

International trade furthered the spread of stock exchanges throughout the world, and with it commerce and economies were able to grow and thrive. After all, the stock market, which allows businesses to be publicly traded, is a vital way that companies raise capital for their expansion. At the same time, stock markets also became an important source of liquidity for investors.

The first stock exchange in the U.S. was the Philadelphia Stock Exchange, established in 1790, followed by the New York Stock Exchange in 1792.

How Stocks and the Stock Market Work

A stock is born when a company goes public through an initial public offering (IPO), and issues actual shares that investors can buy and sell. Stocks are typically traded on exchanges, like the NYSE or Nasdaq or the London Stock Exchange (there are 60 major stock exchanges worldwide).

Individual investors can open a brokerage account so they can buy and sell the stocks of their choosing on a given exchange. Exchanges list the purchase or bid price, as well as the selling or offer price.

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How Are Stock Prices Determined?

The price of a stock is generally determined by an auction process, where buyers and sellers negotiate a price to make a trade. The buyer makes a bid price, while the seller has an ask price; when these two prices meet, a trade occurs.

💡 Recommended: How Bid and Ask Price Work in Trading

The stock market consists of thousands or millions of trades daily, usually through online platforms and between investors and market makers. So, the auction process is not usually completed between investors directly. Rather, prices are determined through electronic trades in fractions of a second.

Nonetheless, this process still helps determine stock prices, usually following the laws of supply and demand. When a stock’s prospects are high and it’s in high demand, the company’s share price will increase. In contrast, when investors sour on a company and want to sell en masse, the price of a stock will decline.

What Are Some Common Stock Terms?

If you need the whole idea of stocks explained and unpacked, it helps to learn a few key words. While it’s impossible to cover the entire lexicon of stock investing here, this is a short list of helpful stock terms to know:

Dividends

A dividend payment is a portion of a company’s earnings paid out to shareholders. For every share of stock an investor owns, they get paid an amount of the company’s profits. Companies can pay out dividends in cash, called a cash dividend, or additional stock, known as a stock dividend.

Growth stocks

Growth stocks are shares of companies that demonstrate a strong potential to increase revenue or earnings thereby ramping up their stock price

Market capitalization

To figure out a company’s market cap, multiply the number of outstanding shares by the current price per share. A company with 10 million outstanding shares of stock selling at $30 per share, has a market cap of $300 million.

Spread

Spread is the difference between two financial measurements; in finance there are a variety of different spreads. When talking specifically about a stock spread, it is the difference between the bid price and the ask price — or the bid-ask spread.

The bid price is the highest price a buyer will pay to purchase one or more shares of a specific stock. The ask price is the lowest price at which a seller will agree to sell shares of that stock. The spread represents the difference between the bid price and the ask price.

Stock split

A company usually initiates a stock split when its stock price gets too high. A stock split lowers the price per share, but maintains the company’s market cap.

A 10-for-1 stock split of a stock selling for $1,000 per share, for instance, would exchange 1 share worth $1,000 into 10 shares, each worth $100.

Value stock

Value stocks are shares of companies that have fallen out of favor and are valued less than their actual worth.

Volatility

Volatility in the stock market occurs when there are big swings in share prices, which is why volatility is often synonymous with risk for investors. While volatility usually describes significant declines in share prices, it can also describe price surges.

Thus, volatility in the equity market can also represent significant opportunities for investors. For instance, investors might take advantage of volatility to buy the dip, purchasing shares when prices are momentarily lower.

Is It Possible to Earn Money by Buying Stocks?

Now that you have a working stock definition, let’s look at whether buying them has the potential to help you meet your financial goals. How does buying stocks earn you money? There are two possible ways.

•   Over time, stocks may increase in value if the company grows, expands, and prospers. Since each share represents proportional ownership, a stock is worth more when the business’s overall value increases — and may also command higher market prices due to demand. That means you may earn money by selling your stocks at a profit at some point.

•   Stockholders may also earn dividends on a company’s profit, which may be paid in cash or as additional stock. Dividends are typically paid on a regular basis, such as quarterly or annually, though executives may also decide to cut dividend payments if the company is faltering.

   Owning stock can create a form of passive income, since you could earn dividends just by holding onto your shares. This strategy is called dividend investing.

Stocks make up the foundation of many investment portfolios because of their potential for returns in the long run. On the other hand, the same dynamic that gives stocks their exponential growth potential also adds considerable risk to owning stock.

