Growing Wealth Archives

Q: What Is the January Effect?

The January Effect is a phenomenon in which stocks supposedly perform well during the first month of the year. The theory is that many investors sell holdings and take gains from the previous year in December, which can push prices down.

Dec

2024

What Is the January Effect and Is It Good For Investors?

January Effect: What It Is and Is It Good for Investors?

By Brian O'Connell | Growing Wealth, invest, Investing | Comments Off

The January Effect is a term that some financial market analysts use to classify the first month as one of the best-performing months, stock-wise, during the year. Analysts and investors who believe in this phenomenon claim that stocks have large price increases in the first month of the year, primarily due to a decline in share prices in December. Theoretically, following the dip in December, investors pour into stocks, which may boost prices in January.

However, many analysts claim that the January Effect and other seasonal anomalies are nothing more than market myths, with little evidence to prove the phenomenon definitively. Nonetheless, it may be helpful for investors to understand the history and possible causes behind the January Effect.

Key Points

• January Effect suggests stocks rise in January due to December price dips, which creates buying opportunities.

• Small-cap stocks benefit most from the January Effect due to liquidity.

• Tax-loss harvesting during the month of December may lower stock prices.

• Investors then buy in January, boosting stock prices.

• January Effect’s impact is debated; It’s either attributed to market myths or real behavior.

What Is the January Effect?

As noted above, the January Effect is a phenomenon in which stocks supposedly see rising valuations during the first month of the year. The theory is that many investors sell holdings and take gains from the previous year in December, which can push prices down. This dip supposedly creates buying opportunities in the first month of the new year as investors return from the holidays. This buying can drive prices up, creating a “January Effect.”

Believers of the January Effect say it typically occurs in the first week of trading after the New Year and can last for a few weeks. Additionally, the January Effect primarily affects small-cap stocks more than larger stocks because they are less liquid.

To take advantage of the January Effect, investors who are online investing or otherwise can eitherbuy stocks in December that are expected to benefit from the January Effect or buy stocks in January when prices are expected to be higher due to the effect. Investors can also look for stocks with low prices in December, but have historically experienced a surge in January, and buy those stocks before the increase.

What Causes the January Effect?

Here are a few reasons why stocks may rise in the first month of the year.

Tax-Loss Harvesting

Stock prices supposedly decline in December, when many investors sell certain holdings to lock in gains or losses to take advantage of year-end tax strategies, like tax-loss harvesting.

With tax-loss harvesting, investors can lower their taxable income by writing off their annual losses, with the tax timetable ending on December 31. According to U.S. tax law, an investor only needs to pay capital gains taxes on their investments’ total realized gains (or losses).

For example, suppose an investor owned shares in three companies for the year and sold the stocks in December. The total value of the profit and loss winds up being taxed.

Company A: $20,000 profit
Company B: $10,000 profit
Company C: $15,000 loss

For tax purposes, the investor can tally up the total investment value of all three stocks in a portfolio — in this case, that figure is $15,000 ($20,000 + $10,000 – $15,000). Consequently, the investor would only have to pay capital gains taxes on $15,000 for the year rather than the $30,000 in profits.

If the investor still believes in Company C and only sold the stock to benefit from tax-loss harvesting, they can repurchase the stock 30 days after the sale to avoid the wash-sale rule. The wash-sale rule prevents investors from benefiting from selling a security at a loss and then buying a substantially identical security within the next 30 days.

Recommended: Tax Loss Carryforward

A Clean Slate for Consumers

U.S. consumers, who play a critical role in the U.S. economy, traditionally view January as a fresh start. Adding stocks to their portfolios or existing equity positions is a way consumers hit the New Year’s Day “reset” button. If retail investors buy stocks in the new year, it can result in a rally for stocks to start the year.

Moreover, many workers may receive bonus pay in December or January may use this windfall to buy stocks in the first month of the year, adding to the January Effect.

Portfolio Managers May Buy In January

Like consumers, January may give mutual fund portfolio managers a chance to start the year fresh and buy new stocks, bonds, and commodities. That puts managers in a position to get a head start on building a portfolio with a good yearly-performance figure, thus adding more investors to their funds.

Additionally, portfolio managers may have sold losing stocks in December as a way to clean up their end-of-year reports, a practice known as “window dressing.” With portfolio managers selling in December and buying in January, it could boost stock prices at the beginning of the year.

Is the January Effect Real?

The January Effect has been studied extensively, and there is evidence to suggest that it is somewhat real. Studies have found that small- and mid-cap stocks tend to outperform the market during January because they are less liquid.

But some analysts note that the effect has become less pronounced in recent years due to the rise of tax-advantaged investing accounts, like 401(k)s and individual retirement accounts (IRAs). Investors who use these accounts may not have a reason to sell in December to benefit from tax-loss harvesting. Therefore, while the January Effect may be somewhat real, its impact may be more muted than in the past.

January Effect and Efficient Markets

However, many investors claim that the January Effect is not real because it is at odds with the efficient markets hypothesis. An efficient market is where the market price of securities represents an unbiased estimate of the investment’s actual value.

Efficient market backers say that external factors — like the January Effect or any non-disciplined investment strategy — aren’t effective in portfolio management. Since all investors have access to the same information that a calendar-based anomaly may occur, it’s impossible for investors to time the stock market to take advantage of the effect. Efficient market theorists don’t believe that calendar-based market movements affect market outcomes.

The best strategy, according to efficient market backers, is to buy stocks based on the stock’s underlying value — and not based upon dates in the yearly calendar.

History of the January Effect

The phrase “January Effect” is primarily credited to Sydney Wachtel, an investment banker who coined the term in 1942. Wachtel observed that many small-cap stocks had significantly higher returns in January than the rest of the year, a trend he first noticed in 1925.

