Growing Wealth Archives

Dec

2024

Benefits of ETFs — Pros & Cons in Investment Portfolio

By Inyoung Hwang | Growing Wealth, Investing | Comments Off

Exchange-traded funds (ETFs) are funds that can be used to build a relatively simple and low-cost diverse portfolio. There are many investing benefits to ETFs, which is why they’ve grown in popularity both for DIY investors and for more traditional money managers. However, there are cons investors should be aware of, too.

Key Points

• ETFs offer diversified exposure across various assets, potentially reducing large swings in overall portfolio value.

• They tend to be cost-effective due to lower management fees compared to mutual funds.

• ETFs provide flexibility with real-time trading, similar to stocks.

• Tax efficiency is enhanced in ETFs because of fewer capital gains distributions.

• However, ETFs can have hidden costs like bid-ask spreads and brokerage fees.

What Are the Benefits of ETFs?

Exchange-traded funds (ETFs) have become increasingly popular in recent years, especially with the rise of online investing allowing people to buy and sell them quickly.

As an investment tool, ETFs have become popular: there were almost 10,000 ETFs in the world with trillions of dollars in assets under management (AUM) at the end of 2023. In the U.S., there was more than $7 trillion in AUM in ETFs.

Here are some of the benefits of ETFs, which has helped spur their popularity.

ETFs Trade Similar to Stocks

ETFs are traded on stock exchanges and can be bought and sold throughout the day, like individual stocks. The market determines the price for a share of an ETF and changes throughout the day. This means investors can buy and sell ETFs efficiently, making them a convenient investment option.

Portfolio Diversification

An additional benefit of an ETF is that you don’t need a lot of money to invest in many different things. One share of an ETF offers investors a way to diversify their portfolio by investing in a basket of assets, such as stocks, bonds, or commodities, rather than just a single asset. This can help to reduce the overall risk of an investment portfolio.

Accessible Across Markets

There is also a range of ETFs on the market now: stocks, bonds, commodities, real estate, and hybrids that offer a mix. ETFs also vary in how they target certain assets — aggressively or defensively, specific to one asset class or broad. So investors should be able to find what they want and build a diverse portfolio.

Lower Costs

Most ETFs are passively managed and track a benchmark index, meaning portfolio managers don’t actively manage the fund to try to beat the market or an index. Passive investing, as opposed to active investing, may be more cost-effective because there tends to be less overhead and fewer investment fees.

Because there is often less overhead, ETFs generally charge investors a lower operating expense ratio than actively managed mutual funds. The operating expense ratio is the annual rate the fund charges to pay for portfolio management, administration, and other costs.

There are other costs investors need to consider, like commissions for trades and a bid/ask spread.

Tax Efficiency

ETFs tend to be more tax efficient than mutual funds because they typically generate fewer capital gains and capital gains taxes. This is because passively managed ETFs tend to have lower turnover than actively managed mutual funds, which means they sell fewer assets and, thus, result in fewer capital gains.

Transparency

ETFs generally disclose their holdings daily, so investors can see exactly what assets the ETF holds. This can be helpful for investors who want to know what they are investing in.

Flexibility

ETFs can be used as a part of various investment strategies, including as part of a long-term buy-and-hold strategy or as a short-term trading tool. This makes them a flexible investment option for a wide range of investors.

Moreover, investors can trade thematic ETFs — funds focusing on a specific trend or niche industry, like robotics, artificial intelligence, or gender equality. However, there are pros and cons to thematic ETFs. While they allow investors to make more targeted investments, the shares of these funds can be volatile. Because they’re so focused, these ETFs may also diminish the most important benefit of ETFs: broad, diverse exposure.

Disadvantages of ETFs

While ETFs offer many benefits to investors, there are also some potential disadvantages to consider. These disadvantages include the following:

Lack of Personalization

Because ETFs are not actively managed, they do not consider an investor’s specific financial goals or risk tolerance. A lack of personalization means that ETF investors may be unable to tailor their investment portfolio to their particular financial needs.

Tracking Error

ETFs are usually designed to track the performance of a particular index or basket of assets. However, the performance of the ETF may not precisely match the performance of the underlying index due to various factors, such as the fund’s expenses or the timing of when it buys and sells assets. This is known as a tracking error.

Short-Term Trading Costs

ETFs can be traded on the market throughout the day, making them attractive to short-term traders. However, the commission costs of trading ETFs can add up over time, which can eat into investment returns.

Limited Choices

While many ETFs are available, the range of options may be limited compared to other investment vehicles, such as mutual funds. Thus, investors may be unable to find an ETF that perfectly matches their investment needs.