Buying Stocks: Risks and Rewards

Although buying stocks can sometimes result in a profit, it’s also possible to see significant losses — or even to lose everything you’ve invested.

Stocks might lose value under the following circumstances:

•   The market as a whole experiences losses, due to wide-reaching occurrences like economic recessions, war, or political changes.

•   The issuing company falters or goes under, in which case individual shares can drop in price and the company may forego paying dividends. This is also known as “specific” or “unsystematic risk,” and may be slightly mitigated by having a diversified portfolio.

Diversifying your portfolio — buying a variety of different stocks as well as other assets like bonds and cash equivalents — is one way to help mitigate the risks of investing. But it’s important to understand that it is possible (and even likely) that you may lose money by investing.

That said, scary news headlines can blow things out of proportion. A certain amount of market fluctuation is absolutely normal — and, in fact, an indicator that the market is healthy and functioning.

Furthermore, the market’s overall value has increased on average over the last century, even taking into account major collapses. In fact, the S&P 500, an index tracking the performance of America’s largest publicly traded companies, saw an annual return of approximately 10% between 1926 and 2020 — a time frame that includes both the Great Depression and the 2008 housing fiasco.

Should You Invest in Stocks?

When you consider the average return of the stock market over time, including boom and bust cycles, the stock market can offer investors the hope — but not the guarantee — of long-term growth for their money.

The difficulty with stocks is that they also come with a high degree of risk; some are riskier than others. There are different ways to invest in stocks that can help mitigate some of that risk.

*Investing in mutual funds, which are like giant baskets of many stocks, may help to distribute risk. Holding one single stock is riskier than holding many.
*Investing in index funds, which track a market index, may be less risky.

Why Do Companies Issue Stock?

When a company decides to go public, part of that decision is based on the need to raise capital in order to help the company grow. By making shares available on public exchanges to the wider investing market, a company may benefit from having more people buy its shares.

The downside for companies that go public is that the value of the company is now subject to market demand and other economic factors. In addition, public companies are highly regulated.

Why Do People Buy Stock?

Due to their growth potential, stocks may offer investors a possible way to build wealth over time, given that they tend to have higher average return rates than many other kinds of assets.

Take bonds, for instance. Bonds are a type of asset sometimes called a “debt instrument” wherein you lend your money to a company or government in exchange for a promise that it will be returned, plus interest, within a set amount of time.

Bonds do offer some growth potential, typically with less risk exposure than stocks. But over the past century, bonds have seen an average return of about 5-6% . As you’ll recall, that’s about half of the annual growth rate actualized by stocks over the same time period. Remember, past performance doesn’t guarantee that the future will be the same.

Along with helping you build wealth to achieve financial goals like retirement or homeownership, investing in stocks is also a possible way to keep up with inflation. As tempting as it may be to stash your cash under your mattress, the value of those paper dollars decreases over time, which means the $100 you squirrel away today might be worth only $95 ten years from now, due to inflation.

On the other hand, if you’d invested that money, it might have nearly doubled in the same amount of time. Of course, that new total would still be subject to inflation, but it could still be a lot more competitive than the dusty paper bills

Getting Started Investing in Stocks

If you decide that investing in the stock market is the right move to help you reach your financial goals, you’ve got a variety of ways to get started. Let’s look at two main account types: tax-deferred retirement accounts and taxable brokerage accounts.

Before you even sit down to choose your first stock (or learn to evaluate stocks in general), you’ll need to decide what kind of investment account you’ll use.

Tax-Deferred Accounts

These accounts are typically used for retirement purposes because they offer certain tax advantages to investors (along with some restrictions). Generally, investors contribute pre-tax money to these accounts — meaning contributions are tax deductible — and pay taxes when they withdraw funds in retirement.

•   The 401(k) is commonly offered to W-2 employees as part of their benefits package. Contributions are taken directly from your paycheck, pre-tax, for this retirement account. In most cases, taxation is deferred until you take the funds out at retirement.

•   IRAs may be useful investment vehicles for the self-employed and others who don’t have access to an employer-sponsored retirement account. There are a number of different types of IRA – two of the most common are the Roth and the traditional IRA – and each type offers unique benefits and limitations to savers.

Taxable Accounts

•   You can also open a brokerage account, which allows you to buy and sell assets pretty much at will. However, there are no tax deductions for investing through a brokerage account.