He attributed this to the “year-end tax-loss selling” that occurred in December, which caused small-cap stocks to become undervalued. Wachtel argued that investors had an opportunity to capitalize on this by buying small-cap stocks during the month of January.

However, it wasn’t until the 1970s that the notion of a stock rally in January earned mainstream acceptance, as analysts and academics began rolling out research papers on the topic.

The January Effect has been studied extensively since then, and many theories have been proposed as to why the phenomenon may occur. These include ideas discussed above, like tax-loss harvesting, investor psychology, window-dressing by portfolio managers, and liquidity effects in stocks. Despite these theories, the January Effect remains an unexplained phenomenon, and there is a debate about whether following the strategy is beneficial.

The Takeaway

Like other market anomalies and calendar effects, the January Effect is considered by some to be evidence against the efficient markets hypothesis. Nevertheless, there is evidence that the stock market does perform better in January, especially with small-cap stocks. Whether one believes in the January Effect or not, it’s always a good idea for investors to use strategies that can best help them meet their long-term goals.

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Nov

2024

9 ESG Metrics Investors Should Know

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

A number of investors are choosing to invest in securities with an environmental, social, and governance (ESG) focus that may align with their values and investment goals. Many see ESG companies as being potentially more sustainable long-term. But determining whether a company’s ESG strategies are having the desired impact requires the use of ESG metrics to measure progress and enable accountability.

In addition, these days many investors also want to know how well companies are managing the risks associated with climate-related changes — which also requires metrics that can show whether a company is meeting key standards.

These concerns aren’t new, but they have driven a number of new ESG-focused regulatory efforts here and abroad. As yet, however, there isn’t a universal set of ESG metrics used by all investors or financial firms to evaluate a company’s progress toward ESG goals, or better manage ESG risks. What’s more, the regulatory landscape in this sector is evolving, which, for the near future, may make it challenging to track certain metrics over time. That said, there are a number of frameworks that companies and governments have embraced that can inform investors’ choices.

Key Points

• With the growing appeal of ESG strategies, there is also a need for reliable ways to assess companies’ ESG performance and risk mitigation.

• ESG metrics are necessary for accurate company disclosures, which also support transparency and accountability.

• The use of ESG metrics and disclosures can also help investors compare companies within and across industries.

• A number of organizations are establishing mandatory standards and/or compliance rules, although some are in flux or facing legal opposition.

• At the moment, companies can choose from a range of ESG frameworks and standards.

What Is ESG Investing?

ESG stands for environmental, social, and governance standards that can help people assess whether companies are meeting certain criteria, as well as whether they are mitigating ESG-related risk factors that may impact performance.

• Environmental factors capture how well a company safeguards the physical environment (e.g., reducing emissions, pollutants).

• Social criteria refer to employee safety, fair labor practices, community investment, relationships with customers and vendors.

• Governance factors include issues of leadership, fraud prevention, transparency in accounting and reporting, and more.

ESG investing began in the 1970s, broadly speaking, although impact investing in various forms has been around for centuries.

At first, investing with the aim of creating positive change for society and the planet seemed anchored in a kind of “do-goodism” and less focused on financial outcomes. In the last 20 or 30 years, though, investors have become interested in socially responsible investing (SRI), as many funds in this category have shown themselves to offer returns that are comparable to traditional strategies, according to a report published in 2023 by Morningstar, a fund rating and research firm.

ESG Metrics Are Key to ESG Reporting

Thus, with the growing appeal of ESG investments to some investors, there is a commensurate need for reliable ways to assess companies’ ESG performance when choosing to invest online or through a traditional brokerage.

ESG frameworks help companies, as well as investors, assess an organization’s stated aims in terms of meeting ESG standards. In theory, relying on a common set of metrics should help encourage more efficient and transparent ESG reporting.

• ESG metrics establish a layer of transparency and accountability.

• Reliable ESG reporting helps build trust and a positive image with investors, communities, and other stakeholders.

• In addition, companies that adhere to ESG standards may be able to demonstrate better risk management.

What Are ESG Metrics?

Until now, ESG metrics and reporting standards have been largely proprietary or voluntary. But owing to widespread concerns about climate change and climate-related risk factors, thousands of companies around the world have adopted voluntary frameworks and metrics in recent years.

There are thousands of metrics in use, many are specific to certain industries. Common ESG metrics typically assess how well an organization is limiting pollutants and emissions, meeting renewable energy targets, upholding fair labor standards, adhering to transparency in accounting, corporate board selection, and more.

The Use of ESG Frameworks

Companies may be required to use certain metrics in their reporting and disclosures. Here too there is considerable variation.

For example, the Global Reporting Initiative (GRI), which has a voluntary governance structure, is a nonprofit organization that was established in 1999 to create a set of guidelines that help companies and governments disclose their efforts in light of climate change, human rights, and corruption.

More than three-quarters (78%) of the world’s largest corporations have adopted the GRI standards, making it the most common ESG framework at the moment.

In addition, there has been a rise in the number of organizations that are establishing mandatory standards and/or compliance rules that require standardized reporting and verifiable metrics regarding ESG performance.

For example, the Corporate Sustainability Reporting Directive (CSRD) began rolling out mandatory ESG reporting rules in January of 2024 in the European Union. The CSRD compliance rules impact non-E.U. companies, as well, about a third of which are based in the United States.

Similarly, some financial institutions have created screener tools that investors can use to evaluate certain securities, but these are typically proprietary and cannot be used to evaluate investments at a different institution.

