Growing Wealth Archives | Page 55 of 224

Oct

2023

What Is the Yield Curve? How It’s Used as a Market Indicator

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

The yield curve itself is a basic graph of the interest rates paid by bonds at different maturities (e.g., two-year, five-year, 10-year bonds). But many investors interpret the slope of the yield curve as a harbinger of what might lie ahead for the U.S. economy.

The yield curve can be an indicator of economic expectations, but not a reliable predictor of events. That said, analysis of historical data patterns shows that understanding the yield curve can be useful for investors.

4 Types of Yield Curves and What They Mean

The yield curve is published by the Treasury every trading day. It reflects the yield or interest rates paid by Treasury securities for one-month through 30-year maturities. The Treasury’s figures also help to set the rates for other debt securities on the market, as well as mortgages and other loan rates offered by banks.

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What is a yield curve, and what does it look like? Here are four common yield-curve patterns and what each might mean for investors.

1. Normal Yield Curve

Under ordinary conditions, longer-maturity bonds will offer a higher yield to maturity than shorter-term bonds. For that reason, the “normal” yield curve shape has an upward slope, with longer-maturity debt providing investors with higher interest rates.

For example, imagine that a two-year bond offers a yield of 0.5%, a five-year bond offers 1.0%, a 10-year offers 1.8%, and a 30-year offers a yield of 2.5%. When these points are connected on a graph, they exhibit a shape of a normal yield curve. It is the most common type of curve, and tends to indicate a positive economic outlook.

2. Steep Yield Curve

Just as a normal upward-sloping bond yield curve is associated with periods of economic expansion, a steep yield curve is seen by investors as an even stronger sign of economic growth on the horizon — as future yields rise higher to take possible inflation into account.

Another reason that a steep yield curve might indicate periods of stronger growth is that lenders are willing to make short-term loans for relatively low interest rates, which tends to stimulate economic activity and growth.

In late 2008, the yield curve became notably steeper, as the Federal Reserve eased the money supply in response to the financial crisis. A bull market followed that lasted over a decade, from 2009 to 2020.

3. Inverted Yield Curve

Bond yield curves aren’t always normal or upward-sloping. With an inverted yield curve, for instance, the yields for shorter-term debt are higher than the yields for longer-term debt. A quick look at an inverted yield curve will show it curving downward as bond maturities lengthen, which can be a sign of economic contraction.

Since 1955, an inverted yield curve has preceded most, if not all U.S. recessions that have occurred. Usually, the curve inverts about two years before a recession hits, so it can be an early warning sign.

The reason is that, historically, an inverted yield curve can reflect significant shifts in the economy or financial markets. The yield curve might invert because investors expect longer-maturity bonds to offer lower rates in the future, for example. One reason for those lower yields is that often during an economic downturn investors will seek out safe investments in the form of longer-duration bonds, which has the effect of bidding down the yields that those bonds offer.

Inverted yield curves are uncommon, and sometimes decades will pass between them. In October 2007, the yield curve flattened (which can precede an inverted yield curve) precipitating the global financial crisis.

4. Flat and Humped Yield Curves

There are also flat or humped bond yield curves, in which the yields of shorter- and longer-term bonds are very similar. While a flat yield curve is self-explanatory, a humped yield curve is one in which bonds with intermediate maturities may offer slightly higher yields. Those higher yields in the middle give the curve its hump.

Investors see flat or humped yield curves as a sign of a coming shift in the broader economy. They often occur at the end of a period of strong economic growth, as it begins to spur inflation and slow down. But these yield curves don’t always portend a downturn.

Sometimes a flat or humped bond yield curve may appear when the markets expect a central bank, such as the Federal Reserve, to increase interest rates. Flat and humped markets can also emerge during periods of extreme uncertainty, when investors and lenders want similar yields regardless of the duration of the debt.

What Is the Current Yield Curve?

2y10y treasury spread 1977-2022

When investors ask, What is the yield curve?, it’s important to remember that it’s not a fixed market factor, but one that changes daily.

Here’s an example: On October 5, 2021, the three-month Treasury bill paid an interest rate of 0.04%, while the two-year bond paid an interest rate of 0.28%, the five-year bond paid an interest rate of 0.98%, the 10-year bond paid an interest rate of 1.54%, and the 30-year bond paid an interest rate of 2.10%.