Counterparty Risk

Certain ETFs may use financial instruments, such as futures contracts or swaps, to gain exposure to specific assets. These instruments carry counterparty risk, which means that there is a risk that the counterparty will not fulfill its obligations under the contract. This can expose ETF investors to additional risks.

Complexity

Some ETFs use complex investment strategies, such as leveraged or inverse ETFs, which can be difficult for some investors to understand. Complex investing strategies can make it challenging for investors to fully understand the risks and potential returns of these types of ETFs.

Market Risk

ETFs, like all investments, are subject to market risk, meaning the value of an ETF can go up or down depending on the performance of the underlying assets.

What to Consider When Investing in ETFs

When investing in ETFs, it is essential to consider the following factors:

• Investment objective: Determine your investment goals and how ETFs fit into your overall investment strategy. This can help you choose an ETF that aligns with your financial goals and risk tolerance.

• Asset class: Consider which asset classes you want to invest in and whether an ETF that tracks those assets is available. For example, if you want to invest in large-cap domestic stocks, look for an ETF that tracks a particular large-cap domestic stock index.

• Diversification: ETFs offer a way to diversify your investment portfolio by investing in a basket of assets rather than just a single asset. Consider the level of diversification an ETF offers and whether it aligns with your investment goals.

• Expenses: ETFs typically have lower fees than mutual funds because they are not actively managed. However, it is still important to compare the expenses of different ETFs to ensure you are getting the best value for your money.

• Tax considerations: ETFs tend to be more tax efficient than mutual funds because they generate fewer capital gains. However, it is still important to consider the tax implications of investing in an ETF and whether it aligns with your overall financial plan.

Investing With SoFi

ETFs are becoming increasingly more popular and ubiquitous in the financial markets, with some being more targeted in focus than others. So, being aware of an ETF’s investments can be important for an investor who chooses to put dollars into this financial vehicle. But, as with any investment, they have their pros and cons, which investors should familiarize themselves with before investing.

Invest in what matters most to you with SoFi Active Invest. In a self-directed account provided by SoFi Securities, you can trade stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, options, and more — all while paying $0 commission on every trade. Other fees may apply. Whether you want to trade after-hours or manage your portfolio using real-time stock insights and analyst ratings, you can invest your way in SoFi's easy-to-use mobile app.

Opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.¹

FAQ

What is the benefit of investing in an exchange-traded fund?

Exchange-traded funds (ETFs) offer investors a convenient and cost-effective way to diversify their portfolios by investing in a basket of assets. ETFs are also typically more tax efficient than mutual funds and offer investors the ability to buy and sell their shares on a stock exchange.

Are ETFs a good investment?

Depending on their investment goals and risk tolerance, ETFs may be a good investment for some investors. ETFs offer a convenient and cost-effective way to diversify a portfolio and provide access to a wide range of asset classes. However, it is important for investors to consider the specific ETF they are considering and how it fits into their overall investment plan.

Why are ETFs better than stocks?

For some investors, ETFs may be a better investment option than individual stocks because they offer diversification by investing in a basket of assets rather than just a single stock.

Is an ETF better than a mutual fund?

Whether an ETF is better than a mutual fund depends on the specific circumstances of the investor and their investment goals. ETFs tend to have lower fees than mutual funds because they are not actively managed and may also be more tax efficient due to their lower turnover. However, mutual funds offer a more comprehensive range of investment options and may be more suitable for some investors.

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.

For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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 emailing customer service at [email protected]. Please read the prospectus carefully prior to investing.

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

¹Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.

SOIN-Q424-028

Dec

2024

What Is a Shareholder Activist?

By Michael Flannelly | Growing Wealth, invest, Investing | Comments Off

A shareholder activist may be a hedge fund, institutional investor, or wealthy individual who uses an ownership stake in a company to influence corporate decision-making. Shareholder activists, sometimes called activist investors, typically seek to change how a company is run to improve its financial performance. However, they may also have other objectives, such as increasing transparency or promoting social responsibility.

Activist shareholders can impact the way a company is managed, thus affecting its stock price. As such, you may benefit from understanding shareholder activism and how these investors may impact the stocks in your portfolio.

Key Points

• Shareholder activists use ownership stakes to influence corporate decisions, aiming to improve financial performance or promote transparency and social responsibility.

• Activists can be hedge funds, institutional investors, or wealthy individuals seeking changes in company management.

• Activist investors may use media and shareholder voting to gain support for their proposals and influence company strategies.

• Goals of activism vary, from improving environmental impact to unlocking shareholder value through strategic changes.

• Activism can lead to stock volatility, but targeted stocks may still be valuable for diversified portfolios if proposed changes are supported.

How Shareholder Activism Works

Shareholder activism is a process in which investors purchase a significant stake in a company to influence the management of the company. When an investor builds up a large enough stake in a company, this usually opens up channels where they may discuss business proposals directly with management.