SEC Climate-Disclosure Rules on Hold

Another widely watched set of reporting requirements was led by the Securities and Exchange Commission (SEC) over the last few years. The SEC adopted new rules in March of 2024, which established a higher bar for companies and required them to disclose ESG-related operational risks and expenses, as well as efforts to meet sustainability targets: e.g., emissions reduction.

But those rules were quickly challenged and remain on hold at the time of publication. Likewise, similar efforts in states like California and elsewhere have been stalled.

The Importance of ESG Metrics

Although the landscape of ESG frameworks and reporting standards is still evolving, and is largely in flux, ESG metrics are important because they help investors to gauge a firm’s impact on environmental issues, societal issues, and issues of corporate responsibility against a set of comparable peers.

Since many investors who are interested in ESG strategies are also committed to making an impact with their money, being able to benchmark outcomes is important.

The Limitations of ESG Metrics

However, it can be difficult to measure ESG policies across different industries, as no official regulations for standardized ESG reporting currently exist. For example, a financial institution might require different standards for energy efficiency vs. an agricultural company or an actual energy producer.

Finally, some of the existing standards are qualitative and may be prone to subjectivity, which can make the ESG evaluation process difficult to quantify. These can all present challenges when you’re trying to apply ESG principles to your investing strategy.

Having an awareness of some of the limitations around these metrics can help investors use the currently available criteria wisely.

9 Common ESG Metrics

Commonly employed ESG metrics consist of both qualitative and quantitative metrics across all three categories of environmental, social, and governance factors.

3 Common Environmental Metrics

Environmental metrics measure the long-term ecological sustainability of a firm’s actions. These can be related to emissions, finite natural resources, and the environment, among other things.

Many of these metrics can be tracked on an aggregate basis or relative to other operating metrics (per capita, per unit produced, etc.).

• Emissions: Quantifies how much a firm emits in greenhouse gasses, or whether it’s working to reduce carbon emissions through its operations.

• Waste: Measures how much waste a company generates or recycles in their operations. Can also reflect a company’s impact on its surrounding ecology: e.g., air or water pollution.

• Resource Usage: Tracks the efficiency and extent of a firm’s operations when it comes to using energy, water, or other key resources.

3 Common Social Metrics

Social metrics evaluate how a firm’s policies impact its workforce, the community, and society at large. Attempts to quantify these metrics have largely been implemented on a per-occurrence basis, or as a rate over time.

• Human resources: Evaluates how a company treats its employees, gender pay gaps, diversity, frequency/magnitude of any workplace litigation, and employee turnover.

• Labor safety: Tracks a firm’s commitment to safe labor practices via metrics like frequency of workplace accidents and lost productivity.

• Product development and safety: Examines a firm’s product quality and sustainability through metrics like number of recalls, complaints, or even frequency of litigation. Can also be linked to environmental standards when it comes to how product inputs are sourced.

3 Common Governance Metrics

Governance metrics pertain to issues relating to business ethics, mitigation of agency risks, and transparency in reporting. These can be measured in terms of how executives are compensated, board policies, and accounting choices, among others.

• Ownership structure: Reviews how faithful a firm is to its shareholders when it comes to metrics like the number of independent directors on the board, or how voting rights are distributed between management and shareholders.

• Executive compensation: Measures executive compensation relative to industry standards or company profitability. Can also be tied to social concerns when measuring how compensation structures vary for different genders/minorities.

• Financial reporting: Tracks a firm’s accounting policies and how comprehensive and accurate they are. Could involve reviewing a firm’s books for key disclosures or frequency of one-off exceptions.

How Do Firms Report ESG Metrics?

To some degree, how each firm reports its ESG metrics depends on its policies regarding disclosures. But now companies do have some standardization for reporting climate-related risk factors and mitigation efforts.

Keep in mind, the adoption of ESG frameworks can vary widely by firm and disclosure of these metrics is still largely voluntary. Additionally, certain metrics may be difficult to quantify and, in some cases, management, stakeholders, or shareholders may disagree on the impact of certain ESG factors.

As a result, professional money managers sometimes may solicit the assistance of third-party ESG consultants to obtain an independent assessment of how a company actually performs on ESG metrics.

How Can Investors Use ESG Metrics?

Investors want to be discerning when investing in specific firms or funds that offer an ESG approach.

Given the range of ESG frameworks and the inconsistency in how frameworks are applied, investors should be aware that some firms may cherry-pick which ESG metrics they use. Investment funds and ETFs that offer an ESG-based approach may use their own proprietary metrics when deciding how to allocate ESG investments; which may make them difficult to compare.

When using ESG metrics, you’ll want to examine a company’s ESG-related disclosures closely to ensure that there’s consistency in the data being reported. Depending on the metric you’re examining, you may wish to avoid making comparisons across disparate industries and focus on identifying “best-in-class” investments for a single industry.

The Takeaway

Broadly speaking, ESG metrics can offer investors a useful dimension for evaluating certain types of sustainable investment choices. Although a unified set of ESG standards and metrics is a work in progress, there has been a steady push among regulatory bodies to establish ESG reporting requirements, here and worldwide.

As with any investment strategy, investors will want to manage their expectations appropriately and employ ESG metrics as part of a larger toolbox for investment analysis.

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Nov

2024

What Are Real Assets? Understanding Tangible Investments

By MP Dunleavey | Growing Wealth, invest, Investing, Terminology | Comments Off

Real assets are tangible, physical assets that can be exchanged for cash, owing to their use in manufacturing and consumer goods, and other purposes. Real assets, as a category, may include precious metals, commodities, real estate, infrastructure, and more.

Typically, real assets are considered a type of alternative investment, owing to their low correlation with traditional asset classes such as stocks and bonds. As such, real assets may provide some portfolio diversification. But real assets are also susceptible to specific risks pertaining to each sector.