The yield curve on that day, with lower short-term yields that rise as the duration of the debt security grows longer, is a good example of a “normal” yield curve.

The difference between the 0.04% yield offered by the three-month T-bill and the 2.10% yield offered by the 30-year bond on Oct. 5, 2021, was 2.06%. At the beginning of August, the three-month Treasury bill paid an interest rate of 0.05%, while the 30-year Treasury bill paid an interest rate of 1.86%. The difference at that time was 1.81%. So it would be accurate to say that the yield curve is normal, and grew somewhat steeper over the course of about two months.

How Investors Can Interpret the Yield Curve

The yield curve has value for investors as an indicator of a host of economic factors, including inflation, growth, and investor sentiment. While it can’t be used to make exact predictions, the yield curve can help investors anticipate potential economic changes, and weigh their financial choices in light of this. The yield curve can’t necessarily help investors choose individual stocks, but it can be of use when formulating broad investment strategies.

For example, if a flat or inverted yield curve indicates the possibility of an economic slowdown, then it might be a good time to purchase the stocks of companies that have historically done well during economic downturns, such as providers of consumer staples.

But if the yield curve is steep – indicating economic growth and higher interest rates – it may be worth considering adding more luxury-goods makers and entertainment companies to your portfolio.

The yield curve also has ramifications for real estate investors. A flat or inverted curve could warn of a slowdown and a drop for current real estate prices. But a steepening of the yield curve can mean just the opposite for real estate.

Changes to the yield curve have the most profound implications for fixed-income investors, however, as steep yield curves indicate that inflation is on the way. And inflation has the effect of eroding the yields on existing bonds, as the purchasing power of those yields goes down.

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Fixed-income investors also face unique challenges in the rare event of a yield curve inversion. Many investors are accustomed to earning a higher yield in exchange for longer debt maturities, but in an inverted curve, they can no longer find that premium. As a result, many of these investors will opt for shorter-term debt instruments, which offer competitive rates, instead of getting locked into the low rates offered by longer-term bonds.

Recommended: Short-Term vs. Long-Term Investments

The Takeaway

The yield curve may be just a basic graph of the interest rates paid by bonds of different maturities, but historical data shows that the yield curve can also be a useful economic indicator for investors. You don’t want to take it too far and assume the yield curve can predict economic events, but since the yield curve is published every day by the U.S. Treasury, it can capture certain economic shifts in real time.

With a normal yield curve, short-term bond rates are lower than long-term bond rates, and the curve swoops upward — which is a positive economic indicator, suggesting steady economic growth and investor sentiment. When short- and longer-term bond rates are similar, and the yield curve flattens, that can indicate that some economic changes may be afoot. Historically, when the yield curve inverts and short-term bond rates are higher than long-term rates, that can signal a recession might be down the road.

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Photo credit: iStock/akinbostanci

SOIN0723068

Oct

2023

What Is Yield?

By SoFi | Growing Wealth, Investing, Terminology | No Comments

Yield is the income generated by an investment over a period of time. Yield is typically calculated by taking the dividend, coupon or net income earned, dividing the figures by the value of the investment, then calculating the result as a percentage.

Yield is not the same as return or the rate of return. Yield is a way to track how much income was earned over a set period, relative to the initial cost of the investment or the market value of the asset. Return is the total loss or gain on an investment. Returns often include money made from dividends and interest. While all investments have some kind of rate of return, not all investments have a yield, because not all investments produce interest or dividends.

How Do You Calculate Yield?

Yield is typically calculated annually, but it can also be calculated quarterly or monthly.

Yield is calculated as the net realized income divided by the principal invested amount. Another way to think about yield is as the investment’s annual payments divided by the cost of that investment.

Here are formulas depending on the asset:

= Dividends Per Share/Share Price X 100%
= Coupon/Bond Price X 100%
= Net Income From Rent/Real Estate Value X 100%

For example, if a $100 stock pays out a $2 dividend for the year, then the yield for that year is 2 ÷ 100 X 100%, or a 2% yield.

Cost Yield vs. Current Yield

One important thing to think about when doing yield calculations is whether you’re looking at the original price of the stock or the current market price. (That can also be referred to as the current market value or face value.)

For example, in the above example, you have a $100 stock that pays a $2 dividend. If you divide that by the original purchase price, then you have a 2% yield. This is also known as the cost yield, because it’s based on the cost of the original investment.

