Apr
13
2023
Robo Advisor vs Financial Advisor: Which Should You Choose?
Discover the pros and cons of robo advising (also called automated investing) and those of using a human financial advisor to make the right choice for you.
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SoFi
Student Loan Consolidation and Refinancing
Apr
13
2023
Are Robo-Advisors Safe and Worth It?
Automated portfolios have become a common option offered by financial companies, providing many people with a cost-efficient way to invest for retirement and other goals — while helping to manage certain market and behavioral risks via automated features.
Because robo-advisors typically rely on sophisticated computer algorithms to help investors set up and manage a diversified portfolio, some have questioned whether technology alone can address the range of needs that investors may have — beyond basic portfolio management.
Others note that the lower fees and lower minimum balance requirements typical of most robo-advisors, in addition to certain automated features, may provide a much-needed option for new investors.
Is a Robo-Advisor Right for You?
Robo-advisors typically use artificial intelligence to generate retirement and financial planning solutions that are tailored to people’s individual needs. Here are some questions to ask yourself, when deciding whether a robo-advisor is right for you.
How Does a Robo-Advisor Pick Investments?
While the term robo-advisor can mean different things depending on the company that offers the service, investors usually fill out an online questionnaire about their financial goals, risk tolerance, and investment time frames. On the back end, a computer algorithm then suggests a portfolio of different securities based on those parameters.
For example one person may be investing for retirement, another saving for the purchase of a home. Depending on each person’s preferences, the robo-advisor generates an asset allocation that aligns with the person’s goals in the form of a pre-set portfolio.
A portfolio for someone nearing retirement age would typically have a different allocation versus a portfolio for someone in their 20s, for example. Depending on these details, the service might automatically rebalance the portfolio over time, execute trades, and may even conduct tax-loss harvesting. SoFi’s automated portfolio does offer automatic rebalancing, but not automatic tax-loss harvesting.
Can I Choose My Own Investments?
A robo advisor typically has a range of investments they offer investors. Usually these are low-cost index exchange-traded funds (ETFs), but the offerings can vary from company to company. In most cases, though, your investment options are confined to those available through the robo-advisor, and typically you’re offered a selection of pre-set portfolios with limited or no ability to change the securities in that portfolio.
As the industry grows and becomes increasingly sophisticated, more companies are finding ways to offer investors new options like themed ETFs, stocks from different market sectors, socially responsible or ESG investing options, and more.
Who Manages the Portfolio?
Part of the appeal for some investors is that these portfolios are automated and thus require less hands-on involvement. This may be useful for people who are new to the process of setting up and managing a diversified portfolio, or who don’t feel comfortable doing so on their own.
In some cases, a robo-advisor service may also offer a consultation with a live human advisor. But again, in most cases the investor has limited control over the automated portfolio.
💡 Recommended: Robo Advisors vs. Financial Advisors
Are There Risks Involved in Using a Robo-Advisor?
Investment always involves some exposure to market risks. But robo-advisors may help manage behavioral risk. Many studies have shown that investors can be impulsive or emotional when making investment choices — often with less than optimal results.
By reducing the potential for human error through the use of automation, a robo-advisor may help limit potential losses.
What Do Robo-Advisors Cost?
While there are some robo-advisor services that have higher minimum balance requirements or investment fees, the majority of these services are cost efficient.
In some cases there are very low or no minimums required to set up a portfolio. And the management fees are typically lower than what you’d pay for a human advisor (although there are typically brokerage fees and expense ratios associated with the investments in the portfolio).
Pros and Cons of Robo Advisors
Hopefully, the questions above have clarified the way a robo-advisor works and shed some light on whether a robo service would be right for you. In addition, there are some pros and cons to keep in mind.
Pros of Robo Advisors
Saving for Retirement
It’s true that you can use a robo-advisor for almost any short- or long-term goal — you could use a robo advisor to save for an emergency or another savings goal, for example. But in many ways these services are well-suited to a long-term goal like retirement. Indeed, most robo services offer traditional retirement accounts like regular IRAs, Roth IRAs, SEP IRAs.
The reason a robo-advisor service can be useful for retirement is that the costs might be lower than some other investment options, which can help you keep more of your returns over time. And the automated features, like portfolio rebalancing and tax optimization (if available), can offer additional benefits over the years.
Typically, many robo portfolios require you to set up automated deposits. This can also help your portfolio grow over time — and the effect of dollar-cost averaging may offer long-term benefits as well.
Diversification
Achieving a well-diversified portfolio can be challenging for some people, research has shown, particularly those who are new to investing. Robo-advisors take the mystery and hassle out of the picture because the algorithm is designed to create a diversified portfolio of assets from the outset; you don’t have to do anything.
In addition, the automatic rebalancing feature helps to maintain that diversification over time — which can be an important tool to help minimize risks. (That said, diversification itself is no guarantee that you can avoid potential risks completely.)