Key Points

• Real assets take their name from the fact that they are tangible, physical assets, as opposed to financial assets (like stocks and bonds) or intangible assets (like a brand).

• Real assets have a cash value, and can generally be traded for cash. They typically include real estate, land, commodities, infrastructure, precious metals, and more.

• It’s possible to invest in real assets directly (by owning the physical goods, resources, or structures) or indirectly (via mutual or exchange-traded funds).

• They are considered a type of alternative asset, because most real assets are not correlated with conventional asset classes, and thus may provide some portfolio diversification, and potential returns.

• Real assets come with specific risk factors that pertain to each type of tangible asset, in addition to the risks that come with most alts: e.g., illiquidity, lack of transparency, less regulation.

Defining Real Assets

What is an asset? On the whole, assets can be considered tangible (e.g., land), intangible (e.g. a brand or trademark), or financial (e.g. shares of stock). While real assets have a cash value and can be exchanged for cash, they are not considered a type of financial asset because they are not securities.

Also, real assets are considered a type of alternative investment. Alts tend not to move in sync with, i.e., they’re not typically correlated with conventional assets like stocks and bonds. But like all types of alternative investments, real assets come with specific risks, including lack of liquidity, transparency, and less regulation in some cases.

Characteristics of Real Assets

The primary characteristic of real assets is that they are physical. They can be objects, goods, resources, or structures that have a specific cash value and can be traded for cash in certain markets.

However, real assets are considered non-securities, because they do not derive their value from a contractual ownership arrangement like stocks, bonds, exchange-traded funds (ETFs), options, and more.

Real Assets vs. Financial Assets

Financial assets fall into the category of securities; generally speaking there are debt securities (like bonds) and equity securities (stocks), as well as derivatives (options and futures). Real assets are non-securities.

• Securities are financial instruments that can be traded on an exchange, with an expectation of making a profit. More important, securities are fungible, meaning the value of one unit is interchangeable with another of the same type of unit: e.g., a share of stock in Company A is the same as another share of that stock.

• Real assets are physical goods, and in many cases they are not fungible: one type of property or infrastructure is not interchangeable with another. That said, commodities are a type of real asset, and are generally fungible: one barrel of crude oil is the same as the next.

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Types of Real Assets

As noted, real assets consist of physical, tangible goods and resources. But while one stock generally behaves the same as another stock, each type of real asset has to be considered individually to understand its benefits and risks.

Real Estate

Real estate includes a wide range of property types and investment choices: e.g., commercial real estate, industrial real estate, healthcare facilities, rental properties, and more. While it’s possible to invest directly in real estate, it’s also possible to buy into a type of pooled investment like real estate investment trusts, or REITs.

Real estate may offer passive income (i.e., from rent), or gains from the sale of properties, but real estate investments come with potential risks: local laws and regulations can change; property can be damaged by extreme weather; interest rate risk can impact property values.

Commodities

Commodities include numerous raw materials, including agricultural products like corn and coffee; precious metals such as copper or nickel; energy sources (including renewables), and more. Commodity trading typically involves futures contracts, but it’s possible to invest in commodities via index funds and mutual funds, or ETFs.

These assets, owing to steady demand, may offer the potential for profits. They may help hedge against inflation. That said, the value of commodities can be impacted by weather, supply chain breakdowns, market fluctuations, and other factors, which makes them risky. Commodities can lose value for a number of reasons, and direct investments in commodities lack certain investor protections offered to other securities.

Infrastructure

Infrastructure assets are durable structures that provide public services, utilities, and the like to enable the smooth functioning of society. Infrastructure includes durable structures like bridges, roads, tunnels, and schools, as well as energy infrastructure like power plants. Infrastructure is typically stationary, has a long period of use, and generates predictable cash flow (via utility payments, tolls, and so on).

While it can be difficult for individual investors to invest directly in infrastructure, it’s possible to invest in municipal bonds, or funds that offer exposure to companies involved in infrastructure.

Investing in infrastructure comes with specific risks investors should consider, including interest-rate risk (which can affect access to loans, and interest on bonds), regulatory issues, climate and weather challenges, and more.

Precious Metals

Generally speaking, precious metals consist of a group of natural assets, including gold, silver, platinum, iridium, and others. Investing in precious metals may be appealing as many metals tend to retain value owing to their scarcity, their critical role in manufacturing and technology, and because some (like gold and silver) are themselves used as a store of value.

For many individual investors, it may not be obvious how to invest in gold, silver, or other metals. Though it’s possible to buy bullion or bars directly, it’s also possible to invest in ETFs that are invested in gold or precious metals, or in stocks of mining companies, and the like.

The risks of investing in precious metals include potential changes in demand, technological innovations that may require more or less of a given metal, supply chain issues, worker safety, and more.

Recommended: Why Invest in Alternative Investments?

Benefits and Risks of Investing in Real Assets

In addition to the advantages and disadvantages of different types of real assets noted above, there are a few other factors investors should consider.

Inflation Hedge

Inflation essentially decreases a dollar’s purchasing power, and a hedge against inflation can offer a potential upside.

In some cases real assets can provide a hedge against inflation. For example, assets that benefit from steady demand, like commodities, may help offset inflation’s bite. Also, land or real estate may rise in value even when the purchasing power of the dollar is declining, which may offer a potential inflation hedge.

That said, it’s impossible to predict for certain which asset classes will help to mitigate inflation, and there are no guarantees.

Portfolio Diversification

Another factor investors should consider is the potential benefit from diversification, which is the practice of investing in different asset classes to help mitigate risk. Diversifying your assets may help offset some investment risk.