However, if that $100 stock has gone up in price to $120, but still pays a $2 dividend, then if someone bought the stock right now at $120, it would be a 1.67% yield, because it’s based on the current price of the stock. That’s also known as the current yield.

Rate of Return vs. Yield

Calculating rate of return, by comparison, is done differently. Yield is simply a portion of the total return.

For example, if that same $100 stock has risen in market price to $120, then the return includes the change in stock price and the paid out dividend: [(120-100) + 2] ÷ 100, so 0.22, or a 22% total return.

The reason this matters is because the rate of return can change if the stock price changes, but often the yield on an investment is established in advance and generally doesn’t fluctuate too much.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

Definition of Yield for Different Investments

Yield in Stock Investing

When you make money on stocks it often comes in two forms: as a dividend or as an increase in the stock price. If a stock pays out a dividend in cash to stockholders, the annual amount of those payments can be expressed as a percentage of the value of the security. This is the yield.

Many stocks actually pay out dividends quarterly. In order to calculate the annual yield, simply add up all the dividends paid out for the year and then do the calculation. If a stock doesn’t pay a dividend, then it doesn’t have a dividend yield.

Note that real estate investment trusts (REITs) are required to pay out 90% of their taxable income to existing shareholders in order to maintain their status as a pass-through entity. That means the yield on REITs is typically higher than for other stocks, which is one of the pros for REIT investing.

Sometimes investors also calculate a stock’s earnings yield, which is the earnings over a year, dividend by the share price. It’s one method an investor may use to try to value a stock.

Yield in Bond Investing

When it comes to bonds vs. stocks, the yield on a bond is the interest paid—which is typically stated on the bond itself. Bond interest payments are usually determined at the beginning of the bond’s life and remain constant until that bond matures.

However, if you buy a bond on the secondary market, then the yield might be different than the stated interest rate because the price you paid for the bond was different from the original price.

For bonds, yield is calculated by dividing the yearly interest payments by the payment value of the bond. For example, a $1,000 bond that pays $50 interest has a yield of 5%. This is the nominal yield. Yield to maturity calculates the average return for the bond if you hold it until it matures based on your purchase price.

Some bonds have variable interest rates, which means the yield might change over the bond’s life. Often variable interest rates are based on the set U.S. Treasury yield.

Is There a Market Yield?

Treasury yields are the yields on U.S. Treasury bonds and notes. When there is a lot of demand for bonds, prices generally rise, which causes yields to go down.

The Department of the Treasury sets a fixed face value for the bond and determines the interest rate it will pay on that bond. The bonds are then sold at auction. If there’s a lot of demand, then the bonds will sell for above face value also known as a premium.

That lowers the yield on the bond, since the government only pays back the face value plus the stated interest. (If there’s lower demand, then the bonds may sell for below face value, which increases the yield.)

When Treasury yields rise, interest rates on business and personal loans generally rise too. That’s because investors know they can make a set yield on government issued products, so other investment products have to offer a better return in order to be competitive. This affects the market in that it affects the rates on mortgages, loans, and in turn, market growth.

There isn’t a set market yield, since the yield on each stock and bond varies. But there is a yield curve that investors track, which is a good reference. The yield curve plots Treasury yields across maturities—i.e., how long it takes for a bond to mature. Typically, the curve plots upward, since it takes more of a yield to convince an investor to hold a bond for a longer amount of time.

An inverted yield curve can be a sign of an oncoming recession and can cause concern among investors. While you don’t necessarily need to track 10-year Treasury yields or worry about the yield curve, it is good to know what the general yield meaning is for investors so you can stay informed about your investments.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

The Takeaway

A high yield means more cash flow and a higher income. But a yield that is too high isn’t necessarily a good thing. It could mean the market value of the investment is going down or that dividends being paid out are too high for the company’s earnings.

Of course, yield isn’t the only thing you’re probably looking for in your investments. Even when investing in the stock market, you may want to consider other aspects of the stocks you’re choosing: the history of the company’s growth and dividends paid out, potential for future growth or profit, the ratio of profit to dividend paid out. You may also want a diversified portfolio made up of different kinds of assets to balance return and risk.

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SOIN0723027

Oct

2023

What Is a Closed-End Fund?