Automatic Rebalancing
Similarly, many investors (even those who are experienced) may find the task of rebalancing their portfolio somewhat challenging — or tedious. The automatic rebalancing feature of most robo-advisors takes that chore off your plate as well, so that your portfolio adheres to your desired allocation until you choose to change it.
Tax Optimization
Some robo-advisors offer tax-loss harvesting, where investment losses are applied to gains in order to minimize taxes. This is another investment task that can be difficult for even experienced investors, so having it taken care of automatically can be highly useful — especially when considering the potential cost of taxes over time.
That said, automatic tax-loss harvesting has its pros and cons as well, and it’s unclear whether the long-term benefits help make a portfolio more tax efficient.
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Cons of Robo-Advisors
Limited Investment Options
Most automated portfolios are similar to a prix fixe menu at a restaurant: With option A, you can get X, Y, Z investment choices. With option B, you can get a different selection, and so on. Typically, the securities available are low-cost index ETFs. It’s difficult to customize a robo account; even when there are other investments available through the financial company that offers the robo service, you wouldn’t have access to those.
In some cases, investors with higher balances may have access to a greater range of securities and are able to make their portfolios more personalized.
Little or No Personal Advice
The term “robo-advisor” can be misleading, as many have noted: These services don’t involve advice-giving robots. And while some services may allow you to speak to a live professional, they aren’t there to help you make a detailed financial plan, or to answer complex personal questions or dilemmas.
Again, for investors with higher balances, more options may be available. But for the most part robo-advisors only cover the basics of portfolio management. It’s up to each individual to monitor their personal situation and make financial decisions accordingly.
Performance
Robo-advisors have become commonplace, and they are considered reliable methods of investing, but that doesn’t mean they guarantee higher returns — or any returns. We discuss robo advisor performance in the section below.
Robo-Advisor Industry
Robo-advisors have grown quickly since the first companies launched in 2008-09, during and after the financial crisis. Prior to that, financial advisors and investment firms made use of similar technology to generate investment options for private clients, but independent robo advisor platforms made these automated portfolios widely available to retail investors.
The idea was to democratize the wealth-management industry by creating a cost-efficient investing alternative to the accounts and products offered by traditional firms.
Assets under management in the U.S. robo-advisor market are projected to reach about $2.76 trillion in 2023, according to Statista (estimates vary). There are dozens of robo-advisors available — from independent companies like SoFi Invest®, Betterment, and Ally, as well as established brokerages like Charles Schwab, Vanguard, T. Rowe Price, and more.
While this market is small compared to the $100 trillion in the global asset-management industry, robo-advisors are seen as potential game-changers that could revolutionize the world of financial advice.
Because they are direct-to-consumer and digital only, robo-advisors are available around the clock, making them more accessible. Their online presence has meant that the clientele of robo-advisors has tended to skew younger.
Also, traditional asset management firms often have large minimum balance requirements. At the high end, private wealth managers could require minimums of $5 million or more.
The cost of having a human financial advisor can also drive up fees north of 1% annually, versus the 0.25% of assets that robo-advisors typically charge (depending on assets on deposit). Note that this 0.25% is an annual management fee, and does not include the expense ratios of the underlying securities, which can add on another 5 or even 50 basis points, depending on the company and the portfolio.
How Have Robo-Advisors Performed in the Past?
Like any other type of investment — whether a mutual fund, ETF, stock, or bond — the performance of robo-advisors varies over time, and past performance is no guarantee of future returns.
Research from BackEnd Benchmarking, which publishes the Robo Report, a quarterly report on the robo-advisor industry, analyzed the performance of 30 U.S.-based robo-advisors. As of Dec. 31, 2022, the 5-year total portfolio returns, annualized and based on a 60-40 allocation, ranged from 2.84% to 5.12%. (Data not available for all 30 firms.)
💡 Recommended: How to Track Robo-Advisor Returns
The Takeaway
Despite being relative newcomers in finance, robo-advisors have become an established part of the asset management industry. These automated investment portfolios offer a reliable, cost-efficient investment option for investors who may not have access to accounts with traditional firms. They offer automated features that newer or less experienced investors may not have the skills to address.
Robo advisors don’t take the place of human financial advisors, but they can automate certain tasks that are challenging for ordinary or newbie investors: selecting a diversified group of investments that align with an individual’s goals; automatically rebalancing the portfolio over time; using tax-optimization strategies that may help reduce portfolio costs.
Curious to explore whether a robo-advisor is right for you? When you open an account with SoFi Invest®, it’s easy to use the automated investing feature. Even better, SoFi members have complimentary access to financial professionals who can answer any questions you might have.
Advisory services provided by SoFi Wealth LLC, an SEC-registered investment advisor.