Also, the interest and dividends you earn are subject to taxes in the year you earn them, and you may incur taxes when you sell an investment. Tax rates are usually lower for “long-term” assets, or those held for a year or longer; taxes on “short-term” capital gains (on securities held for less than a year) tend to be higher.

Different brokers assess different maintenance and trading fees, so it’s important to shop around for the most cost-effective option.

Choosing Your Investments

Once you have a brokerage account, you can typically choose which assets to invest in, including individual stocks as well as mutual funds, index funds, and Exchange-Traded Funds (ETFs), which are pre-arranged “baskets” of stocks that can help build diversification into your portfolio. Typically, ETFs are subject to management fees, but many brokers even offer commission-free ETFs, which can help you start investing at the lowest cost possible.

Of course, no matter what type of account you open or who your broker is, you’re ultimately responsible for the risk you take in buying stocks. That’s why it’s important to carefully vet stocks before you invest in them.

If you’re considering investing in a company directly, researching its financial history and learning more about its earnings patterns can help you make the most educated choice possible. It’s also important to keep your own goals and values in mind when learning what to look for in a stock.

Automated Investment Options

If all that footwork sounds exhausting, that doesn’t necessarily mean investment isn’t right for you. You might consider an automated investing option (also known as a “robo-advisor”), which offer pre-built investment portfolios based on your goals and timelines. It’s similar to a pre-built house: there are some adjustments you can make, and different models to choose from, but your choices are limited.

That said, many investors choose automated options because the algorithm on the back-end takes care of most of the basic maintenance for your portfolio. Also, robo advisors can help you get started with a minimal amount of research and effort.

The programs may charge a small fee in exchange for creating, maintaining, and rebalancing a portfolio. Some may also allow you to choose specific stocks or themed ETFs, which can help you support companies or industries that share your values and vision.

The Takeaway

Stocks, also known as “shares” or “equity investments,” are small pieces of ownership of a larger company. Stocks come in both common and preferred varieties, which offer stockholders different benefits and risks.

Stocks, although relatively risky, tend to offer better earning potential than other asset classes like bonds or long-term savings accounts. Even taking major financial crises into consideration, the market’s overall trend over the last 100 years has been toward growth.

So, if you’re ready to take matters into your own hands and become an investor, you may want to start by opening a stock trading account with SoFi Invest. You can trade stocks, IPO shares, ETFs, and crypto, right from your phone or laptop. Even better, SoFi members have access to complimentary financial advice from professionals. Why not get started today — your future self will thank you.

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

FAQ

What is a stock vs a share?

A share refers to the unit of stock investors buy. Stock is a more general term that refers to the company that issues those shares. So you would buy 100 shares of Company A; you wouldn’t buy 100 stocks (that would imply you owned shares of 100 different companies).

What is shareholder ownership?

Shareholder ownership is specifically based on your ownership of shares in the company. If you own 20% of a company’s shares, you don’t own 20% of the company — you own 20% of the shares.

What is the difference between stocks and bonds?

Companies issue stock in order to raise capital. Investors who own shares of stock will see the value of their holdings rise or fall according to the value of the company. Bonds are a loan of capital to a company or government, which in turn guarantees to repay the bondholder the full amount, plus interest, within a certain time frame.


SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A., or SoFi Lending Corp.
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.
Claw Promotion: Customer must fund their Active Invest account with at least $10 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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IRA vs 401(k): What Is the Difference?

IRA vs 401(k): What Is the Difference?

The biggest difference between an IRA vs. a 401(k) is the amount you can save. You can save over three times as much in a 401(k) vs. an IRA — $20,500 versus $6,000. But not everyone has access to a 401(k), because these are sponsored by an employer, typically for full-time employees.

Other than that, a traditional IRA and a 401(k) are similar in terms of their basic provisions and tax implications. Both accounts are considered tax deferred, which means you can deduct the amount you contribute each year — unless you have a Roth account, which has a different tax benefit.

Before you decide whether one or all three types of retirement accounts might make sense for you, it helps to know all the similarities and differences between a 401(k) and a traditional IRA and Roth IRA.

How Are IRAs and 401(k)s Different?

The government wants you to prioritize saving for retirement. As a result, they provide tax incentives for IRAs vs. 401(k)s.