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

Closed-end funds, or CEFs, are a lesser-known type of investment fund that may benefit income investors who are looking to build a portfolio that provides both diversification and passive income. Similar to other funds such as index funds, mutual funds and exchange-traded funds (ETFs), CEFs pool together funds to purchase a basket of different types of assets, including stocks, bonds, and more.

By investing in them individuals gain exposure to a variety of investments through a single portfolio asset. Many retirees’ investment strategies include CEFs because of their high yields.

What Makes CEFs Unique?

The main difference between CEFs and other funds is that they are “closed,” meaning that investors can’t buy into them at any time they want. Instead, CEFs hold an initial public offering (IPO), similar to a stock IPO, when investors can buy into them and then close sales once the offering ends.

It’s useful to evaluate CEFs based on their Net Asset Value (NAV), which is the sum of the assets in the fund’s portfolio. Brokerage firms post CEF Net asset values on a daily basis. The NAV differs from the CEF’s market price. CEF shares may sell for a discount to their market value, making it beneficial to buy them through the market rather than in their initial offering.

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CEFs vs ETFs: How They Compare

CEFs and ETFs (which have their own pros and cons) have some obvious similarities, and some key differences that investors should be aware of.

CEF and ETF Similarities

• Trade on exchanges during daily trading hours like stocks

• Fund portfolios can be leveraged

• Can offer capital gains and distributions to investors

• Have fee schedules and expense ratios

• Hold portfolios of investments that have a total value

• Investors can trade shares like stocks using margins, shorting, and limit orders

• Can focus on specific sectors or broad indexes

CEF and ETF Differences

• ETFs usually track the performance of an index, whereas CEFs are actively managed

• Investors are more likely to pay capital gains with CEFs than with ETFs

• ETFs can’t issue debt or preferred shares, while CEFs can use these tools to create leverage

• ETFs have features that ensure their share price doesn’t differ very much from their net asset value. In contrast, it’s common for a CEF’s net asset value and share price to be different.

Recommended: ETFs vs Index Funds

CEFs vs Mutual Funds: What’s the Difference?

Like CEFs vs ETFs, CEFs and mutual funds have similarities and differences, too.

CEF and Mutual Fund Similarities

• Can pay out income and capital gains distributions to investors

• Run by professional management teams

• Have fee schedules and expense ratios

• Have a net asset value and contain multiple investments

CEF and Mutual Fund Differences

• Mutual funds issue and redeem shares daily, whereas CEFs trade on exchanges

• CEFs can issue debt and preferred shares in order to leverage their net assets, which can increase the amount of their distributions as well as the fund’s volatility

Recommended: Mutual Funds vs ETFs

Types of CEFs

Like other types of funds, every CEF has a different investment strategy and asset size. Funds may hold millions of dollars in assets or billions. Each has its advantages and downsides.

The main issue with small CEFs is they generally don’t trade at high volumes. That means that if an investor holds a large position they can actually affect the price when they buy or sell.

CEF Distributions

CCEFs pay out distributions on a regular basis. These are similar to dividend payments but have some key differences.

Since CEFs include both stocks and bonds, distributions can include bond interest payments, equity dividends, return of capital, and realized capital gains. The tax on the investment income from those earnings may differ between funds since they each have a different asset makeup.

CEF distributions can change over time, so a fund that has a very high payout may make cuts to it. So while an investor may choose a CEF with a high yield, it’s important to keep in mind that it could change over time.

One way to find a fund with an ideal yield is using the distribution-to-NAV ratio. CEFs are actively managed, and the managers need to earn money in order to pay out distributions. So by looking at the net asset value of the CEF compared to its distributions, investors can see whether a CEF will be able to maintain its current yield rate. If the NAV isn’t high enough to maintain a high distribution, the manager may cut the distributions.

One main benefit of CEFs is since they are actively managed, the managers can redistribute investments to maximize returns. However, like any asset, CEFs don’t always perform well. Some CEFs focus on a particular industry, and if that industry isn’t doing well the CEF may not perform well either. The success of a CEF also depends on the management team.

Recommended: How Often Are Dividends Paid?

How to Buy and Sell CEFs

It’s simple to buy and sell CEFs on major stock exchanges, and both beginning investors and those with more experience can participate in the CEF market. Investors can trade them during regular trading hours just like ETFs and stocks, although there are far fewer CEFs available on the market and they have much smaller trading volumes.