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.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Fund Fees
If you invest in Exchange Traded Funds (ETFs) through SoFi Invest (either by buying them yourself or via investing in SoFi Invest’s automated investments, formerly SoFi Wealth), these funds will have their own management fees. These fees are not paid directly by you, but rather by the fund itself. these fees do reduce the fund’s returns. Check out each fund’s prospectus for details. SoFi Invest does not receive sales commissions, 12b-1 fees, or other fees from ETFs for investing such funds on behalf of advisory clients, though if SoFi Invest creates its own funds, it could earn management fees there.
SoFi Invest may waive all, or part of any of these fees, permanently or for a period of time, at its sole discretion for any reason. Fees are subject to change at any time. The current fee schedule will always be available in your Account Documents section of SoFi Invest.
SOIN0423003
Apr
11
2023
What Is an Annuity and How Does It Work?
We hear a lot about retirement savings options like IRAs and 401(k) plans, but a less talked about investing strategy for retirement is buying an annuity. An annuity is a contract with an insurance company. The buyer pays into the annuity for a certain number of years, at which point the company pays back the money in monthly payments.
An annuity guarantees a certain amount of monthly income in retirement. In essence, buyers pay the insurance company to take on the risk of them outliving their retirement savings. There are both pros and cons to annuities, as well as a number of types of annuities you can buy.
How Does an Annuity Work?
After signing up for an annuity, the account holder begins making payments, either over time or as a lump sum. The years of paying into an annuity are known as the accumulation phase. Sometimes, the payments can be made from an IRA or 401(k).
The money paid into the annuity account may be invested into the stock market or mutual funds, or it might earn a fixed interest rate over time.
Money paid into the annuity can’t be withdrawn for a certain amount of time, called the surrender period. After the accumulation phase is over, the company begins making regular income payments to the annuity owner. This is known as the distribution phase, or amortization period. Similar to 401(k) accounts, annuity payments begin after age 59 ½; a penalty may apply to withdrawals made before this.
One can choose the length and start date of the distribution phase. For example, you might choose to receive payments for 10 years, or perhaps you prefer guaranteed payments for the rest of your life. Terms and fees depend on the structure of the distribution phase.
Types of Annuities
The main annuity categories are fixed, variable, and indexed, but within those types there are various options and subcategories.
Fixed Annuities
The principal paid into a fixed annuity earns a fixed amount of interest, usually around 5%. Although the interest is typically not as high as the returns one might get from investing in the stock market, this type of annuity provides predictable and guaranteed payments.
Variable Annuities
This type of annuity lets buyers invest in different types of securities, usually mutual funds that hold stocks and bonds. Although this can result in a higher payout if the securities do well, it also comes with the risk of losing everything. Some variable annuities do come with a guarantee that investors will at least get back the money they put in.
Indexed Annuities
An indexed annuity is pegged to a particular index, such as the S&P 500. How the index performs will determine how much the annuity pays out. Usually, indexed annuities cap earnings in order to ensure that investors don’t lose money.
For example, they might cap annual earnings at 6% even if the index performed better than that. But then in a bad year, they would pay out 0% earnings rather than taking a loss, so investors would still receive their base payment amount.
Immediate Annuities
With immediate annuities, investors begin receiving regular payments almost as soon as they open an account. Immediate annuities can be expensive.
Deferred-Income Annuities
This type of annuity, also called a longevity annuity, is for people who are concerned they might outlive their retirement savings. Investors must wait until around age 80 to begin receiving payments, but they are guaranteed payments until they die.
The monthly payouts for deferred-income annuities are much higher than for immediate annuities, but risk is involved. If the investor dies before starting to receive payments, heirs do not receive the money in the annuity account. Married couples might opt for a joint-life version, which has lower monthly payouts but continues payments for as long as either spouse lives.
There is also a deferred annuity called a qualifying longevity annuity contract, which is funded all at once from an investor’s IRA or 401(k). One can invest up to 25% of the money from retirement accounts, or a maximum of $200,000.
Equity-Indexed Annuities
With equity-indexed annuities, investors receive a fixed minimum amount of income. That amount may increase if the index the annuity is pegged to increases.
Fixed Period Annuities
Fixed period annuities allow buyers to receive payments for a specific number of years.
Retirement Annuities
With retirement annuities, investors pay into the account while still working. Once they retire, they begin receiving payments.
Direct-Sold Annuities
These annuities have no sales commission or surrender charge, making them less expensive than other types of annuities.
Pros of Annuities
There are several reasons people choose to pay into annuities as part of their retirement plan. The upsides of annuities include:
• Guaranteed and predictable payments: Depending on the annuity, a guaranteed minimum income benefit can be set for a specific number of years or for the buyer’s life. Payments may even be made to a buyer’s spouse or other beneficiary in case of death.
• Tax-deferred growth: Interest earned on annuity deposits is not taxed immediately. Annuity owners generally don’t pay taxes on their principal investment; they pay income taxes on the earnings portion in the year they receive payments.
