What every new investor should know about risk

Investment Risk: What Every New Investor Should Know

Risk is a critical component of each and every investment, and there are several things about risk, and an individual’s ability to handle it, that investors need to know. Those include the types of risk involved in investing, the relationship between risk and potential returns, and how to effectively manage it.

Investors should consider their appetite and tolerance for risk, and try to determine which assets are suitable for them. Investing involves understanding the risk profiles of the different assets, among other things, too.

Key Points

•   Higher risk investments typically offer greater potential returns but also increase the potential for loss.

•   Understanding risk tolerance helps align investments with financial goals and comfort levels.

•   A longer time horizon allows for more risk, as there is more time to recover from market downturns.

•   Various risks include market, business-specific, price volatility, and interest-rate risks.

•   Diversification and asset allocation are key strategies for managing investment risk.

Higher Risk, Higher Potential Return

The most important thing to understand about risk is something you’ve probably heard before: Generally, the higher the risk of your investment, the greater return you should expect on your money. It is, however, the nature of risk that the return you expect might not be the return you actually get.

The concept of “Modern Portfolio Theory” emphasizes that risk and reward are linked. If you hope for a higher return, you should also expect higher volatility — the variability of actual returns. The returns on an exchange-traded fund (ETF) may be up one year and down the next.

Returns on a mutual fund of emerging market stocks will likely have much wider changes in returns from year-to-year, or even month-to-month. You might make a lot more money, but you also could lose much more.


💡 Quick Tip: When people talk about investment risk, they mean the risk of losing money. Some investments are higher risk, some are lower. Be sure to bear this in mind when investing online.

How Much Risk Should You Take?

When determining a level of risk that you’re comfortable with, you want to first look at the goals you have (buying a house, saving for college, and retiring, to name a few), as well as how many years will it be before you need the money for each goal. That’s called a “time horizon.”

balancing risk

As seen in the visual, an investor’s risk tolerance and risk capacity are important elements to take into consideration. Generally speaking, the longer the time horizon, the more risk you can afford to take, because you have more time to recover from market downturns. Both your tolerance and capacity can change over time, as your goals change as well.

This is why young people are advised to put their retirement savings in a more aggressive portfolio. As you get closer to retirement, you’ll generally want to be more conservative. You can also consult a retirement calculator to see where you stand on your retirement goals.

Risk Tolerance Quiz

Take this 9-question quiz to see what your risk tolerance is.

⏲️ Takes 1 minute 30 seconds

What Types of Risk Are There?

There are several types of risk that every investor should be aware of. Here are a few:

•   market

•   business-specific

•   price volatility

•   interest rate

•   concentration

Some risks you can’t avoid, like market risk or beta. The market goes up and down, and this often affects all stocks. Investors can measure the risk in their stock holdings by finding their portfolio’s beta. This will show how sensitive one’s portfolio is to volatility in the market.

You can, however, reduce other risks. For example, if you buy individual stocks, you open yourself up to business-specific risk. But, if you buy an index fund, you are buying assets in multiple companies. If one of these companies falters, it will impact the index, but it won’t have the same harsh impact on your investment. This is why seasoned investors tend to emphasize portfolio diversification so much.

How Should You Manage Risk?

On a broad level, how do you use these concepts to manage your investing risk? One method is to utilize asset allocation strategies that map to your goals and risk profile.

For example, if you wanted to take a particularly low-risk, or conservative position, you could allocate your portfolio to contain more bonds than stocks. Bonds tend to be safer investments than stocks (though it’s important to remember that there’s no such thing as a “safe” investment), and as such, may be less volatile if the market experiences a downturn or correction.

If you still wanted to play it safe but allow for some risk (and potentially bigger returns), you could split your portfolio’s allocation — that could include 50% stocks, 50% bonds, or something along those lines. Further, if you feel like you have a high risk tolerance, you could take an aggressive position, and invest most of, or your entire portfolio in stocks.


💡 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.

Managing Specific Types of Risk

If you want to get more granular, you can try to manage specific types of risk in your portfolio, such as interest rate risk, business-specific risk, etc.

Interest rate risk, for one, has to do with investment values fluctuating due to changing interest rates. This generally involves bond investments, and one way to try and manage it is through diversification, or even by participating in hedge funds — though that can be its own can of worms, so do your research before jumping into hedge funds.

Business-specific risk refers to specific or particular companies or industries. For example, the aerospace industry faces a different set of challenges and risks than the food production industry. So, changes to the Federal Aviation Administration could, as a hypothetical, cause price fluctuation to aerospace stocks, but not other types of stocks. Again, this can largely be addressed through diversification.

There are numerous other types of risks, too, and managing them all is difficult, if not impossible, for the typical investor. You can consider consulting a financial professional for further advice, however.

