Why Diversification Strengthens a Portfolio?

It may be tempting to concentrate your money in a few familiar sectors or in companies for which you have a personal affinity. But putting all your eggs in one basket makes you vulnerable.

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Q: What is a Diversified Portfolio?

Portfolio diversification involves spreading your money across different asset classes—such as stocks, bonds, and real estate—rather than concentrating all of it in one area. It also involves diversifying how you allocate your money within each sector.

Jun

2024

Portfolio Diversification: What It Is and Why It’s Important

By AJ Smith | Growing Wealth, invest, Investing | No Comments

Portfolio diversification involves investing your money across a range of different asset classes — such as stocks, bonds, and real estate — rather than concentrating all of it in one class. The logic is that by diversifying the assets in your portfolio, you may offset a certain amount of investment risk, and thereby, hopefully, improve returns.

Taking portfolio diversification to the next step — further differentiating the investments you have within asset classes (for example, holding small-, medium-, and large-cap stocks, or a variety of bonds) — may also be beneficial.

Building a diversified portfolio is only one of many financial tools that can help mitigate investment risk and improve performance. But there is a lot of research behind this strategy, so it’s a good idea to understand how it works and how it might benefit your financial plan.

What Is Portfolio Diversification?

Portfolio diversification refers to spreading a portfolio’s investments across asset classes, industries, sectors, geographies, and more, in an effort to reduce investment risk, as noted.

When you invest in stocks and other securities, you may be tempted to invest your money in a handful of sectors or companies where you feel comfortable. You might justify this approach because you’ve done your due diligence, and you feel confident about those sectors or companies. But rather than protecting your money, limiting your portfolio like this could make you more vulnerable to losses.

To understand this important aspect of portfolio management, it helps to know about the two main types of risk: Systemic risk, and unsystematic risk.

• Systematic risk, or market risk, is caused by widespread events like inflation, geopolitical instability, interest rate changes, or even public health crises. You can’t manage systematic risk through diversification, though; it’s part of the investing landscape.

• Unsystematic risk is unique or idiosyncratic to a particular company, industry, or place. Let’s say, for example, a CEO is implicated in a corruption scandal, sending their company’s stock plummeting; or extreme weather threatens a particular crop, putting a drag on prices in that sector. This is what may be referred to as unsystematic risk.

While investors may not be able to do much about systematic risk, portfolio diversification may help mitigate unsystematic risk. That’s because even if one investment is hit by a certain negative event, another holding could remain relatively stable. So while you might see a dip in part of your portfolio, other sectors can act as ballast to keep returns steady.

This is why diversification matters.

You can’t protect against the possibility of loss completely — after all, risk is inherent in investing. But building a portfolio that’s well diversified helps reduce your risk exposure because your money is distributed across areas that aren’t likely to react in the same way to the same occurrence.

💡 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.

What Should a Diversified Portfolio Look Like?

60:40 stock bond split returns 1977-2023

A fairly basic example of a relatively diversified portfolio may concern the 60-40 rule, which is a basic rule-of-thumb for asset allocation: You invest 60% of your portfolio in equities and 40% in fixed income and cash.

But that’s just one example. A portfolio can contain a broader mix of assets that includes stocks, bonds, alternative assets, real estate, and much more.

The mix you choose will likely be determined by factors such as your age, investment objectives, and/or risk tolerance. But this model reflects the basic principles of diversification: By investing part of your portfolio in equities and part in bonds/fixed income, you can manage some of the risk that can come with being invested in equities.

Stocks

You can fill your portfolio with stocks, and that would have some upsides and downsides. Most prominently, perhaps, is that stocks, compared to fixed-income assets, offer the potential for higher returns in exchange for higher risk.

If you’re invested 100% in equities, you’re more vulnerable to a market downturn that’s due to systematic risk, as well as shocks that come from unsystematic risk. By balancing your portfolio with bonds, say, which usually react differently than stocks to market volatility, you can offset part of that downside.

Of course, that also means that when the market goes up, you likely wouldn’t see the same gains as you would if your portfolio were 100% in equities.

Bonds

By the same token, if your portfolio is invested 100% in bonds offering a fixed rate of return, you might be shielded to a certain extent from market volatility and other risk factors associated with equities, but you likely wouldn’t get as much growth either.

Other Investments

As noted, you can also add other types of investments to the mix. While a typical portfolio may mostly comprise stocks and bonds, a smaller portion — maybe 10%-20%, just as an example — could hold real estate, or even cryptocurrencies. But again, there would ideally be a mixture of different types of those assets, too, in a diversified portfolio.

Again, a 60-40 portfolio is an example of simple diversification (sometimes called naive diversification) — which means investing in a range of asset classes. Proper diversification would have you go deeper, and invest in several different stocks (domestic, international, tech, health care, and so on), as well as an assortment of fixed income instruments.

Diversification Considerations for Different Stages

It’s also important to take your stage of life into account when considering how to diversify your portfolio and what asset allocation may be right for you.. Broadly speaking, the younger you are, the more risk you may be willing to take with your specific mix of investments (likely more stocks). While stocks may be more volatile and risky in the short-term, they tend to perform better than other lower-risk assets over the long-term.

The older you are, and the closer you are to retiring or needing to liquidate the equity in your portfolio, the less risk you may be willing to take.

Again, this will depend on the individual’s goals and risk tolerance, but consider the stage of your life and investing journey when deciding on your allocation and diversification strategy.

It may be a good idea to regularly review your allocation and change up your asset mix every few years, or work with a financial professional to make sure that your portfolio is aligned with your goals.

6 Ways to Diversify Your Portfolio

To attain a diversified portfolio, it’s important to think through your asset allocation, based on your available capital and risk tolerance. It’s also important to spread investments out within each asset class.

There can be a number of ways to diversify your portfolio, including (but not necessarily limited to) the following strategies.

Invest in a Range of Stocks or Index Funds

Diversifying a stock portfolio requires thinking about a number of factors, including quantity, sector, the risk profile of different companies, and so on.

• Quantity. Instead of owning shares of just one company, a portfolio may have a margin of protection when it’s invested in many stocks (perhaps dozens or even hundreds).

• Sector. You may want to think about a range of sectors, e.g. consumer goods, sustainable energy, agriculture, energy, and so on.

• Variety. Variety is the spice of life, as they say, and variety in the types of stocks you are selecting is also an important factor. A mix of small-, mid-, and large-cap companies may offer diversification. Small-cap stocks, which might include startups, for example, have the potential to offer substantially higher returns than more stable large-cap companies, but they also come with greater risk.

You can further diversify by style. Some investors may opt for a mix of cyclical versus defensive companies, those closely tied to economic growth cycles versus ones that aren’t. Some investors may prefer value vs. growth stocks, companies that are underpriced rather than those that demonstrate faster revenue or earnings growth.

One common way to diversify a stock portfolio is to avoid picking individual stocks and invest instead in a mutual fund or exchange-traded fund (ETF) that offers exposure to dozens of companies or more. This is known as passive investing, as opposed to active. But it can be an effective way to diversify.

Invest in Fixed Income Assets, Such as Bonds

Investing in bonds is a good way to diversify your portfolio because they tend to perform very differently from stocks. Bonds offer a set interest rate, and though bond yields can be lower than the return on some stocks, you can generally predict the income you’ll get from bond investments.

Bonds tend to be less risky than stocks, but they aren’t risk free. They can be subject to default risk or call risk — and can also be subject to market volatility, especially when rates rise or fall. But bonds generally move in the opposite direction from stocks, and so can serve to counterbalance the risk associated with a stock portfolio.