• Low-stress management: The annuity company uses an annuity formula to figure out how much each payment should be and to keep track of account balances. All the investor has to do is pay into the account during the accumulation phase.
• No investment limits or required minimum distributions: Unlike an IRA or 401(k), there is no limit to the amount of money that can be invested into an annuity. Further, there is no specific age at which investors must begin taking payments.
• Option to bolster other retirement savings: For those closer to retirement, an annuity may be a good option if they’ve maxed out their other retirement savings options and are concerned about having enough money for living expenses.
Cons of Annuities
Like any type of investment, annuities come with downsides:
• Lower interest compared to stocks or bonds: The interest earned by annuities is generally lower compared to what investors would earn in the stock market or bonds.
• Penalty for early withdrawals: Once money is invested in an annuity, it can’t be withdrawn without a penalty until age 59 ½.
• Fees: Annuities can have fees of 3% or more each year. There may also be administrative fees, and fees if the investor wants to change the terms of the contract. It’s important before buying an annuity to know the fees attached and to compare the costs with other types of retirement accounts.
• Possible challenges in passing on the money: If investors die before they start receiving payments, they miss out on that income. Some annuities pass the money on to heirs, but others do not. There may be a fee for passing the money on.
• Potential to lose savings in certain circumstances: If the insurance company that sold the annuity goes out of business, the investor will most likely lose their savings. It’s important for investors to research the issuer and make sure it is credible.
• Inflation isn’t factored in: Annuity payments usually don’t account for inflation. However, some annuities pay out higher amounts over time to account for cost of living increase.
• Risk: Variable annuities in particular are risky. Buyers could lose a significant amount, or even all of the money they put into them.
• Complexity: With so many choices, buying annuities can be confusing. The contracts can be dozens of pages long, requiring close scrutiny before purchasing.
What Are Annuity Riders?
When investors buy an annuity, there are extra benefits, called riders, that they can purchase for an additional fee. Optional riders include:
• Lifetime income rider: With this rider, buyers are guaranteed to keep getting monthly payments even if their annuity account balance runs out. Some choose to buy this rider with variable annuities because there’s a chance that investments won’t grow a significant amount and they’ll run out of money before they die.
• COLA rider: As mentioned above, annuities don’t usually account for inflation and increased costs of living. With this rider, payouts start lower and then increase over time to keep up with rising costs.
• Impaired risk rider: Annuity owners receive higher payments if they become seriously ill, since the illness may shorten their lifespan.
• Death benefit rider: An annuity owner’s heirs receive any remaining money from the account after the owner’s death.
How to Buy Annuities
Annuities can be purchased from insurance companies, banks, brokerage firms, and mutual fund companies. As mentioned, it’s important to look into the seller’s history and credibility, as annuities are a long-term contract.
The buyer can find all information about the annuity, terms, and fees in the annuity contract. If there are investment options, they will be explained in a mutual fund prospectus.
Some of the fees to be aware of when investing in annuities include:
• Rider fees: If you choose to buy one of the benefits listed above, there will be extra fees.
• Administrative fees: There may be one-time or ongoing fees associated with an annuity account. The fees may be automatically deducted from the account, so contract holders don’t notice them, but it’s important to know what they are before sealing the deal.
• Penalties and surrender charges: An annuity owner who wants to withdraw money from an account before the date specified in the contract will be charged a fee. Owners who want to withdraw money before age 59 ½ will be charged a 10% penalty by the IRS as well as taxes on the income from the annuity.
• Mortality and expense risk charge: Generally annuity account holders are charged about 1.25% per year for the risk that the insurance company is taking on by agreeing to the annuity contract.
• Fund expenses: If there are additional fees associated with mutual fund investments, annuity owners will have to pay them as well.
• Commissions: Insurance agents are paid a commission when they sell an annuity. Commissions may be up to 10%.
Building Your Portfolio
No matter what stage of life you’re in, it’s not too early or too late to build an investment portfolio. Younger investors may not be ready to buy into an annuity, but they can still start saving for retirement. For those who are considering an annuity as a retirement investment, it’s important to weigh both the pros and cons. Carefully evaluate the seller, any offered riders, and the fees associated with the annuity.
If you’re feeling torn on where to invest your money, that’s understandable. With so many investing options available, it can be overwhelming to decide how to begin. Fortunately, there are easy-to-use platforms like SoFi Invest®, which offers a full suite of investing tools right at your fingertips.
With just a few clicks, you can buy and sell stocks and build a portfolio. It’s also possible to research and track favorite stocks, set personalized financial goals, and see all of your accounts in one place. SoFi offers active investing, where you pick and choose each security you want to invest in, or automated investing.
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOIN0423018
Apr
11
2023
Is Automated Tax-Loss Harvesting a Good Idea?