In that respect, a traditional IRA and a 401(k) are somewhat similar; both offer tax-deferred contributions, which may lower your taxable income, and tax-deferred investment growth. Also, you owe taxes on the money you withdraw from these accounts in retirement (or beforehand, if you take an early withdrawal).

There is a bigger difference between a Roth IRA and a 401(k). Roth accounts are funded with after-tax contributions — so they aren’t tax deductible. But they provide tax-free withdrawals in retirement.

And while you can’t withdraw the contributions you make to a traditional IRA until age 59 ½ (or incur a penalty), you can withdraw Roth contributions at any time (just not the earning or growth on your principal).

These days, you may be able to fund a Roth 401(k), if your company offers it.

401(k)

Traditional IRA

Roth IRA

2022 Contribution limits $20,500 ($27,000 50 and older) $6,000 ($7,000 for those 50+) $6,000 ($7,000 for those 50+)
Pros Contributions are tax deductible

May include an employer match

Participants can save more

Contributions are tax deductible

No income limits*

May offer more investment choices

Qualified withdrawals are tax free

May offer more investment choices

No RMDs

Cons Participants have no control over plan options or fees

Withdrawals are taxed; may incur a penalty for early withdrawals

RMDs starting at 72

Lower contribution limits, no employer match

Withdrawals are taxed; may incur a penalty for early withdrawals

RMDs starting at 72

Lower contribution limits, no employer match

Contributions are not tax deductible

Cannot contribute if income is too high

Employer sponsor distinctions Typically offered to full-time employees; solo 401(k)s available to independent workers Not offered by an employer, but anyone with earned income can open an IRA.

*Income limits may apply if you contribute to a 401(k) and a traditional IRA. See below.

Other Key Differences Between IRAs and 401(k)s

As with anything that involves finance and the tax code, these accounts can be complicated. Because there can be stiff penalties when you don’t follow the rules, it’s wise to know what you’re doing.

Who Can Set Up a 401(k)?

As noted above, a key difference between an IRA and a 401(k) is that 401(k)s are qualified employer-sponsored retirement plans. You typically only have access to these plans through an employer who offers them as part of a full-time compensation package.

In addition, your employer may choose to provide matching 401(k) funds as part of your compensation, which is typically a percentage of the amount you contribute (e.g. an employer might match 3%, dollar for dollar).

Not everyone is a full-time employee. You may be self-employed or work part-time, leaving you without access to a traditional 401(k). Fortunately, there are other options available to you, including solo 401(k) plans and opening an IRA online (individual retirement accounts).

Who Can Set Up an IRA?

Anyone can set up an individual retirement account (IRA) as long as they’re earning income. (And if you’re a non-working spouse of someone with earned income, they can set up a spousal IRA on your behalf.)

If you already have a 401(k), you can still open an IRA and contribute to both accounts. But if you or your spouse (if you’re married) are covered by a retirement plan at work, you may not be able to deduct the full amount of your IRA contributions.

Understanding RMDs

Starting at age 72, you must take required minimum distributions (RMDs) from your tax-deferred accounts, including: traditional IRAs, SEP and SIMPLE IRAs, and 401(k)s. Be sure to determine your minimum distribution amount, and the proper timing, so that you’re not hit with a penalty for skipping it.

It’s worth noting, though, that RMD rules don’t apply to Roth IRAs. If you have a Roth IRA, or inherit one from your spouse, the money is yours to withdraw whenever you choose. The rules change if you inherit a Roth from someone who isn’t your spouse, so consult with a professional as needed.

However, RMD rules do apply when it comes to a Roth 401(k), similar to a traditional 401(k). The main difference here, of course, is that the Roth structure still applies and withdrawals are tax free.

A Closer Look at IRAs

An IRA is an individual retirement account that has a much lower contribution limit than a 401(k) (see chart below). Anyone with earned income can open an IRA, and there are two main types of IRAs to choose from: traditional and Roth accounts.

Self-employed people can also consider opening a SEP-IRA or a SIMPLE IRA, which are tax-deferred accounts that have higher contribution limits.

Traditional IRA

Like a 401(k), contributions to a traditional IRA are tax deductible and may help lower your tax bill. In 2022, IRA contribution limits are $6,000, or $7,000 for those aged 50 or older.

With a traditional IRA, investments inside the account grow tax-deferred. And unlike 401(k)s where an employer might offer limited options, IRAs are more flexible because they are classified as self-directed and you typically set up an IRA through a brokerage firm of your choice.