Activist investors may also use the shareholder voting process to wield influence over a company if they believe it is mismanaged. This more aggressive tactic may allow activist shareholders to nominate their preferred candidates for the board of directors or have a say on a company’s management decisions.

Activist investors typically own a relatively small percentage of shares in a company, perhaps less than 10% of a firm’s outstanding stock, so they may need to convince other shareholders to support their proposals. They often use the media to generate support for their campaigns.

Shareholder activists may also threaten lawsuits if they do not get their way, claiming that the company and its board of directors are not fulfilling their fiduciary duties to shareholders.

Activist investors’ goals can vary. Some investors may want to see companies improve their environmental and social impact, so they will suggest that the company adopt a Corporate Social Responsibility framework. Other investors try to get the company to adopt changes to unlock shareholder value, like selling a part of the company or increasing dividend payouts.

However, shareholder activism can also be a source of conflict between shareholders and management. Some activist investors may prefer the company unlock short-term gains that benefit shareholders, perhaps at the expense of long-term business operations. These investors may exit a position in a company once they unlock the short-term gains with little concern for the company’s future prospects.

Types of Shareholder Activists

There are three primary types of shareholder activists: hedge funds, institutional investors, and individual investors. So, your average investor who may be doing a bit of online investing or building a retirement portfolio likely wouldn’t qualify as a shareholder activist. Each type of shareholder activist has its distinct objectives and strategies.

Hedge Funds

Hedge funds are private investment vehicles usually only available to wealthy individuals who make more than $200,000 annually or have a net worth over $1 million. These funds often take a more aggressive approach to shareholder activism, like public campaigns and proxy battles, to force a company to take specific actions to generate a short-term return on its investment.

Institutional Investors

Institutional investors are typically large pension funds, endowments, and mutual funds that invest in publicly-traded companies for the long term. These investors often use their voting power to influence a company’s strategy or management to improve their investment’s financial performance.

Individual Investors

Though less common than hedge funds and institutional investors, very wealthy individual investors sometimes use their own money to buy shares in a company and then push for change.

Examples of Shareholder Activists

Shareholder activism became a popular strategy in the 1970s and 1980s, when many investors – called “corporate raiders” – used their power to push for changes in a company’s management. Shareholder activism has evolved since this period, but there are still several examples of activist investors

For example, Carl Icahn is one of the most well-known shareholder activists who made a name for himself as a corporate raider in the 1980s. He was involved in hostile takeover bids for companies such as TWA and Texaco during the decade.

Since then, Icahn has been known for taking large stakes in companies and pushing for changes, such as spin-offs, stock buybacks, and management changes. More recently, Icahn spearheaded a push in early 2022 to nominate two new directors to the board of McDonald’s. His goal was to get McDonald’s to change its treatment of pigs. However, his preferred nominees failed to get elected to the board.

Another well known activist investor is Bill Ackman, the founder and CEO of Pershing Square Capital Management, a hedge fund specializing in activist investing. Ackman is known for his high-profile campaigns, including his battle with Herbalife.

In 2012, Ackman shorted the stock of Herbalife, betting the company would collapse. He accused Herbalife of being a pyramid scheme and called for a government investigation. Herbalife denied the allegations, and the stock continued to rise. Ackman eventually closed out his position at a loss.

Other examples of shareholder activists include Greenlight Capital, led by David Einhorn, and Third Point, a hedge fund founded by Dan Loeb.

In 2013, Einhorn took a stake in Apple and pushed for the company to return more cash to shareholders through share repurchases and dividends. Apple eventually heeded his advice and initiated a plan to return $100 billion to shareholders through dividends and buybacks.

In 2011, Loeb’s hedge fund took a stake in Yahoo and pushed for the company to fire its CEO, Scott Thompson. Thompson eventually resigned, and Yahoo appointed Loeb to its board of directors. More recently, in 2022, Loeb took a significant stake in Disney and started a pressure campaign calling on the company to spin-off or sell ESPN. However, he eventually backed off that suggestion.

Is Shareholder Activism Good for Individual Investors?

Depending on the circumstances, a shareholder activist campaign may be good for investors. Some proponents argue that shareholder activism can improve corporate governance, promote ESG investing, and lead to better long-term returns for investors.

Others contend that activist investors are primarily interested in short-term gains and may not always have the best interests of all shareholders in mind. While individual investors may benefit from a stock’s short-term spike after an activist shareholder’s campaign, this rally may not last for investors interested in long-term gains.

The Takeaway

Shareholder activists use their financial power to try to influence the management of publicly traded companies. Because activist investors often leverage the media to promote their goals, individual investors may read about these campaigns and worry about how they could affect their holdings.