Automated tax-loss harvesting can be a tool for tax-efficient investing because it involves using an algorithm to sell securities at a loss so as to offset capital gains and potentially lower an investor’s tax bill.
Standard tax-loss harvesting uses the same principle, but the process is complicated and an advisor might only harvest losses once or twice a year versus automated tax-loss harvesting which can be done more frequently.
That said, automated tax-loss harvesting — which is sometimes a feature of robo-advisor accounts — may give investors only limited (or possibly no) tax benefits. Here’s a breakdown of whether an automated tax-loss strategy makes sense.
Tax-Loss Harvesting: The Basics
First, a quick recap of how standard tax-loss harvesting works. Tax-loss harvesting is a way of selling securities at a loss, and then “harvesting” that loss to offset capital gains or other taxable income, thereby reducing federal tax owed.
The reason to consider this strategy is that capital gains are taxed at two different federal tax rates: long-term (when you’ve held an asset for a year or more) and short-term (when you’ve held an asset for under a year).
• Long-term capital gains are taxed at 0%, 15%, or 20%, depending on the investor’s tax bracket.
• Short-term capital gains are taxed at a typically higher rate based on the investor’s ordinary income tax rate.
The one-year mark is crucial, because the IRS taxes short-term investments at the higher marginal income tax rate of the investor. For high-income earners that can be 37% plus a 3.8% net investment income tax (NIIT). That means the taxes on those quick gains can be as much as 40.8% — and that’s before state and local taxes are factored in.
Example of Basic Tax-Loss Harvesting
For example, consider an investor in the highest tax bracket who sells security ABC after a year, and realizes a long-term capital gain of $10,000. They would owe 20%, or $2,000.
But if the investor sells XYZ security and harvests a loss of $3,000, that can be applied to the gain from security ABC. So their net capital gain will be $7,000 ($10,000 – $3,000). This means that they would owe $1,400 in capital gains tax.
The differences can be even greater when investors can harvest short-term losses to offset short-term gains, because these are typically taxed at a higher rate. In this case, using the losses to offset the gains can make a big difference in terms of taxes owed.
According to IRS rules, short-term or long-term losses must be used first to offset gains of the same type, unless the losses exceed the gains from the same type. When losses exceed gains, up to $3,000 per year can be used to offset ordinary income or carried over to the following year.
What Is Automated Tax-Loss Harvesting?
Until the advent of robo-advisor services some 15 years ago, tax-loss harvesting was typically carried out by qualified financial advisors or tax professionals in taxable accounts. But as robo-advisors and their automated portfolios became more widely accepted, many of these services began to offer automated tax-loss harvesting as well, though the strategy was executed by a computer program.
Just as the algorithm that underlies an automated portfolio can perform certain basic functions like asset allocation and portfolio rebalancing, some automated programs can execute a tax-loss harvesting strategy as well. SoFi’s automated platform does not offer automated tax-loss harvesting, but others may, for example.
So whereas tax-loss harvesting once made sense only for higher-net-worth investors owing to the complexity of the task, automation has enabled some retail investors to reap the benefits of tax-loss harvesting as well. The idea has been that automated tax-loss harvesting can be conducted more often and with less room for error, thanks to the precision of the underlying algorithm — which can also take into account the effects of the wash-sale rule.
The Wash-Sale Rule
It’s important that investors understand the “wash-sale rule” as it applies to tax-loss harvesting.
What Is the Wash-Sale Rule?
The wash-sale rule prevents investors from selling a security at a loss and buying back the same security, or one that is “substantially identical”, within 30 days. If you sell a security in order to harvest a loss and then replace it with the same or a substantially similar security, the IRS will disallow the loss — and you won’t reap the desired tax benefit.
In the example above, the investor who sells security XYZ in order to apply the loss to the gain from selling security ABC may then want to replace security XYZ because it gives them exposure to a certain market sector. While the investor can’t turn around and buy XYZ again until 30 days have passed, they could buy a similar, but not substantially identical security, to maintain that exposure.
That said, it can be tricky to follow this guidance because the IRS hasn’t established a precise definition of what a “substantially identical security” is. This is another reason why automated tax-loss harvesting may be more efficient: It may be simpler for a computer algorithm to make these choices based on preset parameters.
How ETFs Help With the Wash-Sale Rule
This is how the proliferation of exchange-traded funds (ETFs) has benefited the strategy of tax-loss harvesting. Exchange-traded funds, or ETFs, are baskets of securities that typically track an index of stocks, bonds, commodities or other assets, similar to a mutual fund. Unlike mutual funds, though, ETFs trade on exchanges like stocks.
In some ways, ETFs may make tax-loss harvesting a little easier. For instance, if an investor harvests a loss from an emerging-market stocks ETF, he or she can soon after buy a “similar” but non-identical emerging-market stocks ETF because the fund may have slightly different constituents.