You can diversify your mix of bonds, as well. High-yield bonds offer higher interest rates, but have a greater risk of default from the borrower. Short-term Treasury bonds, on the other hand, tend to be safer, but the return on investment isn’t as high.

You may also consider specific types of bonds, such as green bonds, which typically invest in sustainable organizations or municipal projects, or municipal bonds, which can offer tax benefits. And you can expand your options, and create more diversification, when you invest in bond mutual funds, or exchange-traded bond funds.

Consider Investing in Real Estate

Real estate may provide a hedge against inflation and tends to have a low correlation with stocks, so it can also provide diversification. The housing market and equity market can influence each other — case in point: the 2008 recession, when widespread troubles in real estate led to a stock market crash. But they don’t always have such a strong relationship. When stocks or bonds drop, real estate prices can take much longer to follow.

Conversely, when the markets improve, housing can take a while to catch up. Also, every real estate market is different. Location-specific factors that have nothing to do with the broader economy can cause prices to soar or plummet. Real estate can also be unpredictable and comes with risk, such as illiquidity and changing property values, which is something to keep in mind.

These are all factors to consider when investing in real estate. In addition, there are different types of investments, like Real Estate Investment Trusts (REITs), which can provide exposure to different types of properties without you having to own them.

Alternative Investments

While stocks, bonds, and cash equivalents are among the most common investments, you can diversify your portfolio by putting money into alternative investments, such as commodities, private credit, private equity, foreign currencies, and real estate, mentioned above. Alternatives can also include collectibles, such as art, wine, cars, or even non-fungible tokens (NFTs).

Alternatives have a low correlation with conventional assets, and have the potential to offer investors higher returns. Of course, knowing something about the area you want to invest in, or doing a bit of research, is likely a good idea before you get started.

However, alternative investments can be particularly risky compared to other types of assets. Their values may be particularly volatile and subject to a variety of factors, and it’s possible that some investors may even find themselves being targeted as a part of a scam — which is common, for instance, in the crypto space. Remember that though alternative investments may offer the opportunity to secure high returns, they can also subject investors to high potential losses.

Short-term Investments and Cash

Another possibility is to opt for low-risk short-term investments, such as certificates of deposit (CDs). A CD is a savings account that requires you to keep your funds locked up for a set amount of time (typically a few months to a few years). In exchange it pays you a fixed interest rate that may be higher than a traditional savings account.

A diversification strategy can also involve holding some funds in cash, just in case the bottom falls out on other investments.

International Investments

Another strategy for diversification is to invest in both U.S. and foreign stocks. Spreading out your investments geographically might protect you from market volatility concentrated in one area. When one region is in recession, you may still have holdings in places that are booming. Also, emerging and developed markets have different dynamics, so investing in both can potentially leave you with less overall risk.

Why Is Portfolio Diversification Important?

Diversification is important mainly because it can help investors mitigate risk. Although creating a well-diversified portfolio may help improve performance, risk minimization is the true end of diversification efforts.

Of course past performance is no guarantee that outcomes of those portfolio allocations will be the same in the future. But the research is interesting in that it suggests certain strategies might be effective in mitigating risk.

Introducing greater diversification, by way of bonds and fixed income instruments, actually may create a portfolio with similar returns, but lower volatility over time.

💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

Pros and Cons of Diversification

As with any investment strategy, diversification has its pros and cons.

Pros

The clearest benefit, or pro, to diversification is that it may help reduce risk in a portfolio. That can create a smoother ride, so to speak, for investors during times of high market volatility, and there is also evidence, as discussed, that diversified portfolios can provide equal or better returns over time.

Cons

The drawbacks to diversification include the fact that short-term gains may be limited by a more risk-averse approach. It can also take more time and energy to manage your portfolio, or to check in and consider your allocation — although that will depend on your specific strategy.

The Takeaway

Portfolio diversification is one of the key tenets of long-term investing. Instead of putting all your money into one investment or a single asset class like stocks or bonds, diversification spreads your money out across a range of securities. Investors should make sure they vary their investments in a way that matches their goals and tolerance for risk.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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.

FAQ

What is an example of a well-diversified portfolio?

An hypothetical example of a well-diversified portfolio could be one used by hedge fund founder Ray Dalio, who constructed an example portfolio that includes 30% stocks, 40% bonds, 15% U.S. bonds, 7.5% gold, and 7.5% other commodities. Again, this is just one example, and this particular mix is likely not ideal for many investors.

What are the dangers of over-diversifying your portfolio?

The main risk associated with over-diversification is that you stymie your portfolio’s potential gains while seeing diminishing returns in terms of risk mitigation. In other words, you cost yourself potential gains while not meaningfully reducing risk.

When should you diversify your portfolio?

It may be a good idea to diversify your portfolio as soon as you start investing. Further, you can repeatedly check your allocation at regular intervals, to ensure you’re properly diversified in accordance with your risk tolerance, age, and goals.

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.

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

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.

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.

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.

SOIN-Q224-1905286-V1

May

2024

How Often Should You Rebalance Your Portfolio?

By Michael Flannelly | Growing Wealth, invest, Investing | No Comments

Rebalancing your portfolio refers to tweaking the specific mix of assets and investments an investor owns. Once an investor has put together their portfolio, they’ll be faced with the question of how often to rebalance that portfolio to maintain an ideal mix of stocks, bonds, and other assets, in order to maintain a degree of diversification.

Generally, investors can rebalance their portfolios as often or as little as they want. It all depends on individual circumstances and goals.

What Is Portfolio Rebalancing?

Portfolio rebalancing is a way to adjust the asset mix of investments. It means realigning the assets of a portfolio’s holdings to match an investor’s desired asset allocation.

The desired allocation of investments in an investor’s portfolio — a combination of assets like stocks, bonds, mutual funds, commodities, and real estate — should be made with individual risk tolerance and financial goals in mind.

For example, an investor with a conservative risk tolerance might build a portfolio more heavily weighted towards less volatile assets, like bonds. The conservative investor may have a portfolio with 60% bonds and 40% stocks. In contrast, a younger investor may be more comfortable with riskier assets and build a portfolio with more stocks. The younger investor’s portfolio may have an asset allocation of 70% stocks and 30% bonds.

Over time, however, the different asset classes will likely have varying returns. So the amount of each asset changes — one stock or fund might have such high returns it eventually grows to be a more significant portion of the portfolio than an investor wants.

For example, if the younger investor aims to have 70% stocks and stock prices go up drastically during a year, the portfolio may consist of 80% stocks. That’s when it could be time for the investor to rebalance to maintain the target allocation of stocks.

💡 Quick Tip: Did you know that the term robo advisor is a little misleading? An auto investing account isn’t a robot and typically doesn’t offer personalized investment advice. But it does use sophisticated technology to suggest investment options that may suit your goals and risk level.

Why You Should Consider Rebalancing Your Portfolio

Investors may want to rebalance their portfolios as a method to maintain their target asset allocation. This can help investors stay on track to reach long-term financial goals.

The target asset allocation is a plan outlining the percentage of each asset class an investor wants to hold in their portfolio. A target asset allocation is based on investor goals and risk tolerance.

It might be tempting to think that if a specific asset has outperformed, one should keep a higher portion of their portfolio in that asset and not rebalance. But if an investor doesn’t rebalance, the portfolio may eventually drift away from the target asset allocation. This might be a problem because it can change the amount of risk in a portfolio.

How Often Do You Need to Rebalance Your Portfolio?

Investors can rebalance their portfolios whenever they want, depending on personal preferences. However, some investors rebalance their portfolios at set time points, whether monthly, quarterly, or annually.