Diversification is complex, however, and involves more than just including alternative investments along with equities and fixed income. Investors need to consider how certain investments, like tangible assets, might provide some sense of equilibrium in their portfolio if conventional strategies are down.

Potential for Steady Income

As discussed, some types of real assets, like infrastructure investments, can become a source of steady income. For example, roads and bridges and public transportation require a high initial investment, but then they may provide a predictable revenue stream from tolls and fares and so forth.

The same is true for some types of municipal power plants and other energy sources that supply utilities, and derive steady payments over time.

Liquidity Concerns

Taken as a whole, however, real assets are quite similar to other types of alternative investments in that they lack the liquidity and easy access to cash that most conventional investments provide.

Liquidity risk is something all investors must take into account when choosing investments, as the inability to enter and exit positions with ease, and as needed, can impact one’s goals.

Market Volatility

All markets fluctuate to some degree, but some markets are more volatile than others. When it comes to deciding whether to invest in real assets, investors must do their due diligence because the market for each type of tangible asset is vastly different from another.

Just as understanding volatility in the stock market is key to making smart choices about equities, it’s essential for investors to consider the real estate market for a property they might invest in, or the futures market for investing in commodities, and so forth.

Incorporating Real Assets into Your Investment Strategy

Would investing in real assets make sense in your portfolio? There are a few factors to consider.

Asset Allocation

Asset allocation is basically the mix of stocks, bonds, and other investments in your portfolio. While a standard allocation usually includes these conventional asset classes, some investors also include other choices such as commodities, real estate, private equity, and more.

Deciding on the right allocation for your portfolio means thinking about your goals, time horizon, and how much risk you’re willing to take on. Given that real assets are often higher-risk investments, but aren’t correlated with traditional assets, investors may want to consider the advantages and disadvantages before deciding on an asset allocation that makes sense.

Direct vs. Indirect Investment Methods

Owing to the physical nature of real assets, it’s possible to invest in many real assets directly (e.g., owning rental property or gold bullion) as well as investing indirectly in real assets.

For example, commodities are typically traded via futures contracts. A commodity futures contract is an agreement to either buy or sell a specified quantity of that commodity for a specific price at some point in the future. While it’s possible to end up with actual physical commodities this way (e.g., bushels of corn or barrels of oil), for the most part futures are an indirect way to gain access to the commodities markets.

REITs and ETFs

Real estate investment trusts (REITs) and ETFs are two other common instruments for investing indirectly in real assets.

• A REIT is a trust that owns income-generating properties, so that investors are spared the hassle of direct ownership. A REIT may own warehouses, retail stores, storage units, hotels, and more. REITs can focus on a geographic area or specific market (like healthcare). A REIT is required to distribute 90% of its income to shareholders, so owning shares of a REIT may provide passive income, as well.

• ETFs are another way to invest indirectly in certain types of real assets, because these funds invest in companies that either produce, process, or in some way support a given type of real assets.

For example, there are ETFs that invest in mining, equipment, or technology companies in the precious metals and commodities sectors. Likewise, there are ETFs that invest in companies that support infrastructure projects.

Investors who are interested in exploring real assets are not limited to direct investment strategies; there are other options to consider.

The Takeaway

Real assets are tangible assets like real estate, infrastructure, or commodities, and are considered a type of alternative investment. Alts are not typically correlated with traditional assets like stocks and bonds, and thus may provide portfolio diversification that can help mitigate some risk factors. But like all types of alts, real assets come with specific risks, including lack of liquidity and lack of transparency.

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FAQ

How do real assets perform during economic downturns?

Although some alternative investments may not be affected by a downturn, the markets for specific assets can react differently, depending on the economic conditions. For example, if stocks are down, real estate may not be impacted at all. When interest rates fluctuate, the cost of loans can impact real estate values and infrastructure projects, but not necessarily commodities. It’s incumbent on each investor to consider the pros and cons of any investment before putting money into it.

What percentage of a portfolio should be in real assets?

Deciding on the percentage any asset class should have in your portfolio is a personal calculation, taking into account your goals, time horizon, and stomach for risk. It’s especially important to consider that real assets are illiquid, a risk consideration that can impact whether you want to invest in real assets at all.

Are real assets suitable for all types of investors?

No. Real assets are better suited to experienced investors, who may have the skills to navigate the complexities of real asset markets, pricing, risks, and so forth.

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

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

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

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

SOIN-Q324-057

Nov

2024

What Is Extrinsic Value?

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

Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.

What Is Extrinsic Value?

Extrinsic value is the difference between an option’s market price, known as the premium, and its intrinsic value.

Extrinsic value reflects factors beyond the underlying asset’s price that can influence the overall worth of an option. This value fluctuates based on the time to expiration and the volatility of the underlying asset.

Key Points

• Extrinsic value is the difference between an option’s market price and intrinsic value, influenced by time and volatility.

• Longer contracts and higher implied volatility increase extrinsic value.

• Interest rates and dividends affect extrinsic value differently for call and put options.

• Extrinsic value cannot be negative; it represents the portion of an option’s price that exceeds its intrinsic value.

• At-the-money options have the most extrinsic value due to sensitivity to time and volatility changes.

Understanding Intrinsic and Extrinsic Value

The intrinsic value of an option is the difference between an option’s strike price and the current price of the underlying asset, which can be calculated only when the underlying asset is in the money. An out-of-the-money option has no intrinsic value.

Remember, an option that is “in the money” would be profitable for the owner if exercised today, while an option that is “out of the money” would not.

An out-of-the-money option may present an investment opportunity for some, however, because of its potential to become in-the-money at expiration.