Thus it’s possible to invest in a wider range of investments in your IRA, including stocks, bonds, mutual funds, exchange-traded funds, and even real estate.

When making withdrawals at age 59 ½, you will owe income tax. As with 401(k)s, any withdrawals before then may be subject to both income tax and the 10% early withdrawal penalty.

What Are Roth Accounts?

So far, we’ve discussed traditional 401(k) and IRA accounts. But each type of retirement account also comes in a different flavor — known as a Roth.

The main difference between traditional and Roth IRAs lies in when your contributions are taxed.

•   Traditional accounts are funded with pre-tax dollars. The contributions are tax deductible and may provide an immediate tax benefit by lowering your taxable income and, as a result, your tax bill.

•   Money inside these accounts grows tax-deferred, and you owe income tax when you make withdrawals, typically when you’ve reached the age of 59 ½.

Roth accounts, on the other hand, are funded with after-tax dollars, so your deposits aren’t tax deductible. However, investments inside Roth accounts also grow tax-free, and they are not subject to income tax when withdrawals are made at or after age 59 ½.

As noted above, Roths have an additional advantage in that you can withdraw your principal at any time (but you cannot withdraw principal + earnings until you’ve had the account for at least five years, and/or you’re 59 ½ or older — often called the five-year rule).

Roth accounts may be beneficial if you anticipate being in a higher tax bracket when you retire versus the one you’re in currently. Then tax-free withdrawals may be even more valuable.

It’s possible to hold both traditional and Roth IRAs at the same time, though combined contribution limits are the same as those for traditional accounts. And those limits can’t be exceeded.

Additionally, the ability to fund a Roth IRA is subject to certain income limits: above a certain limit you can’t contribute to a Roth. There are no income limits for a designated Roth 401(k), however.

Is your retirement piggy bank feeling light?

Start saving today with a Roth or Traditional IRA.


A Closer Look at a 401(k)

Contributions to your 401(k) are made with pre-tax dollars. This makes them tax-deductible, meaning the amount you save each year can lower your taxable income in the year you contribute, possibly resulting in a smaller tax bill.

In 2022, you can contribute up to $20,500 each year to your 401(k). If you’re 50 or older, you can also make catch-up contributions of an extra $6,500, for a total of $27,000.

401(k) catch-up contributions allow people nearing retirement to boost their savings. In addition to the contributions made, an employer can also match their employee’s contribution, up to a combined employer and employee limit of $61,000 in 2022.

An employer may offer a handful of investment options to choose from, such as exchange-traded funds (ETFs), mutual funds, and target date mutual funds. Money invested in these options grows tax-deferred, which can help retirement investments grow faster.

When someone begins taking withdrawals from their 401(k) account at age 59 ½ (the earliest age at which you can start taking penalty-free withdrawals), those funds are subject to income tax. Any withdrawals made before 59 ½ may be subject to a 10% early withdrawal penalty, on top of the tax you owe.

When Should You Use a 401(k)?

If your employer offers a 401(k), it may be worth taking advantage of the opportunity to start contributing to your retirement savings. After all, 401(k)s have some of the highest contribution limits of any retirement plans, which means you might end up saving a lot. Here are some other instances when it may be a good idea:

1. If your employer matches your contributions

If your company matches any part of your contribution, you may want to consider at least contributing enough to get the maximum employer match. After all, this match is tantamount to free money, and it can add up over time.

2. You can afford to contribute more than you can to an IRA

You can only put $6,000 in an IRA, but up to $20,500 in a 401(k) — if you’re over 50, those amounts increase to $7,000 for an IRA and $27,000 for a 401(k). If you’re in a position to save more than the IRA limit, that’s a good reason to take advantage of the higher limits offered by a 401(k).

3. When your income is too high

Above certain income levels, you can’t contribute to a Roth IRA. How much income is that? That’s a complicated question that is best answered by our Roth IRA calculator.

And if you or your spouse are covered by a workplace retirement plan, you may not be able to deduct IRA contributions.

If you can no longer fund a Roth, and can’t get tax deductions from a traditional IRA, it might be worth throwing your full savings power behind your 401(k).

When Should You Use an IRA?

If you can swing it, it may not hurt to fund an IRA. This is especially true if you don’t have access to a 401(k). But even if you do, IRAs can be important tools. For example:

1. When you leave your company

When you leave a job, you can rollover an old 401(k) into an IRA — and it’s generally wise to do so. It’s easy to lose track of old plans, and companies can merge or even go out of business. Then it can become a real hassle to find your money and get it out.