The Takeaway

Risk is unavoidable when investing, and as such, it’s important to understand the nature of the risk, avoid taking risks you can’t afford, and monitor and adjust your investments over time to align with your risk tolerance. Think about it like driving a car: It’s risky, but you understand that risk and mitigate it by maintaining your car, obeying traffic laws, and buying insurance. The return is the peace of mind of having your future destination in sight.

There are no guarantees in investing, but you can make an informed choice of the amount of risk you are willing to take and invest intelligently to reach your goals.

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).

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 risk tolerance?

Risk tolerance in investing refers to an investor’s appetite for risk, or how much risk they’re willing to assume in order to try and achieve higher returns. Some investors have higher risk tolerance than others.

What are common types of investing risk?

There are numerous types of investment risks, but some of the most common include market risk, business-specific risks, price volatility, interest rate risk, and concentration risk.

What strategies can be used to manage risk?

Some common strategies used to mitigate or manage portfolio risk include diversification and strategic asset allocation, and dollar-cost averaging.


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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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

Claw Promotion: Customer must fund their Active Invest account with at least $50 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

Dollar Cost Averaging (DCA)
Dollar cost averaging is an investment strategy that involves regularly investing a fixed amount of money, regardless of market conditions. This approach can help reduce the impact of market volatility and lower the average cost per share over time. However, it does not guarantee a profit or protect against losses in declining markets. Investors should consider their financial goals, risk tolerance, and market conditions when deciding whether to use dollar cost averaging. Past performance is not indicative of future results. You should consult with a financial advisor to determine if this strategy is appropriate for your individual circumstances.


Third Party Trademarks: Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®

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5 Tips to Hedge Against Inflation

Inflation refers to the ever-increasing price of goods and services as measured against a particular currency. The purchasing power of a currency depreciates as a result of rising prices. Put differently, a rising rate of inflation equates to a decreasing value of a currency.

To achieve financial freedom and build wealth over long periods of time, it’s vital to understand the concept of inflation, and some strategies to protect or hedge against it.

Key Points

•   Inflation decreases currency value, impacting savers negatively.

•   Moderate inflation encourages spending, benefiting economic growth.

•   ETFs offer diversified investment, potentially hedging against inflation.

•   Gold has historically maintained purchasing power, serving as a long-term inflation hedge.

•   Gold prices can rise sharply during periods of rapid inflation, though this is never assured.

What Is Inflation, and How Is It Measured?

Inflation is most commonly measured by the Consumer Price Index (CPI), which averages the national cost of many consumer items such as food, housing, healthcare, and more.

The opposite of inflation is deflation, which happens when prices fall. During deflation, cash becomes the most valuable asset because it can buy more. During inflation, other assets become more valuable than cash because it takes more currency to purchase them.

As for which assets tend to perform best during times of inflation? This is a much-debated topic among investment analysts and economists, with many differing opinions. And while there may be no single answer to that question, there are still some generally agreed-upon concepts that can help to inform investors on the subject.

Is Inflation Good or Bad for Investors?

For the average person who tries to save money without investing much, inflation could generally be seen as negative. A decline in the purchasing power of the saver’s currency leads to them being less able to afford things, ultimately resulting in a lower standard of living.

For wealthier investors who hold a lot of financial assets, however, inflation might be perceived in a more positive light. As the prices of goods and services rise, so do financial assets. This leads to increasing wealth for some investors. And because currencies always depreciate over the long-term, those who hold a diversified basket of financial assets for long periods of time tend to realize significant returns.

It’s generally thought that there is a certain level of inflation that contributes to a healthier economy by encouraging spending without damaging the purchasing power of the consumer. The idea is that when there is just enough inflation, people will be more likely to spend some of their money sooner, before it depreciates, leading to an increase in economic growth.

When there is too much inflation, however, people can wind up spending most of their income on necessities like food and rent, and there won’t be much discretionary income to spend on other things, which could restrict economic growth.

Central banks like the Federal Reserve try to control inflation through monetary policy. Sometimes their policies can create inflation in financial assets, like quantitative easing has been said to do.

5 Tips for Hedging Against Inflation

There are a number of different strategies investors use to hedge against inflation. The common denominators tend to be hard assets with a limited supply and financial assets that tend to see large capital inflows during times of currency devaluation and rising prices.

Here are five tips that may help investors hedge against inflation.

1. Consider Investing in Real Estate Investment Trusts (REITs)

A Real Estate Investment Trust (REIT) is a company that deals in real estate, either through owning, financing, or operating a group of properties. Through buying shares of a REIT, investors can gain exposure to the assets that the company owns or manages.

REITs are income-producing assets, like dividend-yielding stocks. They pay a dividend to investors who hold shares. In fact, REITs are required by law to distribute 90% of their income to investors.

Holding REITs in a portfolio might make sense for some investors as a potential inflation hedge because they are tied to a hard asset—real estate. During times of high inflation, hard assets tend to rise in value against their local currencies because their supply is limited. There will be an ever-increasing number of dollars (or euros, or yen, etc.) chasing a fixed number of hard assets, so the price of those things will tend to go up.