For many people, it makes sense to use these time markers to examine the asset allocation of their portfolios and decide if their investments need adjusting. This time-based approach makes it easier to get in the habit of rebalancing.

The downside of rebalancing at set calendar points is that investors may risk rebalancing needlessly. For example, if an investor’s portfolio drifted just 1% from stocks to bonds at the end of the quarter doesn’t mean they should rebalance. Rebalancing a portfolio with little asset drift might lead to unnecessary transaction costs and other investment fees.

In contrast, other investors rebalance at set allocation points — when the weights of assets in a portfolio change a certain amount. An investor may rebalance a portfolio when the target asset allocation drifts a certain percentage, like 5% or 10%.

Determining how often an investor should rebalance their portfolio also depends on how active they want to be in their investment management and what stage of life they’re in — maybe those closer to retirement will want to rebalance more frequently as a risk-avoidance strategy.

How to Rebalance Your Portfolio

An investor can rebalance a portfolio themselves by selling some assets that are above the target asset allocation and using the proceeds to buy up securities that are below the target allocation.

Investors who plan to rebalance their portfolios should keep track of quarterly and monthly statements from their brokerage and retirement accounts. These statements will give an investor a sense of the value of a portfolio and the overall asset allocation. Once the investor has a handle on rebalancing to reach a target allocation, they’ll need to buy and sell shares or securities to maintain their ideal asset allocation.

However, there can be a fine line between prudent rebalancing and potentially harmful overtrading. While many people like to be involved and actively manage their portfolios, the downside is that active trading can lead to trading at the wrong time. Further, buying and selling shares may incur fees, which eats into the gains or any strategy an investor is trying to execute by rebalancing.

Different Types of Portfolio Rebalancing

There are several ways to rebalance investments for different goals and life stages. Three major strategies include rebalancing to ensure investments are still diversified, using so-called “smart beta” strategies, and rebalancing retirement accounts.

Rebalancing for Diversification

The most basic form of rebalancing is maintaining a diversified portfolio. Over time, a portfolio can become less diverse, as different assets have different rates of return and make up a more significant percentage of the invested money. This is where rebalancing comes in.

For example, assume an investor has a $100,000 portfolio composed of $60,000 in stocks and $40,000 in bonds. After one year, the value of the stock holdings increased by 30%, while the bonds grew by 5%. This portfolio now has a value of $120,000: $78,000 worth of stocks — 65% of the portfolio — and $42,000 worth of bonds — 35% of the portfolio. In this case, the investor would sell enough stocks to get back down to 60% of the portfolio, or $72,000, and buy bonds to get the allocation up to 40%, or $48,000.

An investor would likely have more detailed and sophisticated allocation goals in the real world, but this example illustrates how some simple arithmetic can guide rebalancing.

Smart Beta Rebalancing

Another approach to asset allocation is known as smart beta, a strategy that combines passive index investing with more discretionary active investing strategies. Smart beta rebalancing is typically done by portfolio managers of mutual funds and exchange-traded funds (ETFs).

With passive index investing, an investor buys a fund consisting of stocks that track the performance of a benchmark index, like the whole S&P 500. The stocks in these index funds are weighted based on their market capitalization. The managers of the index funds handle the rebalancing of holdings when market caps shift.

Smart beta is rules-based, like index investing. But instead of tracking a benchmark index weighted towards market cap, funds with smart beta strategies hold securities in areas of the market where managers think there are inefficiencies. Additionally, smart beta funds consider volatility, quality, liquidity, size, value, and momentum when weighting and rebalancing holdings. In this way, smart beta adds an element of active investing to passive investing. And as with index investing, investors can employ a smart beta strategy by buying smart beta mutual funds or ETFs, though they come with higher fees.

Rebalancing Retirement Accounts

In many cases, retirement savings are in investment accounts. Investors need to be aware of the allocation and balances of their retirement accounts, whether they’re 401(k)s, IRAs, or a combination thereof.

The principles at play are similar to any portfolio rebalancing, but investors need to consider changing risk tolerance as they get closer to retirement. Generally, investors will adopt a more conservative target asset allocation as they near retirement. Target date funds typically work by automatically rebalancing over time from stocks to bonds as investors get closer to retirement.

For investors to stay on top of this themselves, they’ll need to know how they want their investments allocated each year as they get closer to retirement and then use quarterly or annual rebalancing to buy and sell securities to hit those allocation targets.

The Takeaway

Rebalancing an investment portfolio can help investors stay on track to meet their long-term goals. By ensuring that there is a steady mix of assets in their portfolio, they can stay on top of their investments to work with their risk tolerance and financial needs.

There are ways investors can rebalance their portfolios on their own and use different strategies. Rebalancing, allocation, and diversification are important concepts for investors to understand, and may help investors generate returns aligned with their goals over the long term when used wisely.

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

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.

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.

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.

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.

SOIN-Q224-1885866-V1

May

2024

Active vs Passive Investing: Differences Explained

By AJ Smith | Growing Wealth, invest, Investing | No Comments

Key Points

• Active investing strategies often underperform the market over time, while passive strategies tend to outperform.

• Active funds typically have higher fees, which can lower returns, while passive funds have lower fees.

• Active investing relies on human intelligence and skill to capture market upsides, while passive investing relies on algorithms to track market returns.

• Active investing is generally less tax efficient, while passive investing is typically more tax efficient.

• Passive investing may be less tied to market volatility, while active investing is more vulnerable to market shocks.

Active investing vs. passive investing generally refers to the two main approaches to structuring mutual fund and exchange-traded fund (ETF) portfolios. Active investing is a strategy where human portfolio managers pick investments they believe will outperform the market — whereas passive investing relies on a formula to mirror the performance of certain market sectors.

Which approach is better, active investing vs. passive? There seems to be no end to this debate, but there are factors that investors can consider — especially the difference in cost. Because active investing typically requires a team of analysts and investment managers, these funds are more expensive and come with higher expense ratios. Passive funds, which require little or no involvement from live professionals because they track an index, cost less.

Also, there is a body of research demonstrating that indexing typically performs better than active management. When you add in the impact of cost — i.e. active funds having higher fees — this also lowers the average return of many active funds. Following are a few more factors to consider when choosing active investing vs. passive strategies.

Active vs Passive Investing: Key Differences

The following table recaps the main differences between passive and active strategies.

Active Funds	Passive Funds
Many studies show the vast majority of active strategies underperform the market on average, over time.	Most passive strategies outperform active ones over time.
Higher fees can further lower returns.	Lower fees don’t impact returns as much.
Human intelligence and skill may capture market upsides.	A passive algorithm captures market returns, which are typically higher on average.
Typically not tax efficient.	Typically more tax efficient.
Potentially less tied to market volatility.	Tied to market volatility and more vulnerable to market shocks.

💡 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.

Active Investing Definition

What is active investing? Active investing is a strategy where an investor attempts to beat the market by trading individual stocks, bonds, or other securities.

With active investing, either an individual investor could be the one trading securities in their own portfolios, or portfolio managers of actively managed exchange-traded funds (ETFs) and mutual funds could be the one buying and selling assets to outperform the market or a specific sector.

Active investors and actively-managed funds often trade stocks and securities to profit in the short term. Short-term trading, like day trading, can be difficult as it requires the investor to be an expert on the financial markets and the factors impacting stock prices. It also requires the investor to have a good deal of discipline, as short-term stock picking can be a volatile and risky endeavor.