Because most robo-advisors generate automated portfolios comprised of low-cost ETFs, this can also support the process of automated tax-loss harvesting.
Other Important Tax Rules to Know
Tax losses don’t expire. So an investor can apply a portion of losses to offset profits or income in one year and then “save” the remaining losses to offset in another tax year. Investors tend to practice tax-loss harvesting at the end of a calendar year, but it can really be done all year.
As noted above, another potential perk from tax-loss harvesting is that if the losses from an investment exceed any taxable profits from trades, the losses can actually be used to offset up to $3,000 of ordinary income per year.
How Much Does Automated Tax-Loss Harvesting Save?
It’s hard to say whether automated tax-loss harvesting definitively and consistently delivers a reduced tax bill to investors. A myriad of variables — such as the fluctuating nature of both federal tax rates and market price moves — make it difficult to calculate precise figures.
The Upside of Automated Tax-Loss Harvesting
One study of standard (not automated) tax-loss harvesting that was published by the CFA Institute in 2020 found that from 1926 to 2018, a simulated tax-loss harvesting strategy delivered an average annual outperformance of 1.08% versus a passive buy-and-hold portfolio.
Taking into account transaction costs and the wash-sale rule, the outperformance or “alpha” fell to 0.95%.
The study found the strategy did better when the stock market was volatile, such as between 1926 and 1949, a period which includes the Great Depression. The average outperformance was 2.13% a year during that period, as investors found more opportunities to harvest losses. Meanwhile, between 1949 and 1972 — a quieter period in the market as the U.S. underwent economic expansion after World War II — tax-loss harvesting only delivered an alpha of 0.51%.
The Downside of Automated Tax-Loss Harvesting
While the research cited above identifies some benefits of tax-loss harvesting, like many investment studies it’s based on historical data and simulations of a portfolio, not real-world investments.
Another fact to bear in mind: This study does not factor in the impact of automated tax-loss harvesting, which is typically conducted more frequently — and may not deliver a tax benefit.
Indeed, in 2018 the Securities and Exchange Commission (SEC) charged a robo-advisor for making misleading claims about the benefits of automated tax-loss harvesting in terms of higher portfolio returns. Investors should know that there could be no or little tax savings, or even a bigger tax bill, depending on how different securities perform after they’re sold (or bought back).
For instance, if the underlying algorithm that automates trades in a robo portfolio harvests a loss from one ETF (to offset the gains from a sale of another ETF), it might then purchase a replacement ETF that’s not substantially identical, per the wash-sale rule.
If the second ETF is sold later, the gains realized from this second sale could be so high that they cancel out or be greater than the tax benefits from selling the first fund to harvest the loss.
In that case, the investor could end up paying more taxes down the road — effectively deferring, not eliminating, the tax burden.
Continuously trading assets in automated tax-loss harvesting also means an investor may incur additional costs, such as more transaction fees.
Pros of Automated Tax-Loss Harvesting
1. Standard tax-loss harvesting is complex and time-consuming, but the benefits are well established. Therefore using automated tax-loss harvesting may be an efficient way to reap the benefits of this strategy because it can be done more automatically and consistently.
2. To realize the benefits of tax-loss harvesting investors must obey the IRS wash-sale rule, which imposes restrictions that can be tricky to follow. In this way, an automated strategy may limit the potential for human error and may increase the tax benefits for investors.
Cons of Automated Tax-Loss Harvesting
1. Because an algorithm performs tax-loss harvesting on an automated cadence, investors cannot choose which investments to sell and when and therefore have less control.
2. An automated tax-loss program may not be able to anticipate a security’s future gains that could reduce or eliminate the tax benefit of harvested losses.
3. Automated tax-loss harvesting could increase the amount an investor pays in transaction fees, which can lower portfolio returns.
The Takeaway
Automated tax-loss harvesting is a feature primarily offered by robo-advisors, which use a computer algorithm to automatically sell securities at a loss in order to potentially reduce the tax impact of capital gains realized from the sale of other securities.
While this practice can offer tax benefits in some cases, and academic studies have used portfolio simulations to gauge the potential for outperformance, it’s unclear whether automated tax-loss harvesting offers the same benefits. Because the strategy is carried out by an underlying algorithm, a computer program may not be capable of making more nuanced choices about which assets to sell and when.
Investors could potentially end up still owing capital gains taxes or paying more in transaction fees and brokerage fees.
If you’re ready to start investing, it’s easy to open an Active Invest account with SoFi Invest® and start trading stocks or set up an automated portfolio. SoFi’s automated portfolio does not offer tax loss harvesting. SoFi members have access to complimentary advice from a financial professional. Set up your portfolio today!
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.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [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.
SOIN0423001
Apr
11
2023
Investing in the Pharmaceutical Industry
The pharmaceutical industry, with nearly $1.5 trillion in global sales a year, offers many opportunities for investors. Some pharma stocks provide dividends, while others have potential for significant growth. Beyond these potential upsides, investing in pharmaceuticals also helps expand health care for people around the world.