Extrinsic value equals the price of the option minus the intrinsic value. As an option’s expiration approaches, extrinsic value usually diminishes since there is less time for the price of the underlying asset to potentially move in a way that benefits the option holder (also known as time decay).

For example, an option that has two weeks before expiry typically has a higher extrinsic value than one that’s one week away. This does not imply it has more intrinsic value, however. It just means there is more time for it to move up or down in price.

Out-of-the-money option premiums consist entirely of extrinsic value, while in-the-money options have both intrinsic value and extrinsic value. Options that trade at-the-money might have a substantial proportion of extrinsic value if there is a long time until expiration and if volatility is high.

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

How Extrinsic Value Works

Simply put, the more time until expiration and the more a share price can fluctuate, the greater an option’s extrinsic value. Extrinsic value demonstrates the time that remains for potential price movement, and the uncertainty in that movement. There are a few different factors that could influence extrinsic value, and understanding them is crucial for evaluating an option’s pricing.

Factors that Affect Extrinsic Value

Two key factors affect an option’s extrinsic value: contract length and implied volatility. In general, the longer the contract, the greater the extrinsic value of an option. That’s because the more time allowed until expiration, the more a stock price might move in favor of the option’s holder. It’s possible, however, that the price moves in the opposite direction; if the holder keeps the option in the hope that the price will rebound, they may lose some or all of their investment.

The second factor that determines extrinsic value is implied volatility. Implied volatility measures the expected magnitude of how much a stock might move over a specific period. Volatility impacts an option’s extrinsic value, and its sensitivity is represented by the Greek letter vega.

1. Length of Contract

An option contract generally has less value the closer it is to expiration. The logic is that there is less time for the underlying security to move in the direction of the option holder’s benefit. As the time to expiration shortens, the extrinsic value decreases, all else equal.

To manage this risk, many investors use the options trading strategy of buying options with varying contract lengths. As opposed to standard option contracts, a trader might choose to buy or sell weekly options, which usually feature shorter contract lengths.

On the opposite side of the spectrum, Long-Term Equity Anticipation Securities (LEAPS) sometimes have contract lengths that measure in years. Extrinsic value could be a large piece of the premium of a LEAPS option.

Some traders will also use a bull call spread, in order to reduce the impact of time decay (and the loss of extrinsic value) on their options.

Recommended: A Beginner’s Guide to Options Trading

2. Implied Volatility

Implied volatility measures how much analysts expect an asset’s price to move during a set period. In general, higher implied volatility means more expensive options, due to higher extrinsic value. That’s because there is a greater chance a stock price could significantly move in the favor of the owner by expiration (or out of favor if the markets shift in the opposite direction). High volatility gives an out-of-the-money option holder more hope that their position will go in-the-money.

So, if implied volatility rises from 20% to 50%, for example, an option holder may benefit from higher extrinsic value (all other variables held constant). On the flip side, an out-of-the-money option on a stock with extremely low implied volatility may have a lower chance of ever turning in-the-money.

3. Others Factors

There is more than just the length of the contract and implied volatility that affect the premium of an option, however.

• Time decay: The time decay, or the rate at which time decreases an option’s value, can greatly impact the premium of near-the-money options, this is known as theta. Time decay works to the benefit of the option seller, also known as the writer.

• Interest rates: Even changes in interest rates, or rho, impact an option’s value. A higher risk-free interest rate pushes up call options’ extrinsic value higher, while put options have a negative correlation to interest rates.

• Dividends: A stock’s dividend will decrease the extrinsic value of its call options while increasing the extrinsic value of its put options.

• Delta: An option’s delta is the sensitivity between an option price and its underlying security. In general, the lower an option’s delta, the less likely it is to be in-the-money, meaning it likely has higher extrinsic value. Options with higher delta are in-the-money and may have more intrinsic value.

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

Extrinsic Value Example

Let’s say a trader bought a call option through their brokerage account on shares of XYZ stock. The premium paid is $10 and the underlying stock price is $100. The strike price is $110 with an expiration date in three months. Also assume there is a company earnings report due out in the next month.

Since the share price is below the call’s strike, the option is out-of-the-money. The option has no intrinsic value because it is out-of-the-money. Thus, the entire $10 option premium represents extrinsic value, or time value.

As expiration draws nearer, the time value declines, also known as time decay. A trader who takes the long position with a call option hopes the underlying asset appreciates by expiration.

An increase in volatility, perhaps due to the or another catalyst, might push the option’s price higher. Let’s assume the stock has risen to $120 per share following strong quarterly earnings results, and the call option trades at $11 immediately before expiration.

The call option’s intrinsic value is now $10, but the extrinsic value has declined to just $1, in this scenario, since there is little time to expiration and the earnings date volatility-driver has come and gone. In this case, the trader can sell the call for a small profit or they might choose to exercise the option.

Note that if the stock price had instead fallen below the strike price of $110, the call option would have expired worthless and the trader would have lost the premium they paid for the option.

Extrinsic vs Intrinsic Value

Extrinsic value reflects the length of the contract plus implied volatility, while intrinsic value is the difference between the price of the stock and the option’s strike when the option is in the money.

Extrinsic Value Factors (Call Option)	Intrinsic Value Factor (Call Option)
Length of Contract	Stock Price Minus Strike Price
Implied Volatility

Extrinsic Value and Options: Calls vs Puts

Both call options and put options can have extrinsic value.

Calls

Extrinsic value for call options can be high. Consider that a stock price has no upper limit, so call options have infinite potential extrinsic value. The more time until expiration and the greater the implied volatility, the more extrinsic value a call option will have.