Active Investing Pros and Cons

Active investing is what live portfolio managers do; they analyze and then select investments based on their growth potential. Active strategies have a number of pros and cons to consider when comparing them with passive strategies.

Pros and Cons of Active Investing
Pros	Cons
May be fun to follow the market and make your own investment decisions	Difficult to beat the market
May profit in up, down, and sideways markets	Time consuming
Can tailor a strategy based on your goals and risk tolerance	Higher fees and commissions

Pros

• One potential advantage of having a real person crunching numbers and making investment decisions is that they may be able to spot market opportunities and take advantage of them. A computer algorithm is not designed to pivot the way a human can, which might benefit the performance of an actively managed ETF or mutual fund.

• Whereas a passive strategy is designed to follow one market sector index (e.g. the performance of large cap U.S. companies via the S&P 500® index), an active manager can be more creative and is not limited to a single sector.

• The number of actively managed mutual funds in the U.S. stood at about 6,585 as of June 2023 vs. 517 index funds, according to Statista. Given that there are many more active funds than passive funds, investors may be able to select active managers who have the kind of track record they are seeking.

Cons

• The chief downside of active investing is the cost. Hedge funds and private equity managers are one example, charging enormous fees (sometimes 10%, 15%, 20% of returns) for their investing acumen.

But even standard actively managed funds, which may charge 1% or 1.5% or even 2% annually, are far higher than the investment fees of most passive funds, where the annual expense ratio might be only a few basis points.

• The majority of active strategies don’t generate higher returns over the long haul. According to the well-known SPIVA (S&P Indices vs. Active) 2022 year end scorecard report, 95% of U.S. active equity funds underperformed their respective S&P indexes over the last two decades. So investors who are willing to pay more for the insight and skill of a live manager may not reap the rewards they seek.

• A professional manager may create more churn in an actively managed fund, which could lead to higher capital gains tax.

Passive Investing Definition

Passive investing strategy is when an investor buys and holds a mix of assets for an extended period. Many passive investors will invest in passively-managed index funds, which attempt to replicate the performance of a benchmark index. Passive investors are not necessarily trying to beat the market.

Passive Investing Pros and Cons

The term “passive investing” may not have a strong positive connotation, yet the funds that follow an indexing strategy typically do well vs. their active counterparts.

Pros

• Passive strategies are more transparent. Because index funds simply track an index like the S&P 500 or Russell 2000, there’s really no mystery how the constituents in the fund are selected nor the performance of the fund (both match the index).

• As noted above, index funds outperformed 79% of active funds, according to the SPIVA scorecard.

• Passive strategies are generally much cheaper than active strategies.

• Passive strategies can be more tax efficient as there is generally much less turnover in these funds.

Cons

• Because passive funds use an algorithm to track an existing index, there is no opportunity for a live manager to intervene and make a better or more nimble choice. This could lead to lost opportunities.

• Passive strategies are more vulnerable to market shocks, which can lead to more investment risk.

Which Should You Pick: Active or Passive Investing?

Deciding between active and passive strategies is a highly personal choice. It comes down to whether you believe that the active manager you pick could be among the few hundred who won’t underperform their benchmarks; and that the skill of an active manager is worth paying the higher investment costs these strategies command.

You could also avoid treating the active vs. passive investing debate as a forced dichotomy and select the best funds in either category that suit your goals.

The Takeaway

Active vs. passive investing is an ongoing debate for many investors who can see the advantages and disadvantages of both strategies. Despite the evidence suggesting that passive strategies, which track the performance of an index, tend to outperform human investment managers, the case isn’t closed.

After all, passive investing may be more cost efficient, but it means being tied to a certain market sector — up, down, and sideways. That timing may or may not work in your favor. Active investing costs more, but a professional may be able to seize market opportunities that an indexing algorithm isn’t designed to perceive.

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

FAQ

What is the difference between active and passive investing?

The main difference between active and passive investing is that active investing is when a portfolio manager — or the investor themselves — manages their portfolio, buying and selling investments to try to outperform the market. Passive investing is when an investor buys assets and holds onto them for a long period. Passive investing usually means investing in index funds, which track the performance of an index.

What are the examples of active funds?

According to a Morningstar February 2024 analysis, some examples of actively managed ETFs include the Avantis U.S. Equity ETF (AVUS), the Capital Group Dividend Value ETF (CGDV), and the Dimensional Core U.S. Equity 1 ETF (DCOR). Note that these are just examples. An investor should always do their own research before making any investments.

Does active investing have high risk?

Active investing is considered higher risk. Active investors and actively-managed funds often trade stocks and securities to profit in the short term. Short-term trading typically requires knowledge about financial markets and the factors impacting stock prices. It can be volatile and risky.

Should I invest in active or passive funds?

Deciding whether to invest in active or passive funds is a personal choice that only you can make. It depends on your personal situation, goals, and risk tolerance, among other factors. In general, passive investing is better for beginners, and active investing is better for experienced investors with knowledge of the market and who understand the risk involved.

Are ETFs active or passive?

ETFs can be active or passive. Passive ETFs track indexes such as the S&P 500 and may make sense for investors pursuing a buy and hold strategy. Active ETFs rely on portfolio managers to select and allocate assets in an effort to try to outperform the market.

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

SOIN0124067

May

2024

How to Know When to Sell a Stock

By Inyoung Hwang | Growing Wealth, invest, Investing | Comments Off

Table of Contents

When Is a Good Time to Sell Stocks?
8 Reasons You Might Sell a Stock
4 Reasons You Might Not Want to Sell a Stock
Selling a Stock 101

Knowing when to sell a stock is a complex enterprise, even for the most sophisticated investors. In a perfect world you’d sell a stock when you’d made a profit and wanted to capture the gains. But even that scenario raises questions of your target amount (have you made enough?) and timing (would it be better to hold the stock longer?).

Similar questions arise when the stock is losing value. Is it a true loser or is the company just underperforming? Should you sell and cut your losses — or would you be locking in losses just before a rebound?

Adding to the above there are questions of personal need, opportunity costs, tax considerations, and more that investors must keep in mind as they decide when to sell their stocks. Fortunately there is a fairly finite list of considerations, as well as different order types like market sell, stop-loss, stop-limit, and others that give investors some control over the decision of when to sell a stock.

Key Points

• Knowing when to sell a stock is complex, considering factors like profit, timing, personal needs, taxes, and investment style.

• Factors to consider when deciding to sell a stock include goals, company fundamentals, economic trends, volatility, and taxes.

• Some investors rarely sell stocks, while others sell more frequently based on their investment goals and desired returns.

• Reasons to sell a stock include loss of faith in the company, opportunity cost, high valuation, personal reasons, and tax considerations.

• Reasons to hold onto a stock include potential growth, belief in long-term performance, economic forecasts, and avoiding emotional decision-making.

When Is a Good Time to Sell Stocks?

There are a few ways to approach the question of when to sell stocks. Risk, style, investing goals, and how much time you have are all critical variables. Perhaps the most relevant answer is “when you need to,” as that criterion alone requires specific calculations that depend on your overall plan, the type of investor you are, your risk tolerance, market conditions (i.e. stock market fluctuations), and of course the stock itself.

When deciding when to sell a stock, you might weigh:

• How the stock fits into your goals

• Company fundamentals

• Economic trends

• Your hoped-for profit

• Volatility and/or losses

• Taxes

In addition, whether you sell your stocks will boil down to your investment style — are you day trading or employing a buy-and-hold strategy? — how much risk you’re willing to assume, and your overall time horizon and other goals (i.e. tax considerations).

Many investors who are simply investing for retirement may rarely sell stocks. After all, over time the average stock market return has been about 10% (not taking inflation into account).