CEF Fees

One major downside of investing in CEFs is the high fees. Annual CEF fees tend to top 2%. However, the fees are taken out of the fund so investors may not notice them immediately. Proponents of CEFs claim that they have high fees because they have high quality managers who help the fund earn more money.

Fees can also include the cost of leverage, which is a tool CEFs use to make the fund more profitable. CEFs have more borrowing ability than individuals, so they can greatly benefit from using leverage, making the high fees worth it for investors. Of course, using leverage for investing also brings on additional risk.

It’s important for investors to consider whether paying high fees is worth it based on the performance of any particular CEF.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

The Takeaway

CEFs are a type of investment fund that typically offers diversification and passive income. CEFs have several similarities to exchange-traded funds and mutual funds, but they are closed investments that typically have higher fees and smaller trading volumes.

CEFs are also unique in that they have IPO-like market debuts. In effect, CEFs are something special on the market, and may be attractive to investors for a number of reasons. However, investors would do well to do their homework before investing – as always.

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

Photo credit: JLco – Julia Amaral

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

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

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

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

SOIN0723029

Oct

2023

Dogs of the Dow: Meaning, How It Works & Examples

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

What Are the Dogs of the Dow?

The “Dogs of the Dow” is an investment strategy that focuses on large, established companies that offer relatively high dividends. There are different ways to pursue the strategy, but it generally attempts to outperform the Dow Jones Industrial Average (DJIA) by investing in the highest dividend-yielding stocks from among the 30 stocks that comprise the DJIA.

The Dow Jones is among the oldest and most popular stock indices in the world, with casual investors often using it as a shorthand for the performance of the broader stock market, and even the global economy. Over time, the Dogs of the Dow tends to perform in line with it.

The Dogs of the Dow strategy became popular in 1991 with the publication of Beating the Dow in which author Michael B. O’Higgins coined the term “Dogs of the Dow.” The strategy itself reflects the assumption – usually true – that blue-chip companies have the stability to continue to pay out their regular dividends regardless of the performance of their stocks.

How the Dogs of the Dow Work

The formula for identifying the companies in the Dogs of the Dow is – by the standards of economics – fairly simple. It comes down to the stock’s dividend yield, calculated by dividing the annual dividend paid by a stock (in dollars) by its stock price. The stocks with the highest dividend yields are the Dogs of the Dow.

Followers of the Dogs of the Dow strategy believe the dividend paid by a company more accurately reflects its average value than the trading price of that company’s stock. Unlike the dividend, the stock price is always in flux.

When the stock prices of companies go down in response to the business cycle, the ratio of those companies’ dividends to their stock prices will go up. In other words, the dividends of those stocks will be disproportionately high in relation to their stock prices. Adherents of the Dogs of the Dow strategy believe the companies with that high dividend-to-stock-price ratio will eventually revert to their mean and should grow faster when the business cycle turns, and their prices increase. In addition to promising performance, the strategy also offers investors regular income in the form of dividend payments.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Who Are the Dogs of the Dow in 2023?

The 2023 Dogs of the Dow are led by Verizon with a dividend yield of 6.62%, followed by Dow with a dividend yield of 5.56%. The others are: Intel (5.52%), Walgreens (5.14%), 3M (4.97%), IBM (4.68%), Amgen (3.24%), Cisco (3.19%), Chevron (3.16%), and JP Morgan Chase (2.98%).

The Dogs are always changing, as are the companies that make up the DJIA itself. In 2020, for example, Salesforce.com joined the index – a rare entrant that has never paid its investors a dividend. In the same year, troubled aerospace titan and DJIA member Boeing suspended its dividend.

Between 2022 and 2023, Cisco and JP Morgan Chase joined the list, and Merck and Coca-Cola left the list because their dividend yields dropped.

It’s easy to see that the highest-yielding stocks in the DJIA are always changing. This means that an investor who is pursuing this strategy needs to regularly rebalance their holdings, whether monthly, quarterly or annually.

One reason such rebalancing is necessary is that even though the large stocks in the DJIA typically have lower volatility than some other stocks, their values still change over time. So rebalancing is an important step toward preventing a situation where one stock plays too big of a role in a portfolio’s performance. But with a Dogs of the Dow strategy, rebalancing is even more important, as the companies that fit the description will change on a semi-regular basis.