You can also roll the funds into your new company’s retirement plan (or stick with an IRA rollover, which may give you more control over your investment choices).

2. If your 401(k) investment choices are limited

If you have a good mix of mutual funds in your 401(k), or even some target date funds and low-fee index funds, your plan is probably fine. But, some plans have very limited investment options, or are so confusing that people can’t make a decision and end up in the default investment — a low interest money market fund.

If this is the case, you might want to limit your contributions to the amount needed to get your full employer match and put the rest in an IRA.

3. When you’re between jobs

Not every company has a 401(k), and people are not always employed. There may be times in your life when your IRA is the only option. If you have self-employment income, you can make higher contributions to a SEP IRA or a Solo 401(k) you set up for yourself.

4. If you can “double dip.”

If you have a 401(k), are eligible for a Roth IRA, or can deduct contributions to a traditional IRA, and you can afford it — it may be worth investing in both. After all, saving more now means more money — and financial security — down the line. Once again, you can check our IRA calculator to see if you can double dip. Just remember that the IRA contribution limit is for the total contributed to both a Roth and traditional IRA.

The real question is not: IRA vs. 401(k), but rather — which of these is the best place to put each year’s contributions? Both are powerful tools to help you save, and many people will use different types of accounts over their working lives.

When Should You Use Both an IRA and 401(k)?

Using an IRA and a 401(k) at the same time may be a good way to save for your retirement goals. Funding a traditional or Roth IRA and 401(k) at once can allow you to save more than you would otherwise be able to in just one account.

Bear in mind that if you or your spouse participate in a workplace retirement plan, you may not be able to deduct all of your traditional IRA contributions, depending on how high your income is.

Having both types of accounts can also provide you some flexibility in terms of drawing income when you retire. For example, you might find a 401(k) as a source of pre-tax retirement income. At the same time you might fund a Roth IRA to provide a source of after-tax income when you retire.

That way, depending on your financial and tax situation each year, you may be able to strategically make withdrawals from each account to help minimize your tax liability.

The Takeaway

What is the difference between an IRA and a 401(k)? As you can see now, the answer is pretty complicated, depending on which type of IRA you’re talking about. Traditional IRAs are tax deferred, just like traditional 401(k)s — which means your contributions are tax deductible in the year you make them, but taxes are owed when you take money out.

Roth accounts — whether a Roth IRA or a Roth 401(k) — have a different tax treatment. You deposit after-tax funds in these types of accounts. And then you don’t pay any tax on your withdrawals in retirement.

The biggest difference is the amount you can save in each. It’s $20,500 in a 401(k) ($27,000 if you’re 50 and over) versus only $6,000 in an IRA ($7,000 if you’re 50+).

Another difference is that a 401(k) is generally sponsored by your employer, so you’re beholden to the investment choices of the firm managing the company’s plan, and the fees they charge. By contrast, you set up an IRA yourself, so the investment options are greater — and the fees can be lower.

Generally, you can have an IRA as well as a 401(k). The rules around contribution limits, and how much you can deduct may come into play, however.

If you’re ready to open an IRA, it’s easy when you set up an Active Invest account with SoFi Invest.

Not sure what the right strategy is for you? SoFi Invest® offers educational content as well as access to financial planners. The Active Investing platform lets investors choose from an array of stocks, ETFs or fractional shares. For a limited time, funding an account gives you the opportunity to win up to $1,000 in the stock of your choice. All you have to do is open and fund a SoFi Invest account.

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

FAQ

Is a 401(k) considered an IRA for tax purposes?

No. A 401(k) is a completely separate account than an IRA because it’s sponsored by your employer.

Is it better to have a 401(k) or an IRA?

You can save more in a 401(k), and your employer may also offer matching contributions. But an IRA often has a much wider range of investment options. It’s wise to weigh the differences, and decide which suits your situation best.

Can you roll a 401(k) Into an IRA penalty-free?

Yes. If you leave your job and want to roll over your 401(k) account into an IRA, you can do so penalty free within 60 days. If you transfer the funds and hold onto them for longer than 60 days, you will owe taxes and a penalty if you’re under 59 ½.

Can you lose money in an IRA?

Yes. You invest all the money you deposit in an IRA in different securities (i.e. stocks, bonds, mutual funds, ETFs). Ideally you’ll see some growth, but you could also see losses. There are no guarantees.