Puts

Put options have a lower potential value since a stock price can only drop to zero. Thus, there is a limit to how much a put option can be worth, which is the difference between the strike price and zero. Out-of-the-money puts, when the stock price is above the strike, feature a premium entirely of extrinsic value.

The Takeaway

Understanding the fundamentals of intrinsic and extrinsic value is important for options traders. Although intrinsic value is a somewhat simple calculation, extrinsic value takes a few more factors into consideration — specifically time and volatility of the underlying asset. The more time until the contract expires, and the more a share price can fluctuate, the greater an option’s extrinsic value.

SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.

With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.

Explore SoFi’s user-friendly options trading platform.

FAQ

Which options have the most extrinsic value?

At-the-money options typically have the most extrinsic value since their price is closest to the strike price, thus being most sensitive to changes in time and volatility.

Can an option’s extrinsic value be negative?

No. Extrinsic value represents the portion of an option’s price beyond its intrinsic value, so it can never be less than zero. If an option’s market price is lower than its intrinsic value, it can only be as low as zero.

Photo credit: iStock/alvarez

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

SOIN-Q324-066

Nov

2024

Understanding ESG Frameworks: Definition and Types

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

As ESG-focused strategies continue to attract investors, there is a growing interest in establishing frameworks that can help companies meet specific environmental, social, and governance criteria — the better to help investors evaluate company performance in light of ESG standards.

ESG frameworks are important because they can allow market participants to reference a common set of guidelines when evaluating companies for investment purposes. In theory, consistent ESG frameworks could help encourage more efficient and transparent markets.

Although there are a number of ESG frameworks in use, however, the ESG sector as a whole still lacks a set of clear-cut criteria that have found universal approval or acceptance. Most recently, the Securities and Exchange Commission (SEC) put its own new set of ESG disclosure rules on hold.

Key Points

• ESG frameworks include specific criteria and metrics to help firms assess and disclose their progress toward environmental, social, and governance goals.

• ESG frameworks aim to standardize methodologies that will support transparency and accountability, and thereby serve all stakeholders.

• While there are a dozen or more existing ESG frameworks worldwide, most are non-binding (mandatory guidelines tend to be implemented in local jurisdictions).

• The SEC released a set of mandatory disclosure rules in March of 2024; these were put on hold a month later, owing to legal challenges.

• In the absence of ESG standards mandated by financial regulators, individual firms are left to select appropriate frameworks and/or develop proprietary disclosures.

What Is an ESG Framework?

ESG frameworks include principles, guidelines, and often metrics to help firms measure and, importantly, report their progress regarding specific environmental, social, and governance standards — which in turn helps investors interested in green investing.

• Environmental factors may include carbon emissions, sustainable energy use, pollution regulation, climate impact, and more.

• Social factors may include a company’s involvement and support of local community issues, worker safety, as well as diversity, equity and inclusion in the workforce.

• Governance factors may include a company’s leadership selection process, accounting practices, data privacy, and transparency in reporting.

As such, ESG frameworks are an attempt to standardize both methodologies and metrics employed in ESG disclosures to better serve all stakeholders.

The State of ESG Frameworks

Although there are numerous organizations (including policy groups and regulatory agencies) that have developed frameworks for ESG reporting in recent years, there has yet to be a single set of standards to insure that companies are held accountable for managing certain risk factors, and that investors are afforded some reliability in terms of their ESG investment choices.

While the SEC approved a set of ESG disclosure rules in March 2024, a month later, owing to legal challenges, these rules were put on hold.

In short: With no official ESG standards required by U.S. financial regulators or other governmental bodies, the question of which framework to adopt is left up to the individual firm.

Likewise, the lack of agreed-upon ESG frameworks means that investors must shoulder the responsibility for understanding which standards and/or metrics a company may be following, and whether this meets their own standards for investment.

What Is the Goal of an ESG Framework?

ESG frameworks give companies a way to define key principles, standards, and goals in each area (i.e., pertaining to the environment, societal factors, and corporate governance) in order to facilitate accurate ESG reporting. These frameworks may include metrics to measure progress toward specific goals.

Thus, ESG frameworks serve three main purposes:

1. To provide guidelines for companies in terms of their operations and outcomes.

2. To enable consistent reporting that enables investors to evaluate companies.

3. To help governments track regulatory compliance, and identify areas for improvement or disciplinary action.

ESG Frameworks and Risk

In addition to helping support positive ESG outcomes, companies that adhere to an ESG framework may also be able to mitigate certain ESG risk factors that can impact company performance long term.

For example: Reducing the demand for fossil fuels as part of product manufacturing can be beneficial for the environment, and it also may help protect a company from price shocks from oil or gas shortages — which can help its bottom line.

Recommended: What Is Socially Responsible Investing?

Benefits of Using an ESG Framework

To the extent that an ESG reporting framework can act as a blueprint for progress in specific areas, it may be more likely that organizations that embrace a certain framework are able to drive more positive outcomes in desired areas.

In that light, an ESG framework can enable companies to expand the scope of their business reporting to a wider universe of stakeholders.

• From an environmental perspective, using ESG to guide corporate actions can mitigate the chance of government oversight; and it may reduce a firm’s overreliance on natural resources, and help to limit insurance and legal costs if environmental safety guidelines are followed.

• From a social perspective, ESG-influenced policies can improve working conditions, employee retention, reduce the likelihood of labor disputes that can impact productivity, build community support, and improve a firm’s image.

• When it comes to governance, ESG policies can improve transparency at all levels of a firm; protect data privacy; reduce fraud; and potentially reduce operational costs through the better alignment of all stakeholders within a firm.

Large financial institutions, such as public pension funds, have started incorporating ESG criteria into their investment selections. In addition, there are now ESG-focused ETFs and mutual funds being offered by mutual fund companies, online investing platforms, and brokerage firms.