And while there are no guarantees, in general the old saying that “time in the market is better than timing the market” tends to hold true.

Others, who are looking to turn a profit on a weekly or monthly basis, may sell much more frequently. It’s more a matter of looking at what you’re hoping to generate from your investments, and how fast you’re hoping to generate it.

💡 Quick Tip: If you’re opening a brokerage account for the first time, consider starting with an amount of money you’re prepared to lose. Investing always includes the risk of loss, and until you’ve gained some experience, it’s probably wise to start small.

8 Reasons You Might Sell a Stock

8 reasons you might sell a stock

There are several reasons that could prompt you to think about selling your stock.

1. When You No Longer Believe in the Company

When you bought shares of a certain company, you presumably did so because you believed that the company was promising and you wanted to invest in its stock, and/or that the share price was reasonable. But if you start to believe that the underlying fundamentals of the business are in decline, it might be time to sell the stock and reinvest those funds in a company with a better outlook.

There are many reasons you may lose faith in a stock’s underlying fundamentals. For example, the company may have declining profit margins or decreasing revenue, increased competition, new leadership taking the company in a different direction, or legal problems.

Part of the task here is differentiating what might be a short-term blip in the stock price due to a bad quarter or even a bad year, and what feels like it could be the start of a more sustained change within the business.

Recommended: Tips on Evaluating Stock Performance

2. Due to Opportunity Cost

Every investment decision you make comes at the cost of some other decision you can’t make. When you invest your money in one thing, the tradeoff is that you cannot invest that money in something else.

So, for each stock you buy you are doing so at the cost of not buying some other asset.

Given the performance of the stock you’re currently holding, it might be worth evaluating it to see if there could be a more profitable way to deploy those same dollars. Exchange-traded funds (ETFs) that provide easy access to other asset classes — like bonds or commodities — have also created competition to simply holding company stocks.

This is easier said than done, however, because we are often emotionally invested in the stocks that we’ve already purchased. Nonetheless, it’s important to include an evaluation of opportunity costs as part of your overall decision about when to sell a stock.

3. Because the Valuation Is High

Often, stocks are evaluated in terms of their price-to-earnings (P/E) ratios. The market price per share is on the top of the equation, and on the bottom of the equation is the earnings per share. This ratio allows investors to make an apples-to-apples comparison of the relative earnings at different companies.

The higher the number, the higher the price as compared to the earnings of that company. A P/E ratio alone might not tell you whether a stock is going to do well or poorly in the future. But when paired with other data, such as historical ratios for that same stock, or the earnings multiples of their competitors or a benchmark market, like the S&P 500 Index, it may be an indicator that the stock is currently overpriced and that it may be time to sell the stock.

A P/E ratio could increase due to one of two reasons: Because the price has increased without a corresponding increase in the expected earnings for that company, or because the earnings expectations have been lowered without a corresponding decrease in the price of the stock. Either of these scenarios tells us that there could be trouble for the stock on the horizon, though nothing’s a sure bet.

4. For Personal Reasons

It’s also possible that you may need to sell a stock for personal reasons, such as:

• You need the cash (owing to a job loss, emergency, etc.)

• You no longer believe in the mission of the company

• Your risk tolerance has changed and you’re moving away from equities

• You want to try another strategy other than active investing, for example automated investing, where your investment choices are largely guided by the input of a sophisticated algorithm.

Since personal reasons may also have emotions attached to them, it’s wise to balance out your personal feelings with an evaluation of other reasons to sell the stock.

5. Because of Taxes

Employing a tax-efficient investing strategy shouldn’t outweigh making decisions based on other priorities. Still, it’s important to take taxes into account when making decisions about which stocks to keep and which stocks to sell.

When purchased outside of a retirement account, gains on the sale of an investment are subject to capital gains tax rules. It may be possible to offset some capital gains with capital losses, which are triggered by selling stocks at a loss.

This strategy is known as tax-loss harvesting.

For example, if an investor sells a security for a $25,000 gain, and sells another security at a $10,000 loss, the loss could be applied so that the investor would only see a capital gain of $15,000 ($25,000 – $10,000).

If you’re considering this as part of a self-directed trading strategy, you may want to consult a tax professional, as the rules can be complicated in terms of short-term vs. long-term gains, replacing a stock you sell with one that’s substantially different, as well as how to carryover losses.

• Understanding how a tax loss can be carried forward

The difference between capital gains and capital losses is called a net capital gain. If losses exceed gains, that’s a net capital loss.

• If an investor has an overall net capital loss for the year, they can deduct up to $3,000 against other kinds of income — including their salary and interest income.

• Any excess net capital loss can be carried over to subsequent years (known as a tax-loss carryover or carry forward) and deducted against capital gains and up to $3,000 of other kinds of income — depending on the circumstances.

• For those who are married filing separately, the annual net capital loss deduction limit is only $1,500.

Recommended: Unrealized Gains and Losses Explained

6. To Rebalance a Portfolio

If you’re looking to make some tweaks to your investment strategy for one reason or another, you may want to sell some stocks as a part of a strategy to rebalance your portfolio. The reason for rebalancing is to keep your portfolio anchored on the asset allocation that you prefer.

As some investments rise and fall over time, your asset allocation naturally shifts. Some asset classes might exceed the percentage you originally chose, based on your risk tolerance.

Investors are encouraged to rebalance their portfolios regularly — but not too often — as market and economic conditions can and do change. An annual rebalancing strategy is common.

This typically involves taking a look at your desired asset allocation, thinking about your risk tolerance (and how it may have changed), and deciding how you may want to change the different asset classes that comprise your portfolio, if at all.

7. Because You Made a Mistake

You may want to sell stocks if you simply made a mistake. Perhaps the company or sector is not a priority for you, or not a good bet in your eye. Maybe a stock is too risk or volatile. Maybe you bought into a company because it was in the news, or friends were raving about it (a.k.a. FOMO trading).

All of these conditions can happen to investors, and knowing when to sell a stock sometimes means owning up to a mistake.

8. You’ve Met Your Goals

In the best case, of course, you might want to sell a stock once you’ve met your goals. Perhaps the price is right, or you’re ready to retire, or you’ve crossed some other threshold where you no longer need to hold onto the stock.
In that case, the decision to sell will likely come down to timing and taxes. Or, if you’re preparing to retire, you may also want to consider whether you’re holding the stock in a tax-deferred account or not.

💡 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.

4 Reasons You Might Not Want to Sell a Stock

4 reasons you might not sell a stock

In addition to weighing possible reasons for selling a stock, there are counter arguments for holding onto your shares.

1. Because a Stock Went Up

As mentioned, most stock prices will go up at some point, and you may want to hold onto your stock in the hope that it will continue to grow. That’s a valid reason, especially if you’re thinking long term.

Just bear in mind that there are no guarantees, and past performance is no guarantee of future results, as the industry mantra goes. So even if a stock’s price is rising, you may want to have a few other reasons for not selling the stock.

2. Because a Stock Went Down

Just as a stock may go up, the price will also go down at some point. At those moments it may be tempting to cut your losses before you accrue even bigger ones — especially if you believe that the stock’s value will continue to drop.

But, again, it may be helpful to think longer term rather than what’s happening today. The stock price might rebound, and you may only lock your losses in by selling. Analyzing the company fundamentals as well as the economic climate can help you make this decision.

Recommended: What Happens If a Stock Goes to Zero?

3. Because of an Economic Forecast

Economic forecasting uses a range of economic indicators — such as interest rates, consumer confidence, the rate of inflation, unemployment rates — to predict or anticipate economic growth. But economic forecasting is not an exact science, and it’s wise to consider other factors.