Generally, the impact of shareholder activism on investors depends on the specific goals of the activist and the response of the company’s management. If an activist successfully pressures management to make changes that improve the company’s performance, this can increase shareholder value. However, if an activist’s campaign is unsuccessful or the company’s management resists the activist’s demands, this can lead to a decline in the stock price.

Opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.¹

Photo credit: iStock/xavierarnau

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SOIN-Q424-015

Dec

2024

What Is a Carbon Tax?

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

In countries where there is a carbon tax, businesses must pay a levy based on the amount of carbon emissions produced by their business operations. A carbon tax is designed to reduce the amount of carbon in the atmosphere — also known as CO2 emissions.

There are generally two types of carbon taxes: a tax on quantities of greenhouse gases emitted, and a tax on carbon-intensive goods and services such as gasoline production. In the United States, several carbon tax proposals have been introduced in Congress, but none have yet been implemented.

Key Points

• A carbon tax is a levy on businesses for their carbon emissions, aimed at reducing CO2 emissions and promoting low-emission energy sources.

• Two main types of carbon taxes exist: one on greenhouse gas emissions and another on carbon-intensive goods and services.

• The U.S. does not have a federal carbon tax, but several states and localities have implemented regional versions, with ongoing discussions about a national approach.

• Revenue from carbon taxes can fund environmental restoration and decarbonization, though deciding the best use of these funds is challenging.

• Countries like Finland, Norway, and Sweden have high carbon tax rates, and the concept is becoming increasingly popular as a climate change tool globally.

How Does a Carbon Tax Work?

When a government implements a carbon tax, a price per ton of greenhouse gas emissions is chosen, and a company is taxed the applicable amount for every ton of carbon it emits or is responsible for. In some cases, the price per ton increases the more an entity emits, thereby incentivizing companies to reduce and prevent emissions.

What Type of Carbon Is Taxed?

Although it is called a carbon tax, usually the price is actually per ton of CO₂ gas emitted. That’s because every fossil fuel has a particular amount of carbon content in it, and when burned each carbon molecule combines with two oxygen molecules and becomes CO₂ gas which goes into the atmosphere.

So the amount of emissions associated with the fuel can be taxed at the point of extraction, refinement, import, or use.

As many ESG investors likely know, burning coal emits the highest amount of CO₂, followed by diesel, gasoline, propane, and natural gas. Therefore, coal gets taxed higher than other fossil fuels. Once CO₂ is emitted into the atmosphere, it remains there for a hundred years or more, creating a greenhouse effect which heats up the planet and leads to climate change (hence the name “greenhouse gases”).

Only products associated with the burning of fossil fuels get taxed. So products such as plastic that contain petroleum but don’t directly result in CO₂ emissions don’t get taxed.

What Is the Economic Impact of Carbon Taxation?

Since a carbon tax increases costs across the entire supply chain, everyone from extractors to consumers are theoretically incentivized to reduce fossil fuel consumption. Those being taxed can raise the prices of their goods and services, but only as much as the market is willing to pay while allowing them to remain competitive.

What Is the Social Impact of Carbon Emissions?

The theory around carbon pricing is that each ton of CO₂ should have a price equal to the social cost of carbon. The social cost of carbon is the current amount of estimated damages over time that each ton of CO₂ emitted causes today.

In addition to causing climate change, emissions and pollution typically lead to negative effects on human health and natural ecosystems. Thus investing in companies with lower carbon emissions can be considered a type of socially responsible investing.

Over time, the social cost of carbon increases, because each ton of emissions is more damaging as climate change worsens. Therefore, the price of carbon and the tax would increase over time.

Those producing emissions know that the tax will increase over time, and so investments into decarbonization are worth it to them today. For instance, a company can invest in solar energy and wind power, and while that might have a high upfront cost for them, over time it could be worth it could help them avoid a rising carbon tax.

Examples of Carbon Taxes

Understanding carbon taxes is an important facet of sustainable investing. Carbon taxes have been put into place in many countries around the world so far, and their popularity is rising. As of 2024, 75 countries had a form of carbon tax or energy tax.

• Finland was the first country to implement a carbon tax in 1990, soon followed by Norway and Sweden in 1991. In 2024, Finland’s price per ton was more than $100. Norway is known to have one of the strictest carbon taxes.

• The Canadian province of British Columbia implemented a carbon tax in 2008. In 2019, South Africa became the first African country to install a carbon tax.

• Although there is not yet a federal carbon tax in the U.S., there are more than 50 regional ones. For instance, the city of Boulder, CO, implemented a carbon tax in 2006 after it passed a local vote.

Support for a U.S. federal carbon tax has generally increased over time, but one of the things holding it back is debate about how the revenue from the tax would be used. A few ideas include: paying back consumers through a carbon dividend; using the money to fund infrastructure upgrades or low-emissions technologies, or reducing other taxes.