Investing in the Dogs of the Dow

Different investors view the Dogs of the Dow differently. Some say it’s only the five or 10 DJIA stocks with the highest dividend-to-share-price relationship. But it’s worth noting that not all 30 companies on the DJIA index currently pay dividends.

Investors can buy 10, 15 or all 30 of those stocks through a brokerage account. Or they can invest in the DJIA by purchasing exchange-traded funds (ETFs). There are even Dogs of the Dow ETFs that invest in the dividend-focused strategies similar to Dogs of the Dow approach. But when buying one of these funds, it is important to read their strategies before investing.

Recommended: What Are Dividend ETFs?

Pros and Cons of Dogs of the Dow Strategy

There are several advantages to using a Dogs of the Dow strategy, but there are also some drawbacks for investors to consider.

Dogs of the Dow: Pros

• The strategy invests in Blue Chip companies with a long history of success and industry-leading positions.

• It has a history of outperforming the DJIA.

• Investors receive regular dividend payments.

Dogs of the Dow: Cons

• The IRS taxes dividends paid by the stocks at the income-tax rate rather than the lower capital gains rate.

• It is a value-oriented strategy that may lag during growth markets.

• The strategy isn’t widely diversified.

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

Does Dogs of the Dow Still Work?

The Dogs of the Dow struggled during the market upheaval of 2020. As a group of 10, the Dogs lost 13% over the course of the year, well below the 7% increase posted by the DJIA. In 2021, the Dogs were also below the DJIA and the S&P 500. And 2021 was the third straight year the Dogs didn’t do as well as the broader Dow.

However, in 2022, Dogs of the Dow did better than the DIJA with a positive return of 2.2%, while the DJIA had a negative return of -7.0.

Historically, Dogs of the Dow has occasionally done worse than the broader DJIA, notably in the financial crisis of 2008, when it suffered larger losses than the index. But through the 10 years that followed, it outperformed the Dow, though not profoundly.

But even small amounts of outperformance add up over time. A $10,000 investment in the DJIA made at the outset of 2008 would have grown to approximately $17,350 by the end of 2018. The same amount invested in the Dogs of the Dow strategy would have reached $21,420 by the end of 2018, assuming that the investor rebalanced their holdings once per year.

The Takeaway

Dogs of the Dow is an investment strategy that uses dividends as a way to spot undervalued Blue Chip stocks, and to benefit from economic cycles.

While investors may be interested in exploring the Dogs of the Dow, the strategy does have pros and cons. Investors should weigh the benefits and drawbacks carefully before using it.

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Photo credit: iStock/Helin Loik-Tomson

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

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

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

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SOIN0723058

Oct

2023

What are Underlying Assets?

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

In financial circles, assets make the world go round. The goal is to accumulate the most valuable assets to create and sustain long-term wealth.

That lifelong process starts with education, and that, in turn, begins with a key tenet of wealth building: knowing all about underlying assets and what role they play in portfolio management.

What is an Underlying Asset?

An underlying asset is the foundational security, or investment vehicle, on which derivatives operate. Underlying assets can be individual securities (like stocks or bonds) or groups of securities (like in an index fund).

A derivative represents a financial contract between two or more parties based on the current or future value of an underlying asset. Derivatives can take many forms, with trading in widely used markets like futures, equity options, swaps, and warrants. These are high-risk, high-reward vehicles where investors bet on the future value of an underlying asset, and they are often used as hedges against other investments (which seeks to reduce investment risk) or as speculative instruments that pay off down the road (which can heighten investment risk.)

That’s where underlying assets come into play. To make the most optimal derivative bets, investors aim to either hedge risk or enhance it, by making speculative moves in higher-risk areas like options and futures. The underlying assets that enable those bets are critical to the derivatives investment process.

💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

How Underlying Assets Work

To illustrate how underlying assets work in the derivatives market, let’s use options trading as an example.

An option is a financial derivative that gives the contract owner the right to buy or sell an underlying security at a specific time and at a specific price. When an option is exercised by the contract holder, that simply means the holder has exercised the rights to buy or sell an underlying asset and now owns (or sells out of) the underlying asset.

Options come in two specific categories: puts and calls.

• Put options allow the options owner to sell an underlying asset (like a stock or commodity) at a certain price and by a certain date (known as the expiration date.)

• Call options enable the owner to buy an underlying asset (like a stock or a commodity) at a certain price and at a certain date.