In addition, economic forecasts come and go. This is especially the case in the short term. Therefore, changes in stock prices may have as much to do with investor sentiment or outside forces (such as political or economic events or announcements) as they do with the health of the underlying company.

4. Because Everyone Else Is Selling

Understanding the impact of other investors on your own decisions is equally important. While you may think you’re capable of remaining calm in the face of media hype and headlines, as numerous behavioral finance studies have shown it’s surprisingly easy to get caught up in what other investors are doing.

If you find yourself questioning your own investment plan or your own logic, think twice to make sure the impulse to sell isn’t brought on by strong emotions or by the opinions of others.

Selling a Stock 101

These are the basic steps required to cash out and sell stocks:

1. Whether by phone or via an online brokerage account platform, let your broker know which of your stock holdings you’d like to sell.

2. Specify which order type (more on that below). This can determine at what price level your stock is sold.

3. Fill out any other information your broker requires in order to initiate the sale. For instance, some accounts may have a “time in force” option, or when the order expires. Keep in mind, the trade date is different from the settlement date. It usually takes a couple of days for a trade to settle.

4. Click “Sell” or “Submit Order.”

Different Sell Order Types

sell order types

There are several different stock order types that can be useful in different situations.

Market Sell Order

This order type involves selling a stock immediately. The order will be executed without the investor specifying any price level to sell at. It’s important for investors to know however that because share prices are constantly shifting, they might not get the exact price they see on their stock-data feed. There may also be a difference due to delayed versus real-time stock quotes to consider as well.

Generally speaking, the advantage of using a market order is that your trade is likely to be executed quickly. That’s especially true for bigger or more popular stocks, which tend to be more liquid. But again: the biggest potential drawback is that you might not get the exact price you thought you were due to market volatility.

Limit Sell Order

Limit orders involve selling a stock at a specific price. For example, if you’re buying stocks, you can specify a price that you’re willing to pay — the trade will then be executed at that price, or lower.

If you’re selling stocks, the inverse is true — your stock will be sold at the specified price, or higher.

The upside to using limit orders is that they give investors some semblance of control by allowing them to name their price. The investor can then walk away, and let their brokerage handle the execution for them.

The downsides, though, include the fact that the trade may never execute if the specified price isn’t reached, and that using limit orders may take some practice and experience to properly execute.

Stop-Loss Sell Order

A stop-loss order is a level at which an automatic sell order kicks in. In other words, an investor specifies a price at which the broker should start selling, should the stock hit that level. This can also be referred to as a “sell-stop order.” But note that there are other types of stop-loss orders, such as buy-stop orders, and trailing stop-loss orders.

Stop-loss orders can be useful in that they can prevent investors from losing more than they’re comfortable with, or that they can afford to lose. They, as the name implies, are a very useful tool to prevent losses. But depending on overall market conditions, they can also work against an investor. If there’s a short-term drop in share prices, for instance, it’s possible that an investor could miss out on gains if share prices rebound in the medium or long term.

Stop-Limit Sell Order

A stop-limit sell order is an order that’s executed if your stock’s price drops to a certain price, but only if the shares can be sold at or above the limit price specified. They are, in effect, a sort of bridge between stop and limit orders. These types of orders can help investors dodge the risk that a stop order executed at an unexpected price, giving them more control over the price at which a sell order will execute.

Different Ways to Sell Stocks

There are desktop platforms and mobile phone apps that offer brokerage services. These are likely the most common platforms individual or retail investors use to currently buy or sell stocks. However, another option is through a financial advisor.

Financial advisors are professionals who have been entrusted to handle certain financial responsibilities and you can send them a stock sale order to execute. They can do a number of other things for you, too, including proffer advice and help you formulate an investing strategy. But there are costs to using financial advisors, so it may not be worth it, depending on how involved in the markets you are.

The Takeaway

There are times when it may be a good idea to sell your stocks, and others when it’s not. For example, if you’ve lost faith in a company, need a cash infusion, or are doing some portfolio rebalancing, it may be a good time to sell shares of a certain stock.

On the other hand, if you’re unnerved that your stock’s price fell after a bad earnings report, you may want to hold on and let things play out. It’s difficult, and is a true test of your risk tolerance. But over time, it should become easier and more natural as you gain experience as an investor.

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

FAQ

How can you tell when to sell a stock?

There’s no exact science, and determining whether it’s a good time to sell a stock will come down to the individual investor’s strategy, risk tolerance, and time horizon. However, you can also keep an eye on a stock’s valuation, consider your opportunity costs, and weigh other factors in order to make the decision.

Should you ever sell stocks when they’re down?

You can sell stocks when they lose value for any number of reasons, but it’s wise to make sure you’re doing so as a part of an overall investing strategy, e.g. tax-loss harvesting, and not simply because you’re making an emotional or impulsive decision based on current market conditions.

How much profit do I need before I sell a stock?

There’s no exact science or answer to determine how much of a return you’d need to see before you sell a stock. That’s up to the specific investor, and there may be times when selling a stock at a loss is preferable for tax purposes or other reasons.

Photo credit: iStock/FotoDuets

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.

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.

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

SOIN0224005

May

2024

What Is Stock Volatility and How Do You Measure It?

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

Key Points

• Stock volatility refers to the variation in a stock’s price from its mean, and it can provide opportunities for investors.

• Standard deviation, beta, VIX, and maximum drawdown are common measures used to gauge stock volatility.

• Standard deviation measures how far a stock’s performance deviates from its average, while beta compares a stock’s volatility to the overall market.

• Factors such as company performance, investor behavior, global events, seasonality, and market cycles can contribute to stock market volatility.

• Balancing risk and reward, diversifying your portfolio, sticking to long-term investing strategies, avoiding timing the market, and considering dollar-cost averaging are effective ways to manage volatility when investing.

What Is Stock Volatility?

Stock volatility is often defined as big swings in price, but technically the volatility of a stock refers to how much its price tends to vary from the mean. The same is true of stock market volatility; when an index tends to perform a certain percentage above or below the mean, it’s a signal of volatility.

Generally, the higher the volatility of a stock, the more risk an investor incurs when they purchase or hold it. But volatility can also provide opportunities for some investors.

How to Measure Stock Volatility

There are a handful of ways to measure stock volatility. Each metric gives investors different information, and a different view of stock market fluctuations.

Standard Deviation

Standard deviation is a common stock volatility measure; it refers to how far a stock’s performance varies from its average. Investors often measure an investment’s volatility by the standard deviation of returns compared with a broader market index or past returns. Standard deviation measures the extent to which a data point deviates from an expected value, i.e. the mean return.

Beta

Beta is another way to measure volatility; it captures systematic risk, which refers to the volatility of a security (or of a portfolio) versus the market as a whole.

For example, beta can measure the volatility of a stock versus its benchmark (e.g. the S&P 500 or another relevant index). If a stock or mutual fund has a beta of 1.0, its inherent volatility is no different than the market at large. If the beta of a stock is higher or lower than its benchmark, that indicates higher or lower volatility.

Recommended: How to Find Portfolio Beta

VIX

The Cboe Global Markets Volatility Index, known as the VIX for short, is a tool used to measure implied volatility in the market. In simple terms, the VIX index tells investors how professional investors feel about the market at any given time.

The VIX Index is a real-time calculation that measures expected volatility in the stock market. One of the most recognized barometers of fluctuations in financial markets, the VIX measures how much volatility investing experts expect to see in the market over the next 30 days. This measurement reflects real-time quotes of S&P 500 Index (SPX) call option and put option prices.