The Importance of Carbon Tax

Scientists believe that reducing global emissions is essential to stop the buildup of CO2 in the Earth’s atmosphere. The more CO₂ gets emitted, the more the planet warms and the worse climate change becomes — including the frequency of climate-related disasters.

Global temperatures have already increased 1°C over pre-industrial levels, and if emissions are not reduced temperatures are projected to rise 4°C by the end of this century.

A carbon tax is a powerful tool to discourage the use of fossil fuels and incentivize a shift to low- and zero-emission energy sources. This is why many people invest in green stocks.

Pros and Cons of Carbon Tax

There are several pros and cons to a carbon tax.

Some of the pros of a carbon tax include:

• The carbon tax is a way to regulate emissions without having to actually mandate production and consumption limits directly.

• Carbon taxes incentivize companies and individuals to reduce and avoid emissions.

• Carbon taxes are easy to administer.

• A carbon tax may help reduce the buildup of greenhouse gasses, which in turn may help reduce pollution, improve air and water quality, and more.

• The revenue raised through a tax can be used to fund decarbonization efforts, environmental restoration, and other projects.

• Other programs, such as an incentive using renewable energy, haven’t been as successful in reducing fossil-fuel use.

A few cons of a carbon tax include:

• It can be challenging to figure out how the revenues should be spent.

• A carbon tax can be put on any point of a supply chain and it’s hard to decide which is best.

• It’s hard to predict how much emissions will be reduced as a result of the carbon tax.

• If a carbon tax increases energy costs, this can have a big impact on lower-income households which tend to spend a higher percentage of their income on energy than higher-income households.

• If one country implements a carbon tax and others don’t, then that puts local industries at a competitive disadvantage. If they have to raise prices, customers may start buying from the countries that don’t have the tax, resulting in the same or more emissions. For this reason carbon tax plans build in ways to prevent emissions leakage and issues with competition. Some of these include rebates, exemptions for particular industries, and taxation based on past emissions.

• Companies can purchase carbon offsets or carbon credits to lower the amount they pay in taxes. They can also use those offsets to claim that they are carbon neutral or carbon negative. This isn’t exactly true, since they are still emitting carbon. The ability to purchase offsets reduces their incentive to decarbonize.

Who Regulates Carbon Taxes?

Carbon tax programs are regulated by federal, state, or local governments. Regulation involves setting the price per ton of carbon, deciding which entities get taxed, collecting the tax, and deciding how the revenues are spent.

There is an ongoing discussion about the international coordination of carbon pricing. If a minimum price per ton is set, this would eliminate issues around competition and guarantee a certain amount of effort towards emission reduction. Canada has already implemented national price coordination. The minimum price per ton in Canadian provinces and territories is CAD $50.

Which Countries Have the Highest Carbon Tax?

Below are a few of the countries that have the highest carbon tax rates. The rates are in USD price per ton:

• Uruguay: $155.87

• Switzerland: $130.81

• Sweden: $125.56

• Liechtenstein: $96.30

• Norway: $90.86

The Takeaway

A carbon tax can be a powerful tool for reining in carbon emissions, and potentially helping reduce the amount of greenhouse gasses in the atmosphere. Essentially, these taxes penalize companies by making them pay a fee for CO2 emissions relating to their products or operations.

While the U.S. doesn’t have a federally mandated carbon tax, there are state and local levies. Given concerns about climate change, it’s likely that more countries will continue to adopt and adjust carbon taxes.

Ready to start investing toward your future, but want some help? You might consider opening an automated investing account with SoFi. Whether you're interested in investments for your traditional brokerage or IRA account, you can access personalized, expert-curated recommendations and automatic monitoring, trading, and rebalancing. With a robo advisor from SoFi Wealth, you'll get a professionally managed portfolio aligned with your goals.

See why SoFi is this year’s top-ranked robo advisor.

Photo credit: iStock/Delmaine Donson

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SOIN-Q424-014

Dec

2024

Guide to Investment Risk Pyramids

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

An investment risk pyramid is an illustration used to help investors understand the risk/reward profile of various assets. The investment risk pyramid uses a base, middle, and top to rank investments by the likelihood of losing money or seeing big returns. The tool is useful when getting started with investing.

Building a portfolio is no easy task. It requires due diligence and an assessment of your risk tolerance and return goals. The investment risk pyramid may help you determine what approaches work best for you.

What Are Investment Pyramids?

Investment pyramids are practical tools for gauging how risky certain asset types are. The pyramid model has been used in many areas for a long time, and it’s useful when learning what your risk tolerance is.

An investment risk pyramid has three levels grouped by risk/return profile. The least-risky securities are found in the large base; growth and moderately risky assets are in the middle; then the most speculative strategies are at the top.