But as with any industry, pharmaceutical stocks have risks, and investors would be wise to research each company before they buy stock. Here’s some key information about the industry and ways to find pharmaceutical stocks for interested investors.
An Intro to the Pharmaceutical Industry
Pharmaceutical companies research, develop, make, and sell medications, including preventive medicines, treatments, and vaccines. Two segments of therapeutics make up the industry: pharmaceuticals and biologics. It’s also important to know the difference between pharmaceutical stocks and biotech stocks.
Pharmaceutical drugs are tablets or pills made out of synthetic or plant-based chemicals. Because they are small and fairly easy to make, companies can produce hundreds of thousands of them. When drugs are first approved, they generally have a patent or market exclusivity, meaning that only the pharma company that developed them can manufacture and sell the drugs.
Once the patent or exclusivity ends, other companies can create generic forms of the drug and begin to compete with the pharma company. The generic drugs are chemical copies of the original drug but sell at lower prices, making it hard for the original pharma company to compete. This can lead to its stock losing value.
Meanwhile, biologics are products such as vaccines, gene therapies, and medications for blood disorders that are large, protein-based molecules made out of living cells. Biologics are more complex to manufacture, which is one reason they’re more expensive.
They also have tighter restrictions on distribution than pharmaceuticals do. These factors make it more challenging for companies to enter this space and for competitors to succeed. If competitors do create a similar product, it is called a biosimilar. Unlike generics, biosimilars aren’t interchangeable, so biologics don’t have the same stock drop-off that pharmaceuticals do.
It takes about 10 years and an average of $1.3 billion to $2.8 billion to bring a new drug to market, but in special circumstances, the FDA can expedite approval.
Why Invest in Pharmaceuticals?
With pharmaceuticals, whether investors are looking for high growth potential, long-term value, or stable dividends, they can find a pharma stock that will fit the bill. There are hundreds of early-stage and established stocks, mutual funds, and exchange-traded funds out there.
About 10,000 Americans turn 65 every day, according to the AARP. And by 2030, the country will have more residents 65 and older than children, the Census Bureau has projected.
This means more people needing health care and pharmaceutical drugs, which in turn is expected to make pharma stocks grow. U.S. health spending is projected to reach nearly $6.8 trillion by 2030, according to the Centers for Medicare & Medicaid Services.
Pharmaceutical stocks don’t always follow the same trends as other stocks because people need medications no matter what is going on in the market. This doesn’t mean that pharma stocks always perform better than the broader market, but sometimes they don’t follow the same lines. Certain pharmaceutical exchange-traded funds (ETFs) have historically performed quite a bit better than the S&P 500 Index.
The health care sector can perform well during tough economic times, since people always need health care no matter what is going on in the world. About 49% of people in the U.S. report having used at least one prescription drug in the past 30 days, with 24% using three or more, according to the Centers for Disease Control and Prevention.
This translates to the companies that make those drugs consistently earning revenue even when the rest of the stock market is down. Larger companies have fairly consistent income streams, while smaller companies that show promise get funding from investors and sometimes get acquired by larger companies.
A few other reasons pharmaceutical stocks look promising as a long-term investment are:
• People are living longer, and the majority of elderly Americans take prescription medications. The longer people live, the more years they will be paying for those drugs.
• The health care sector is expanding in countries outside the United States.
• The government has been spending more on health care research.
• New types of therapies, such as gene therapy, are getting more sophisticated. Some of these are very expensive.
How to Choose Pharmaceutical Stocks
With so much potential in pharma, it can be difficult to navigate the hype and figure out what’s really a good investment. Billions of dollars are invested in medical research and drugs each year. But not every company becomes a success.
As with any stocks, investors will want to research pharma stocks before buying. Here are a few key factors to look at when evaluating stocks.
Growth Prospects
By looking at a company’s earnings and revenue, one can see how much it’s been growing and whether growth is slowing down. Investors can also look into each company’s pipeline to see how close to market a drug being developed is.
Pharma companies have to go through certain steps to develop, test, and get drugs approved. They often make pipelines available to the public, so investors can see which drugs are in the early stages of development, preclinical testing, going through clinical trials in humans, or getting FDA approval or other necessary regulatory approvals.
Drugs may get approval for treatment of certain diseases or for specific demographics, but the makers can then apply for approval for additional uses. If they get the expanded approval, this can lead to growth for the company.
Knowing when to buy stocks is challenging, and trying to time the market generally isn’t a good strategy. That said, investors can follow different pharmaceutical companies to see when they have the potential to grow and become successful. If a pharma company has patents that are close to expiring, for instance, this may slow down growth, as competitors can create generic forms of the same drugs.
The process companies go through to develop and bring drugs to market is generally as follows:
• Drug discovery: During this phase, drugs and the diseases they can potentially treat are discovered.