Maximum Drawdown

Maximum drawdown, or MDD, is another stock volatility measure, and can give investors a sense of how much downside risk exists for a given stock (though not the risks of the stock market overall). It basically measures the maximum fall in value that a stock has seen in the past, and is reflected in the difference between that maximum trough, and the highest peak in value before its value fell.

You may recognize the terms peak and trough when discussing the business cycle and bull markets, too. MDD is a peak-to-trough calculation, in other words. It’s a simpler calculation than standard deviation, too:

MDD= Trough Value−Peak Value / Peak Value

Using Standard Deviation to Calculate Volatility

You can use the standard deviation and variance of returns to create a basic measure of stock volatility. This measure captures variance in price changes over a certain period of time, so you can gauge how far from the mean the stock price tends to go (i.e. how volatile it is).

Formula: σ √T = volatility, where:

σ = standard deviation of returns

T = number of time periods

1. To arrive at the variance, imagine a stock that starts in January with a monthly closing price of $10, and adds $1 per month. Month 1 = $10. Month 2 = $11. Month 3 = $12 … and so on, for all 12 months (or whatever time period you choose).

2. Add the stock price for each month, to arrive at a total of $186.

3. Divide $186 by the number of time periods (12 months in this case) to get an average stock price of $15.50 for the year.

4. Subtract the mean ($15.50) from each monthly value; include results that are negative numbers.

5. Square all the deviations (which will also remove negative numbers), and add them together to get the sum ($50.50); divide the sum by the number of time periods (in this case 12) to get a variance of $4.21.

6. Take the square root of $4.21 to get $2.05 = which is the standard deviation for this particular stock. Knowing this provides an important point of comparison for investors, because it indicates whether a stock’s price fluctuations could be within ‘normal’ ranges or too volatile.

Recommended: What Is a Stock?

Types of Stock Volatility

types of stock volatility

There are two common types of stock volatility that investors use to measure the riskiness of an investment: implied volatility and historical volatility. These two types of volatility are often used by options traders, who make trades based on the potential volatility of the options contract’s underlying asset.

Historical Volatility

Historical volatility (HV), also known as statistical volatility, is a measurement of the price dispersion of a financial security or index over a period of time. Investors calculate this by determining the average deviation from an average price. Historical volatility typically looks at daily returns, but some investors use it to look at intraday price changes.

As the name implies, historical volatility used past performance to assess present volatility. When a stock sees large daily price swings compared to its history, it will typically have a historical volatility reading. Historical volatility does not measure direction; it simply indicates the deviation from an average.

Implied Volatility

Implied volatility (IV) is a metric that captures the market’s expectation of future movements in the price of a security. Implied volatility employs a set of predictive factors to forecast the future changes of a security’s price.

Implied volatility doesn’t anticipate which way prices might move, up or down, only how likely the volatility will be.

What Causes Market Volatility?

what causes stock market volatility

The stock market is known for having boom-and-bust cycles, which is another way of describing stock market volatility. And there are numerous factors that can influence market volatility. Here are just a few:

• Company Performance: Regarding individual stocks, events tied to the company’s performance can drive volatility in its shares. This can include countless factors including: earnings reports, a product announcement, a merger, a change in management, and much more.

• Investor Behavior: Long periods of rising share prices tend to drive investors to take on more risk. They enter into more speculative positions and buy assets like high-risk stocks.

In doing so, investors may disregard their own risk tolerance, and make themselves more vulnerable to market shocks. This pattern can lead to market busts when investors need to sell their holdings en masse when the market is shaky.

• Global Events: For instance, the early stages of the COVID pandemic in February and March 2020 created shockwaves in the markets. As economies across the globe shut down, investors began to sell off risky assets, bringing about high levels of volatility in the financial markets.

Governments enacted extraordinary fiscal and monetary stimulus programs to calm this volatility and bring stability to the markets.

But even as these efforts took effect, other global factors — the war in Ukraine impacting energy prices — also took a toll. And federal reserve interest rate increases during 2022 — instituted at the fastest rate in history in an effort to tamper inflation — likewise roiled the markets, causing stock volatility.

• Seasonality: You’ve heard the old saying, “Sell in May and go away.” That’s a reflection of a phenomenon called market seasonality, which means that year in and year out there are certain patterns that tend to occur around the same times.

While seasonality certainly doesn’t guarantee any investment outcomes, some sectors do see more demand and greater production during specific times of year. Summer months tend to impact the travel sector; the fall might see an uptick in school-related consumer goods, and so on.

Depending on the year, this rise and fall of demand can impact volatility for some stocks.

• Market Cycles: In a similar way, markets also have their cycles; these cycles emerge thanks to trends generated by what’s going on in different business sectors. For example, the rapid evolution of AI in 2023 and early 2024 may have sparked a bit of a market cycle in the tech sector, as the demand for certain products and technologies jumped.

That said, it’s difficult to spot a market cycle until it’s over. Sometimes what appears to be a cycle is simply a normal set of fluctuations. But the anticipation or perception of a cycle can drive volatility.

• Liquidity: Other factors that can drive volatility include liquidity and the derivatives market. Stock liquidity is the ease with which an asset can be bought and sold without affecting prices. If an asset is tough to unload and gets sold at a significantly lower price, that could inject fear into the market and cause other investors to sell, ramping up volatility.

Separately, there’s sometimes a debate as to whether equity derivatives — contracts that are based on an underlying asset (e.g. futures and options) — can cause volatility. For instance, in 2020, investors debated whether large volumes of stock options trading caused sellers of the options, typically banks, to hedge themselves by buying stocks, exposing the market to sudden ups and downs when the banks had to purchase or sell shares quickly.

What Causes Stock Prices to Go Up?

As noted, any number of things can cause a stock’s price to go up — be it good or bad news. For instance, geopolitical events can cause certain stocks to appreciate in price, while others may fall. When there’s political instability, some investors seek safer investments and may pile into consumer staple stocks, or investments that track the price of precious metals.

When the economy is faring well, earnings season can be another time during which stock prices go up as companies report positive news to investors, who may, in turn, feel better about the economy overall, which can affect their investing decisions.

What Causes Stock Prices to Go Down?

Just as nearly anything and everything can drive stock prices up, there are countless factors that can likewise drive values down. That can include bad earnings reports from companies, or earnings data that doesn’t live up to expectations. Political or regulatory changes can also spook investors, who may sell certain stocks and drive prices down.

Again: Stock prices can go down for any and every reason, or no reason at all. This is as good a time as any to remind you that there really is no such thing as a completely safe investment.

💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

How to Manage Volatility When Investing

Let’s imagine that it’s 2007, and an individual has money invested in the U.S. stock market. Unfortunately, this investor is about to face one of the largest stock market crashes in history: The S&P 500 fell by 48% during the crash of 2008-2009.

This sort of dramatic drop in the stock market isn’t typical, and it can be traumatic even for the savviest and most experienced investor. So, the first step to handling stock market volatility is understanding that there will always be some price fluctuation.

The second step is to know one’s risk tolerance and financial goals, then invest, readjust, and rebalance your portfolio accordingly.

Balance Risk and Reward

Generally speaking, higher rewards sometimes come with higher risks. For example, younger investors in their 20s might want to target higher growth options and be open to more volatile stocks. They may have enough time to weather the gains and losses and, possibly, come out ahead over time.

The reverse is true for someone approaching retirement who wants stable portfolio returns. With a shorter time horizon there’s less time to recover from volatility, so investing in lower-risk securities may make more sense.
Some strategies offer ways that more cautious investors might take to mitigate volatility in their portfolios. One way is diversification.