The underlying asset comes into play when that options contract is initiated.

Example of an Underlying Asset in Play

Let’s say for example that an investor opts to buy Microsoft (MSFT) at an options strike price (the price you can buy the shares) of $275 per share. The stock is currently trading at $325 per share. The contract is struck on September 1 and the options contract expiration date is November 30.

Now that the contract is up and running, the performance of the underlying asset (Microsoft stock) will define the success or failure of the options investment.

In this scenario, the options owner now has the “option” (hence the name) to buy 100 shares of Microsoft at $275 per share on or before November 30. If the underlying stock, which is now trading at $300, remains above the $275 strike price, the options owner can exercise the contract and make a profit on the investment.

If, for example, MSFT slides to $280 per share in the options contract timeframe, the call options owner can exercise the purchase of Microsoft at $275 per share, $5 below the current value of the stock (i.e., the underlying asset.) With each contract representing 100 shares of stock, the profits can add up on the call option investment.

If on the other hand, Microsoft stock falls below the $275 per share level, and the November 30 deadline has come and gone, the options owner loses money, as the underlying asset is valued at less than $275, although that’s the price the options owner has to pay for the stock by the expiration date.

That scenario represents the power of the underlying asset. The derivatives investment depends entirely on the performance of the underlying asset, with abundant risk for derivative speculators who’ve bet on the underlying asset moving in a certain direction over a certain period of time.

💡 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.

5 Different Types of Underlying Assets

Underlying assets come in myriad forms in the derivatives trading market, with certain assets being more equal than others.

Here’s a snapshot.

1. Stocks

One of the most widely used underlying assets are stocks, which is only natural given the pervasiveness of stocks in the investment world.

Derivatives traders rely on common and preferred stocks as benchmark assets when making market moves. Since stocks are so widely traded, it gives derivatives investors more options to speculate, hedge, and generally leverage stocks as an underlying asset.

2. Bonds and Fixed Income Instruments

Bonds, typified by Treasury, municipal, and corporate bonds among others, are also used as derivative instruments. Since bond prices do fluctuate on general economic and market conditions, derivative investors may try to leverage bonds as an underlying asset as both bond interest rates and price fluctuate.

3. Index Funds

Derivative traders also use funds as underlying assets, especially exchange-traded funds (ETFs), which are widely traded in intra-day trading sessions. Besides being highly liquid and fairly easy to trade, exchange-traded funds are tradeable on major global exchanges at any point during the trading day.

That’s not the case with mutual funds, which can only be traded after the day’s trading session comes to a close. The distinction is important to derivative traders, who have more opportunities for market movement with ETFs than they might with mutual funds.

ETFs also cover a wide variety of investment market sectors, like stocks, bonds, commodities, international and emerging markets, and business sector funds (such as manufacturing, health care, finance, and more recently, cryptocurrencies). That availability gives derivatives investors even more flexibility, which is a characteristic investors typically seek with underlying assets.

4. Currencies

Global currencies like the dollar or yen, among many others, are also frequently deployed by derivative investors as underlying assets. A primary reason is the typically fast-moving foreign currency (FX) market, where prices can change rapidly based on geopolitical, economic, and market conditions.

Currencies usually trade fast and often, which may make for a volatile market — and derivative investors tend to steer cash toward underlying assets that demonstrate volatility, as quick market movements allow for quick money-making opportunities. Given that they move so quickly, currencies can also move in the wrong direction quickly, which is why investment experts generally advise individual investors to shy away from markets where investment risk is abundant.

5. Commodities

Common global commodities like gold, silver, platinum, and oil and gas, are also underlying assets that are widely used by derivatives investors.

Historically, commodities are one of the most volatile and fast-moving investment markets. Like currencies, commodities are often highly desirable for derivative traders, but high volatility may lead to significant investment losses in the derivatives market if the investor lacks the experience and acumen needed to trade against underlying assets.

The Takeaway

Underlying assets used in derivative deals can come with high risk — and trading against those assets require a comprehensive knowledge of trading, leverage, hedging and speculation.

Those attributes are typically aligned with high-end investment firms, hedge firms, and other institutional investors. They’re not typically associated with regular people looking to save for retirement and build household wealth. Regular investors will likely be looking to balance risk and return to help save for the future.

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

Photo credit: iStock/MixMedia

SOIN0723059

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