• Preclinical trials: Potential drugs get tested in test tubes or on live animals.
• Clinical trials: Small human trials determine a safe dosage and how humans react to it. Then, groups of 100 or more people test the drug to discover short-term side effects and optimal dosage. Finally, groups of hundreds or thousands of people test the drug to determine efficacy and safety. When drugs reach the clinical trial stage, this could be a good time for investors to keep an eye on them. If a drug makes it through trials, the company has potential for significant growth. But if the drug fails during testing, the stock is unlikely to do well.
• Regulatory approval: In the United States, the Food and Drug Administration’s Center for Drug Evaluation and Research assesses and approves new drugs, and in the EU, approval is completed by the European Medicines Agency. If the benefits of the drug outweigh the side effects and risks, and the drug is a good alternative or additional treatment for the disease it is targeting, these agencies will consider approving the drug.
Types of FDA Application
There are different types of pharmaceutical FDA applications, some of which give companies more potential for stock growth than others. The application types are:
• Investigational new drug application: This is the first application step that companies must go through.
• New drug application: This is an application to market and sell a new drug. Companies filing this application have the most potential for stock growth because they are introducing a new product to market.
• Abbreviated new drug application: Companies developing a generic form of an existing drug go through this application.
• Therapeutic biologics application: This is required under the PHS Act for biologics.
• Over-the-counter drug application: This is for companies looking to sell over-the-counter drugs, which are categorized as being safe to distribute without a prescription.
Dividends
Not all pharmaceutical companies pay dividends, but some of them do provide consistent payouts to investors. The dividends can add up.
Qualitative and Quantitative Metrics
The same rules apply to pharmaceutical stocks as to any other stock when it comes to evaluation. Investors should look at a company’s valuation, revenues, growth, leadership team, product pipeline, and other key metrics to decide whether to invest. Stock valuation ratios, such as price-to-earnings ratio and price-to-earnings-growth ratio, are very useful when comparing different stocks within the same industry.
However, some pharmaceutical companies are not yet profitable if they are in the drug development and trial phases. In this case, investors can look at the rate of cash burn: how much money the company is spending each quarter to develop a drug. It’s very expensive to develop a drug, so if a company is burning through cash and doesn’t have much left to work with, this might not bode well for the stock.
Another useful metric to look at is the price-to-sales ratio. This compares a company’s sales to the price of its stock. If the company doesn’t have sales yet, investors can make predictions about what those sales figures might look like.
Trends and Developments
Over time, trends in the types of diseases being targeted and the types of therapies being developed change. Investors can look into stocks in popular areas of treatment to find stocks with growth potential.
For instance, many drugs are in development to treat breast cancer and non-small-cell lung cancer. Treatments that are bringing in significant revenue globally include oncologics, antidiabetics, respiratory therapies, and autoimmune disease drugs. Additional lucrative treatment areas include antibiotics, anticoagulants, pain, and mental health.
Risks of Investing in Pharmaceutical Stocks
As with any type of investment, pharma stocks come with some risks. Some of the main risks to be aware of are:
• Clinical failure: Many drugs don’t make it through the phases of clinical trials. If a drug has made it to the final stage, it’s more likely to succeed, but even at this phase, drugs can fail.
• Inability to obtain approval: Just because a drug does well in trials doesn’t mean it will be approved by regulatory agencies.
• Difficulties getting reimbursement and pricing drugs: Health insurance companies, government programs, or individuals must cover the cost of drugs, and companies aren’t always able to secure the money they need. Sometimes, companies are pressured to lower the price of drugs to make them more accessible, and this can result in financial struggles for the company.
• Industry competition: As mentioned, when patents run out, pharma companies can struggle to keep up with competitors that develop cheaper generic versions of drugs. In addition, during the drug development phase, it’s not uncommon for multiple companies to be working on medications to treat the same illness. If one company can make it to trials or get approval first, this can put them way ahead of the competition, especially if it results in patent exclusivity.
• Litigation and liability: In the pharmaceutical industry, lawsuits are common. Drugs can also be recalled from the market if they’re found to be unsafe.
Investing in Pharmaceutical Stocks
If you’re looking to start investing in the pharmaceutical industry, you might consider buying pharmaceutical ETFs. Or, you could do your due diligence and choose individual stocks, aiming for stable dividends or growth potential. Before investing, it helps to familiarize yourself with the pharmaceutical industry to better understand how to choose pharma investments, and also ensure you understand the potential risks of investing in pharmaceutical stocks.
Online platforms are a great tool to use if you’re investing in ETFs and other stocks, whether in the pharmaceutical industry or elsewhere. SoFi Invest®, for instance, offers a suite of tools to track specific stocks, select individual stocks, trade fractions of stocks, or purchase ETFs.
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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.
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.
SOIN0423017
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