Portfolio diversification involves investing your money across a range of different asset classes — such as stocks, bonds, and real estate — rather than concentrating all of it in one area. Studies have shown that by diversifying the assets in your portfolio, you may offset a certain amount of investment risk and thereby improve returns.

For example: Lower volatility stocks, such as utility or consumer staple companies, can add stability to a stock portfolio. Meanwhile, energy, technology, and consumer discretionary shares tend to be more turbulent because their businesses are more cyclical, or tied to the broader economy.

Another way to diversify one’s portfolio is to add bonds, alternative investments, or even cash. When deciding to add bonds or stocks to a portfolio, it’s helpful to know that the former is generally a less volatile asset class.

This is useful to know if you’re managing your own portfolio, or if you want to try automated investing, where a sophisticated algorithm provides different asset allocation options in pre-set portfolios.

There are a few other things to take into consideration when managing volatility in your portfolio.

Assess Risk Tolerance

A big part of effectively managing stock volatility as it relates to your portfolio is knowing your limits, or, as discussed, your risk tolerance. How much risk can you actually handle when it comes down to it?

Every investor will need to give that question some thought when deciding how to deploy their money.

While bigger risks often come with bigger rewards, when the market does experience a downturn, there’s the outstanding question of whether you’ll stick to your investing strategy or cut and run. Each investor’s risk tolerance will be different, but it’s important to think about how you can actually handle the risk you take on when investing.

Stick to Long-Term Investing Strategies

One way to manage market volatility is to stick to a long-term investing strategy, such as a buy-and-hold strategy. If you stick to long-term investments rather than derivatives or other short-term assets or tools, you can somewhat ignore the day-to-day ups and downs of stock prices, and in doing so you may be able to better weather market volatility.

Avoid Timing the Market

Timing the market, as it relates to trading and investing, means waiting for ideal market conditions, and then making a move to try and capitalize on the best market outcome. But nobody can predict the future, and this is a high-risk strategy.

When seeing stock market charts and business news headlines, it can be tempting to imagine you can strike it rich by timing your investments perfectly. In reality, figuring out when to buy or sell securities is extremely difficult. Both professional and at-home investors make serious mistakes when trying to time the market.

Consider Dollar-Cost Averaging

Dollar cost averaging is essentially a way to manage volatility as you continue to save and build wealth. It’s a basic investment strategy where you buy a fixed dollar amount of an investment on a regular cadence (e.g. weekly or monthly). The goal is not to invest when prices are high or low, but rather to keep your investment steady, and thereby avoid the temptation to time the market.

That’s because with dollar cost averaging (DCA) you invest the same dollar amount each time. When prices are lower, you buy more; when prices are higher, you buy less. Otherwise, you might be tempted to follow your emotions and buy less when prices drop, and more when prices are increasing (a common tendency among investors).

How Much Stock Volatility Is Normal?

The average stock market return in the U.S. is roughly 10% annualized over time, or about 6% or 7% taking inflation into account.

When looking at nearly 100 years of data, as of the end of July 26 2023, the yearly average stock market return was between 8% and 12% only eight times. In reality, stock market returns are typically much higher or much lower.

It’s also important to remember that past market performance is not indicative of future returns. But looking at history can help an investor gauge how much volatility and market fluctuation might be considered normal. Since the end of World War II, the S&P 500 has posted 14 drops of more than 20%, including the most recent in 2022 — a dip precipitated by the rapid rise in interest rates.

These prolonged downturns of 20% or more are considered bear markets. While bear markets have a bad name, they don’t always lead to recession, and on average bear markets are shorter than bull markets.

Investing in Stocks With SoFi

Stock volatility is the pace at which the price of a company’s shares move up or down during a certain period of time. Volatility is a complex topic, and it often sparks debate among investors, traders, and academics about what causes it.

While equities are considered an important part of any investment portfolio, they are also known for being volatile, and some degree of turbulence is something most stock investors have to live with.

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

FAQ

Is volatility the same as risk?

In a sense, yes. Volatility is an indicator of risk. So a stock that is highly volatile, with big price changes, is considered riskier than a stock that is less volatile and maintains a more stable price.

Who should buy stocks when volatility strikes?

Certain types of investors, e.g. day traders and options traders, may have strategies that enable them to profit from volatile securities (although there are no guarantees). In some cases, ordinary investors with a very high risk tolerance may want to invest in a volatile stock — but they have to be willing to face the possibility of steep losses.

What is the best stock volatility indicator?

Perhaps the most common or popular one is the VIX. Depending on which way the VIX is trending, it may throw off buy or sell signals to investors. The VIX can be helpful for assessing risk in order to capitalize on anticipated market movements.

What is good volatility for a stock?

Deciding whether the volatility of a certain stock is “good” is a matter of your personal investing style and goals. Some investors may seek out volatile equities if they believe they have a strategy that can capitalize on price fluctuations. Other investors with a long-term view may not mind volatility if they believe the outcome over time will be favorable — while others may opt for as little volatility in their portfolios as possible.

What causes volatility in a stock?

Just about anything can cause stock volatility. Some of the more common causes of volatility are earnings reports or other company news; geopolitical news and developments; or broader economic changes, such as interest rate hikes or inflation.

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Portfolio Diversification: What It Is and Why It’s Important

What Is Portfolio Diversification?

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What Should a Diversified Portfolio Look Like?

Stocks

Bonds

Other Investments

Diversification Considerations for Different Stages

6 Ways to Diversify Your Portfolio

Invest in a Range of Stocks or Index Funds

Invest in Fixed Income Assets, Such as Bonds

Consider Investing in Real Estate

Alternative Investments

Short-term Investments and Cash

International Investments

Why Is Portfolio Diversification Important?

Pros and Cons of Diversification

Pros

Cons

The Takeaway

FAQ

What is an example of a well-diversified portfolio?

What are the dangers of over-diversifying your portfolio?

When should you diversify your portfolio?

How Often Should You Rebalance Your Portfolio?

What Is Portfolio Rebalancing?

Why You Should Consider Rebalancing Your Portfolio

How Often Do You Need to Rebalance Your Portfolio?

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How to Rebalance Your Portfolio

Different Types of Portfolio Rebalancing

Rebalancing for Diversification

Smart Beta Rebalancing

Rebalancing Retirement Accounts

The Takeaway

Active vs Passive Investing: Differences Explained

Active vs Passive Investing: Key Differences

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Active Investing Definition

Active Investing Pros and Cons

Pros

Cons

Passive Investing Definition

Passive Investing Pros and Cons

Pros

Cons

Which Should You Pick: Active or Passive Investing?

The Takeaway

FAQ

What is the difference between active and passive investing?

What are the examples of active funds?

Does active investing have high risk?

Should I invest in active or passive funds?

Are ETFs active or passive?

How to Know When to Sell a Stock

When Is a Good Time to Sell Stocks?

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8 Reasons You Might Sell a Stock

1. When You No Longer Believe in the Company

2. Due to Opportunity Cost

3. Because the Valuation Is High

4. For Personal Reasons

5. Because of Taxes

6. To Rebalance a Portfolio

7. Because You Made a Mistake

8. You’ve Met Your Goals

4 Reasons You Might Not Want to Sell a Stock

1. Because a Stock Went Up

2. Because a Stock Went Down

3. Because of an Economic Forecast

4. Because Everyone Else Is Selling

Selling a Stock 101

Different Sell Order Types

Market Sell Order

Limit Sell Order

Stop-Loss Sell Order

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