External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A., or SoFi Lending Corp.
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 [email protected] 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.
Claw Promotion: Customer must fund their Active Invest account with at least $10 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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Correspondent Bank: What They Are & How They Work

A correspondent bank helps to connect domestic and foreign banks that need to do business together. Correspondent banks can facilitate different types of transactions, including wire transfers, cash and treasury management, and foreign exchange settlement.

Correspondent banking plays an important part in the international financial system and the flow of cross-border payments. Correspondent banks are often a subject of scrutiny as they can also be used to perform illegal operations, such as money laundering.

If you’re wondering how they work and if you need to use one, read on to learn:

•   What is a correspondent bank?

•   How does correspondent banking work?

•   How much does it cost to use a correspondent bank?

•   What are nostro vs. vostro accounts?

•   What is the difference between correspondent and intermediary banking?

What Is Correspondent Banking?

Correspondent banking is a formal system through which banks in different countries are able to provide payment services to one another. Correspondent banking makes it easier for funds to move between domestic and foreign banks, regardless of whether they have an established relationship. This plays an important role in smoothing international transactions.

What is a correspondent bank? Simply, it’s the financial institution or bank that connects other banks within a correspondent banking system. Foreign banks may rely on correspondent banking if establishing one or more branches in another country isn’t feasible. While correspondent banking is often used to facilitate business transactions on a larger scale, individual consumers may also use correspondent banking to complete a money transfer from one bank to another.

For example, if you’re Canadian but living in the U.S. temporarily for work, you may use cross-border banking services to transfer funds between your U.S. and Canadian bank accounts. A correspondent bank would handle those transactions for you so that you never lose access to your money. (You’ll learn more details about how correspondent banking works below.)

Recommended: Separate vs. Joint Bank Account in Marriage

How Correspondent Banking Works

Correspondent banking works by allowing payments to move between banks located in different countries that may not have a formal relationship with one another. In a typical correspondent arrangement, you have two respondent banks and one correspondent bank.

The correspondent bank is effectively a liaison or halfway point between the two respondent banks. The main role of the correspondent bank is to provide necessary financial services to the two respondent banks. The types of services correspondent banks can provide include:

•   Wire transfers

•   Check clearing and payment

•   Trade finance

•   Cash and treasury management

•   Securities, derivatives or foreign exchange settlement.

In exchange for these services, correspondent banks can charge respondent banks fees.

Correspondent banks operate through the Society for Worldwide Interbank Financial Telecommunication (SWIFT network). SWIFT allows for the secure transfer of financial messages to correspondent banks and other financial institutions around the world. Millions of messages move through the SWIFT network on a daily basis, transmitting financial information.

Correspondent Banking Example

Curious about how exactly correspondent banking works? Money moves from respondent bank to respondent bank in a sequential way, with the correspondent bank in the middle. Here’s an example:

•   Say you run an auto repair business, and you need to order parts from a supplier in Canada. The supplier only accepts wire transfers as payment so you go to your local bank to schedule one.

•   Since your bank and the supplier’s Canadian bank do not have an established banking relationship, there needs to be an intermediary. In order to send the wire transfer, your bank will need to connect to a correspondent bank in the SWIFT network that has a relationship with the supplier’s bank.

•   Once your bank is connected to the correspondent bank, it can facilitate the wire transfer from your account. The money will move from your account to the correspondent bank, along with an added fee.

•   The correspondent bank will then send the money along to the supplier’s bank in Canada, less the amount of the fee.

You might also use correspondent banking if you’re working in one country and want to send part of your pay to your bank account in your home country. You could send a wire transfer through the local bank you have an account with, which would forward it to the correspondent bank. The correspondent bank would then send the money to your account at your home bank.

Recommended: Should I Open More Than One Bank Account?

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Additional Considerations

Correspondent banks may operate largely behind the scenes for most consumers, but they play an important role in international financial transactions. Without correspondent banking, it might be much more difficult to complete international wire transfers as many banks do not have formal relationships with banks in other countries.

While correspondent banking is used to facilitate legitimate financial transactions, it can also be a vehicle for criminal activity. Two of the biggest concerns center around the use of correspondent banks to launder money and fund terrorist organizations. In the U.S., regulatory requirements exist that aim to bar the use of correspondent banking for these types of transactions, though they’re not always foolproof.