Types and Examples of ESG Frameworks

In the last 20 years or so, over a dozen ESG frameworks have been established. And while some methods may overlap with each other, and in the last few years some have been consolidated, the existing frameworks each provide a separate set of standards, metrics, and reporting requirements that organizations can consider.

Despite the confusing number of options, some frameworks or disclosure systems seem to be taking the lead in terms of wider adoption, particularly with the expansion of the International Financial Reporting Standards (IFRS) Sustainability Disclosure Standards.

While some firms have adopted all or parts of these frameworks, others have created proprietary sets of criteria, metrics, and reporting methods that, in some cases, may complement existing frameworks.

Following is a brief summary of some prominent ESG frameworks:

Global Reporting Initiative (GRI)

The Global Reporting Initiative, established in 1999, is an independent organization that helps companies and governments assess and report their impact on ESG issues such as climate change, human rights, and corruption. Although the GRI standards are voluntary, nearly 80% of the world’s biggest companies by revenue have adopted the GRI reporting standards, making it the most widely adopted framework.

International Financial Reporting Standards (IFRS) Sustainability Disclosure Standards

The IFRS establishes corporate accounting standards and policies overseas; it’s the equivalent of the U.S. Generally Accepted Accounting Principles (US GAAP). Because a growing number of companies need a way to incorporate sustainability into their accounting and reporting disclosures, the IFRS Foundation set up the International Sustainability Standards Board (ISSB) in 2021.

The ISSB disclosure standards are voluntary, and build on previous frameworks, a few of which have since been folded into the working IFRS Sustainability Disclosure Standards, including: the Task Force on Climate-Related Financial Disclosures (TCFD), Climate Disclosure Standards Board (CDSB) and others.

Sustainability Accounting Standards Board (SASB) Standards

The SASB Standards were established in 2018 to enable the disclosure of sustainability-related information that would be considered financially material; the framework detailed key ESG issues across 77 different industries. These standards were absorbed by the IFRS Foundation in 2022, and as such are now overseen by the ISSB, which maintains the SASB Standards for organizations that prefer this method.

CDP

The CDP (formerly the Carbon Disclosure Project) is an international non-profit that helps not only companies, but state and local governments to evaluate and disclose key environmental impacts such as carbon and greenhouse gas emissions, water quality protection, and deforestation on a voluntary basis.

Companies are given a score on separate areas; the questionnaires have been modified to align with the IFRS climate disclosure requirements (above), and continue to evolve. According to CDP, over 23,000 companies around the world rely on the CDP disclosure framework.

United Nations Global Compact

The U.N. Global Compact is considered one of the world’s largest corporate sustainability initiatives; it is “principle based” in that this U.N. pact is non-binding and offers 10 voluntary principles that organizations can use to establish or enhance policies based on human rights, labor practices, the environment, and anti-corruption measures. These 10 Principles are aligned with the 17 Sustainable Development Goals (SDGs), which continue to serve as global guidelines and voluntary frameworks for greater corporate accountability.

The Takeaway

For investors who are exploring ways to invest sustainably, or invest in companies committed to ESG goals, it can be helpful to understand the landscape of ESG standards and reporting frameworks. While there are a number of existing ESG frameworks, a handful have been more widely adopted, which can be useful for ESG-focused investors to know.

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Photo credit: iStock/Drazen_

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

SOIN0722052

January Effect: What It Is and Is It Good for Investors?

What Is the January Effect?

What Causes the January Effect?

Tax-Loss Harvesting

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Portfolio Managers May Buy In January

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Is the January Effect Real?

January Effect and Efficient Markets

History of the January Effect

The Takeaway

9 ESG Metrics Investors Should Know

What Is ESG Investing?

ESG Metrics Are Key to ESG Reporting

What Are ESG Metrics?

The Use of ESG Frameworks

SEC Climate-Disclosure Rules on Hold

The Importance of ESG Metrics

The Limitations of ESG Metrics

9 Common ESG Metrics

3 Common Environmental Metrics

3 Common Social Metrics

3 Common Governance Metrics

How Do Firms Report ESG Metrics?

How Can Investors Use ESG Metrics?

The Takeaway

What Are Real Assets? Understanding Tangible Investments

Defining Real Assets

Characteristics of Real Assets

Real Assets vs. Financial Assets

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Types of Real Assets

Real Estate

Commodities

Infrastructure

Precious Metals

Benefits and Risks of Investing in Real Assets

Inflation Hedge

Portfolio Diversification

Potential for Steady Income

Liquidity Concerns

Market Volatility

Incorporating Real Assets into Your Investment Strategy

Asset Allocation

Direct vs. Indirect Investment Methods

REITs and ETFs

The Takeaway

FAQ

How do real assets perform during economic downturns?

What percentage of a portfolio should be in real assets?

Are real assets suitable for all types of investors?

What Is Extrinsic Value?

What Is Extrinsic Value?

Understanding Intrinsic and Extrinsic Value

How Extrinsic Value Works

Factors that Affect Extrinsic Value

1. Length of Contract

2. Implied Volatility

3. Others Factors

Extrinsic Value Example

Extrinsic vs Intrinsic Value

Extrinsic Value and Options: Calls vs Puts

Calls

Puts

The Takeaway

FAQ

Which options have the most extrinsic value?

Can an option’s extrinsic value be negative?

Understanding ESG Frameworks: Definition and Types

What Is an ESG Framework?

The State of ESG Frameworks

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What Is the Goal of an ESG Framework?

ESG Frameworks and Risk

Benefits of Using an ESG Framework

Types and Examples of ESG Frameworks

Global Reporting Initiative (GRI)

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