Again, this can be helpful to investors who are looking to buy and sell stocks or other securities, and also get a sense of how much associated risk they’re introducing or jettisoning from their portfolio.

How Investing Pyramids Work

There are many investing risk need-to-knows, and the pyramid of investment risk works by helping investors understand the connection between their asset allocation and their risk tolerance.

The visual should ultimately lead individuals to better grasp what percentage of their investable assets should go to which types of investments based on risk level and return potential.

Using a risk pyramid investment strategy provides a basic framework for analyzing portfolio construction. The investment risk pyramid is structured so that it suggests people hold a higher percentage of lower-risk assets, and relatively little in the way of ultra-high-risk, speculative assets.

Base of the Pyramid

Managing investment risk is among the most fundamental aspects of investing, and risk is controlled by ensuring an allocation to some safe securities. The base of the investment risk pyramid, which is the bulk of total assets, contains low-risk assets and accounts. Investments such as government bonds, money markets, savings and checking accounts, certificates of deposit (CDs), and cash are included in the base.

While these securities feature relatively low risk, you might lose out to inflation over time if you hold too much cash, for example.

Middle of the Pyramid

Let’s step up our risk game a bit by venturing into the middle of the investment risk pyramid. Here we will find medium-risk assets. In general, investments with some growth potential and a lower risk profile are in this tier. Growth and income stocks and capital appreciation funds are examples.

Other holdings might include real estate, dividend stock mutual funds, and even some higher-risk bond funds.

Top of the Pyramid

At the top of the investment risk pyramid is where you’ll find the most speculative asset types and even margin investing strategies. Options, futures, and collectibles are examples of high-risk investments.

You will notice that the top of the pyramid of investment risk is the smallest – which suggests only a small portion of your portfolio should go to this high-risk, high-reward niche.

Sample Investment Pyramid

Here’s what a sample investment risk pyramid might contain:

Top of the pyramid, high risk: Speculative growth stocks, put and call options, commodities, collectibles, cryptocurrency, and non-fungible tokens (NFTs). Generally, just a small percentage of an overall portfolio should be allocated to the top of the pyramid.

Middle of the pyramid, moderate risk: Dividend mutual funds, corporate bond funds, blue-chip stocks, and variable annuities. Small-cap stocks and foreign funds can be included, too. A 30-40% allocation could make sense for some investors.

Base of the pyramid, low risk: U.S. government Treasuries, checking and savings accounts, CDs, AAA-rated corporate bonds. This might comprise 40-50% of the portfolio.

Pros and Cons of Investment Pyramids

The investment risk pyramid has advantages and disadvantages. Let’s outline those to help determine the right investing strategy for you.

Pros

The investment risk pyramid is useful as a quick introduction to asset allocation and bucketing. Another upside is that it is a direct way to differentiate asset types by risk.

Cons

While the investment risk pyramid is helpful for beginners, as you build wealth, you might need more elaborate strategies beyond the pyramid’s simplicity. Moreover, in the end, you determine what securities to own – the pyramid is just a suggestion.

Examples of Low-Risk Investments

Let’s describe some low-risk investments in more detail since these are including the investment risk pyramid’s biggest tier.

Bonds

Bonds are essentially a loan you make to the government or other entity for a set amount of time. In return for lending your money, the debtor promises to pay you back at maturity along with periodic coupon payments, like interest.

Lower-risk bonds include short-term Treasury bills while riskier bonds are issued by speculative companies at a higher yield.

Cash

Cash feels like a low-risk asset, but ideally you would store it in an interest-bearing savings account in order to keep up with inflation.

Also consider that holding too much cash can expose you to inflation risk, which is when cash loses value relative to the cost of living.

Bank Accounts

You can earn a rate of return through a bank account with FDIC insurance. Keeping an emergency fund in a checking account can be a prudent move so you can pay expenses without having to sell assets like stocks and bonds or take on debt.

Examples of High-Risk Investments

At the top of the pyramid, you will find assets and strategies that may generate large returns, but also expose you to serious potential losses. Margin trading is a method often employed by some investors to try and increase their returns.

Margin Trading

Margin trading is using borrowed funds in an attempt to amplify returns. A cash account vs. margin account has key differences to consider before you go about trading. Trading with leverage offers investors the possibility of large short-term gains as well as the potential for outsize losses, so it is perhaps best suited for sophisticated investors.

Options

Options on stocks and exchange-traded funds (ETFs) are popular these days. Options, through calls and puts, are derivative instruments that offer holders the right but not the obligation tobuy shares at a specific price at a predetermined time. These are risky since you can lose your entire premium if the option contract strategy does not work out for the holder.