Recommended: Why Your Bank Account Is Frozen

Vostro vs. Nostro Accounts: How Banks Settle Cross-Border Transactions

Correspondent banks handle large amounts of money every day, which can easily get confusing. They keep track of the movement of funds between respondent banks using nostro and vostro accounts. These accounts allow one bank to hold another bank’s money on deposit during the completion of international financial transactions. Here’s the difference:

•   Vostro means “yours” in Latin, while nostro means “ours.” Vostro and nostro can be used to describe the same account for recordkeeping purposes. The label that’s used describes which bank holds the funds.

•   For example, say a Canadian bank has an account with a U.S. bank and funds are held in U.S. currency. The Canadian bank would apply the nostro label to that account signifying that the money in it is “ours.”

•   Meanwhile, the U.S. bank would refer to it as a vostro account, acknowledging to the Canadian bank that the money is “yours”.

Correspondent banks use nostro and vostro accounts to settle transactions and identify accounts as money flows between them. For every vostro account, there’s a corresponding nostro account and vice versa.

Correspondent vs. Intermediary Banking

Intermediary banking is similar to correspondent banking in that it involves the transfer of funds between banks that do not have an established relationship with one another. Similar to a correspondent bank, an intermediary bank acts as a middleman for the other banks involved in the transaction.

But consider these distinctions:

•   Intermediary banks primarily assist in completing wire transfers between different banks, either domestically or internationally. For example, the U.S. Department of the Treasury acts as an intermediary bank in wire transfers between other banks.

•   In intermediary banking, there are three parties: the sender bank, the beneficiary bank, and the intermediary bank. It’s the intermediary bank’s role to ensure that money from the sender bank gets to the beneficiary bank.

Typical Correspondent Bank Fees

As mentioned, correspondent banks can charge fees for the services they provide. The fees charged can depend on the bank itself and the service that’s being provided. Fees are typically charged in the currency of the payment.

A general range for wire transfer fees for this kind of transaction can be anywhere from $0 to $50, depending on the bank. The easiest way to get a sense of what you might pay for correspondent banking is to check your bank’s fee schedule for wire transfers. Banks can charge fees for:

•   Incoming domestic wire transfers

•   Outgoing domestic wire transfers

•   Incoming international wire transfers

•   Outgoing international wire transfers

International wire transfers are typically more expensive than domestic transfers. Some banks may charge no fee at all to receive incoming domestic or international wire transfers. But you may still be charged a fee by the correspondent or intermediary bank. It can be wise to investigate before you conduct the transaction so you can be prepared.

Recommended: How to Set Up Direct Deposit

Difference Between Correspondent and Intermediary Banks

Correspondent and intermediary banking share some similarities, but it’s important to understand what sets them apart. Here are some of the key differences between correspondent and intermediary banks:

•   Correspondent banks can handle transactions in multiple currencies.

•   Intermediary bank transactions typically involve a single currency.

•   Correspondent banks can be used to facilitate a number of different transaction types.

•   Intermediary banks are most often used in situations involving wire transfers between two unconnected banks.

•   Correspondent banks are the middle ground between two respondent banks, which may or may not be located in the same country.

•   Intermediary banks act on behalf of sender and beneficiary banks.

The Takeaway

Correspondent banks make it easier for money to move across borders and around the world. If you simply need to move money between banks in the same country, there are alternative banking options you can turn to.

For example, you can open a checking and savings account with SoFi and connect them to accounts at traditional banks. SoFi’s high yield bank accounts may help you grow your money faster, too, thanks to our hyper competitive 2.00% APY when you sign up with direct deposit and our no-fee policy. What’s more, eligible accounts can access their paychecks up to two days early.

Bank smarter with SoFi.

FAQ

Why is a correspondent bank needed?

Correspondent banks are necessary because they help to facilitate cross-border payments between banks that have no formal banking relationship. Without correspondent banking, it would be more difficult to complete international financial transactions.

What is the difference between correspondent bank and beneficiary bank?

A correspondent bank is a go-between for two different respondent banks in an international financial transaction. A beneficiary bank is the bank that receives money from a sender bank through a third-party intermediary bank.

What is correspondent and respondent bank?

A correspondent bank is a financial institution that helps respondent banks to complete financial transactions. A respondent bank is a bank that needs help connecting to another respondent bank through a third-party, i.e., the correspondent bank.

Photo credit: iStock/Auris

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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