Collectibles

Collectibles, such as artwork or wine, are alternative investment types that may provide some of the benefits of diversification, but it’s hard to know what various items are worth since they are not valued frequently. Consider that stocks and many bonds are priced at least daily.

Collectibles might also go through fad periods and booms and bust cycles, which can add to the risk factors in this category.

Discovering Your Risk Tolerance

The investment risk pyramid is all about helping you figure out your ability and willingness to accept risk. It is a fundamental piece of being an investor. You should consider doing more research and even speaking with a financial advisor for a more detailed risk assessment along with an analysis of what your long-term financial goals are.

The Takeaway

Using an investment risk pyramid can make sense for many investors. It’s an easy, visual way to decide which asset classes you might want to hold in your portfolio, so that the percentage of each (i.e. your asset allocation) is aligned with your risk tolerance.

The other helpful aspect of the investment risk pyramid is that it presumes a bigger foundation in lower-risk investments (the bottom tier), with gradually smaller allocations to moderate risk and higher-risk assets, as you move up the pyramid. This can be helpful for a long-term strategy. In a nutshell, the investment risk pyramid helps you figure out how to allocate investments based on your risk tolerance and return objectives.

If you’re an experienced trader and have the risk tolerance to try out trading on margin, consider enabling a SoFi margin account. With a SoFi margin account, experienced investors can take advantage of more investment opportunities, and potentially increase returns. That said, margin trading is a high-risk endeavor, and using margin loans can amplify losses as well as gains.

Get one of the most competitive margin loan rates with SoFi, from 4.75% to 9.50%*

FAQ

What are the levels of an investment pyramid?

The levels of an investment risk pyramid are low-risk at the base, moderate-risk in the middle, and high-risk at the top. The risk/return investment pyramid helps investors understand how to think about various assets they may want to own.

What does investment risk refer to?

Investment risk can be thought of as the variance in return, or how great the chance is that an investment will experience sharp losses. While the risk investment pyramid helps you build a portfolio, you should also recognize that a diversified stock portfolio performs well over time, while cash generally loses out due to the risk of inflation.

What are some examples of high-risk investments?

High-risk investments include speculative assets like options, trading securities on margin, and even some collectibles that might be hard to accurately value since they are based on what someone might be willing to pay for them. The low-risk to high-risk investments pyramid can include virtually any asset.

Photo credit: iStock/MicroStockHub

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.

For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.

Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.

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.

¹Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.

SOIN-Q324-024

Dec

2024

Risks and Benefits of Margin Trading: Is It a Good Idea?

By Kenny Zhu | Growing Wealth, invest, Investing | Comments Off

Margin trading refers to trading or investing using funds borrowed from a brokerage. Investors should understand that trading on margin operates like a double-edged sword; while it allows you to potentially multiply your gains, it can also multiply your losses.

At its core, margin trading involves borrowing from your broker to increase your purchasing power. This allows you to buy well beyond the actual cash you have at your disposal. We’ll cover the mechanics of how this works, as well as the risks and benefits of undertaking such a strategy.

Key Points

• Margin trading is trading or investing with funds borrowed from a brokerage.

• Borrowing boosts purchasing power but requires interest repayment.

• Risks include high interest costs and margin calls, leading to forced sales.

• Margin trading may help some traders access more purchasing power.

• Margin trading is risky, and may be unsuitable for some investors, especially those with long-term strategies.

Understanding Margin Trading

Margin trading means borrowing funds from your broker and using those funds to buy securities. Any borrowed funds must be repaid, with interest, regardless of whether or not you earn a profit on your trade. If you’re wondering about the difference between leverage vs. margin, you can think of margin as a form of leverage.

When investing – be it online investing or otherwise – with margin, your broker will require you to post cash collateral to match a percentage of the funds you borrowed. This is known as the margin, and the exact amount is set by your broker, the type of security traded, and prevailing market conditions.

Risks and Benefits of Margin Trading

Here’s a rundown of some of the most obvious risks and benefits to margin trading:

Risks	Benefits
Amplified losses	Increased purchasing power
High interest expense	Added liquidity
Risk of margin call	No set repayment schedule

Benefits of Margin Trading

Some of the benefits of margin trading include:

Added liquidity: Assuming you remain inside of acceptable maintenance margin requirements, margin trading grants additional buying power to smaller cash balances, which can be useful if you don’t want to liquidate existing holdings.

No set repayment schedule: Unlike standard fixed loans, there’s no repayment schedule for repaying your margin loan. The interest accrues while your balance remains outstanding, and is only repaid once the position is closed.

Risks of Margin Trading

Some of the risks of margin trading include:

Debt risks: Trading or investing with borrowed money has its risks, as you could end up in debt to your broker.

High interest expense: Interest rates on margin loans can range from low single digits to as high as 11% or more, depending on your broker and the size of your margin balance. At best, this is a drag on investment returns; at worst, an additional cost you have to pay on a loss.

Risk of margin calls: If at any point, the value of your investments fall beneath a broker’s posted margin requirements, you will be required to deposit additional collateral to cover the shortfall. This is known as a margin call. Failure to meet a margin call can result in a forced sale of your security, additional charges, and other penalties as dictated by your brokerage firm’s policies.

Is Margin Trading Ever Risk-Free?

Under no circumstances is margin trading ever considered free of risk. The core precept of all investing involves risk, and leveraged strategies like margin trading increase risk exposure.

Unlike cash accounts, which limit your losses to the value of your initial investment, margin accounts can result in losses that exceed the value of your initial deposit.

Is Margin Trading a Good Idea for You?

Margin trading isn’t for all investors, and its suitability depends on both the scenario as well as the experience and knowledge of each individual investor.

Trading on margin can be useful when you have a high conviction short-term trade idea. It can also provide the benefit of additional liquidity when much of your cash is tied up in existing investments that can’t be quickly unwound.

When considering margin trading, investors need to be willing and able to absorb any potential losses associated with this strategy. Make sure you fully understand the dynamics of each trade before opening a margin position.

Margin Trading With SoFi

Margin trading allows traders and investors to increase their purchasing power by using borrowed funds to buy securities. But it’s critical that traders and investors keep in mind that using margin can swing both ways – that is, it can allow them to invest more money, but it could also lead to increased losses.

Get one of the most competitive margin loan rates with SoFi, from 4.75% to 9.50%*

FAQ

What are the downsides of trading on margin?

Trading on margin involves a number of possible downsides, including added interest costs, heightened portfolio volatility, and magnified losses that may exceed the value of your initial investment.

Do some people make a lot of money trading on margin?

Trading on margin can amplify your potential investment returns thanks to the added buying power it offers. However, this multiplier effect swings both ways and will amplify the size of your loss, should the market move against you.

Is margin trading a good long-term investment strategy?

Margin trading is a form of leveraged trading and therefore not recommended for long-term investors. Over extended periods of time, there’s a heightened risk that market volatility may force a margin call. Also, the added interest expense incurred by margin loans can act as a drag on your investment returns.

Photo credit: iStock/valentinrussanov

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.

For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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.

Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.

¹Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.

SOIN-Q424-016

Benefits of ETFs — Pros & Cons in Investment Portfolio

What Are the Benefits of ETFs?

ETFs Trade Similar to Stocks

Portfolio Diversification

Accessible Across Markets

Lower Costs

Tax Efficiency

Transparency

Flexibility

Disadvantages of ETFs

Lack of Personalization

Tracking Error

Short-Term Trading Costs

Limited Choices

Counterparty Risk

Complexity

Market Risk

What to Consider When Investing in ETFs

Investing With SoFi

FAQ

What is the benefit of investing in an exchange-traded fund?

Are ETFs a good investment?

Why are ETFs better than stocks?

Is an ETF better than a mutual fund?

What Is a Shareholder Activist?

How Shareholder Activism Works

Types of Shareholder Activists

Hedge Funds

Institutional Investors

Individual Investors

Examples of Shareholder Activists

Is Shareholder Activism Good for Individual Investors?

The Takeaway

What Is a Carbon Tax?

How Does a Carbon Tax Work?

What Type of Carbon Is Taxed?

What Is the Economic Impact of Carbon Taxation?

What Is the Social Impact of Carbon Emissions?

Examples of Carbon Taxes

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

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

The Importance of Carbon Tax

Pros and Cons of Carbon Tax

Some of the pros of a carbon tax include:

A few cons of a carbon tax include:

Who Regulates Carbon Taxes?

Which Countries Have the Highest Carbon Tax?

The Takeaway

Guide to Investment Risk Pyramids

What Are Investment Pyramids?

How Investing Pyramids Work

Base of the Pyramid

Middle of the Pyramid

Top of the Pyramid

Sample Investment Pyramid

Pros and Cons of Investment Pyramids

Pros

Cons

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

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

Examples of Low-Risk Investments

Bonds

Cash

Bank Accounts

Examples of High-Risk Investments

Margin Trading

Options

Collectibles

Discovering Your Risk Tolerance

The Takeaway

FAQ

What are the levels of an investment pyramid?

What does investment risk refer to?

What are some examples of high-risk investments?

Risks and Benefits of Margin Trading: Is It a Good Idea?

Understanding Margin Trading

Risks and Benefits of Margin Trading

Benefits of Margin Trading

Risks of Margin Trading

Is Margin Trading Ever Risk-Free?

Student Loan
Refinancing

Personal
Loans

Online
Investments