Owning physical real estate — like a home, commercial complex, or rental property — also works as an inflation hedge. But most investors can’t afford to purchase or don’t care to manage such properties. Holding shares of a REIT provides a much easier way to get exposure to real estate.

2. Know How Bonds and Equities Could React to Inflation

The recurring theme regarding inflation hedges is that the price of everything goes up. What investors are generally concerned with is choosing the assets that go up in price the fastest, with the greatest possible return.

In some cases, it might be that stocks and bonds very quickly rise very high in price. But in an economy that sees hyperinflation, those holding cash won’t see their investment, i.e., cash, have the purchasing power it may have once had.

In such a scenario, the specific securities aren’t as important as making sure that capital gets allocated to stocks or bonds in some amount, instead of holding all capital in cash.

3. Consider Investing in Certain Exchange-Traded Funds

An exchange-traded fund (ETF) that tracks a particular stock index or group of investment types is another way to get exposure to assets that are likely to increase in value during times of inflation and can also be a strategy to maximize diversification in an investor’s portfolio.

ETFs are generally passive investments, which may make them a good fit for those who are new to investing or want to take a more hands-off approach to investing. Since they are considered a diversified investment, they may be a good hedge against inflation.

4. Consider Gold and Gold Mining Stocks

For thousands of years, humans have used gold as a store of value. Although the price of gold or other precious metals can be somewhat volatile in the short term, few assets have maintained their purchasing power as well as gold in the long term. Like real estate, gold is a hard asset with limited supply.

Still, the question of “is gold a hedge against inflation?” has different answers depending on whom you ask. Some critics claim that because there are other variables involved and the price of gold doesn’t always track inflation exactly, that it is not a good inflation hedge. And there might be some circumstances under which this holds true.

Investors seeking to add gold to their portfolio have a variety of options. Physical gold coins and bars might be the most obvious example, although these are difficult to obtain and store safely. But investors can also invest in mining companies, or others that have exposure to the gold market.

5. Do Your Homework About Inflation and the Market

Ultimately, no assets are 100% protected from inflation, but some investments might be better than others for some investors. Understanding how inflation affects investments is the beginning of growing wealth over time and achieving financial goals.

The Takeaway

Inflation is marked by a period of rising prices, and is a normal side effect of a healthy economy — within certain bounds. Inflation may have positive effects for certain people, and bad ones for others, but overall, inflation is generally a negative for savers and consumers. Still, there may be certain investment strategies that can help hedge against inflation.

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).

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 inflation?

Inflation refers to the tendency of prices to rise over time, and is often measured by the Consumer Price Index, or CPI.

Is inflation good for investors?

While inflation is generally a bad thing for consumers and savers, it’s debatable as to whether it’s a positive thing for investors. It largely depends on the specific assets the investor holds.

What assets do some investors invest in during times of inflation?

Some investors may invest in precious metals like gold, real estate through vehicles like REITs, or various stock or bond-related instruments. But it’s important to remember that no asset is likely to be immune to inflation.



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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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

Claw Promotion: Customer must fund their Active Invest account with at least $50 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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The Basics of Electronic Trading

Electronic trading refers to the process of conducting trades in financial markets through an online broker-dealer using the internet. These trades can take place in the stock, bond, options, futures, or foreign exchange (FOREX) markets. Electronic trades can only be conducted during standard market hours: between 9:30 am and 4 pm Eastern Standard Time on weekdays. Traders can create orders after markets close, but the orders won’t be executed until the next trading day.

This represents a big change from the way the stock exchange worked prior to the internet, when traders would gather in one central place like The New York Stock Exchange (NYSE) and buy and sell stocks in person. With advances in digital technology, that’s no longer necessary, and the age of electronic trades now dominates.

Key Points

•   Electronic trading enhances convenience and reduces costs, allowing easy access to financial markets.

•   Investors should consider platform features, fees, and alignment with investment goals.

•   Market, limit, and stop-loss orders help manage investments effectively.

•   Tax implications include capital gains and losses from trading activities.

•   Risks involve lack of guidance, quick market changes that investors are unable to keep up with, and accumulating fees.

How to Start Electronic Trading

Many investors today will only ever engage in online stock trading. Traders no longer need a personal broker whom they have to call on the phone each time they want to buy or sell a security.

Instead, investors can now open an online brokerage, create an account, and start placing trades. But choosing a platform is only step one in electronic stock trading. After that, you’ll need to decide what stocks to trade, what type of orders to use, what expenses will be involved (if any), and how trading might affect your tax liability.

Choose an Electronic Trading Platform

There are many electronic trading platforms to choose from. They are all similar in many ways, with general ease of use: Signing up and getting started can take less than an hour, with perhaps a few days of wait time involved for identity or “know your customer” verification.

Among the various platforms, there are slightly different features or different options as far as the user experience is concerned. Not too long ago, most platforms charged a commission fee for each buy or sell order executed, and there was a minimum amount of money needed to create a new account.

Recently, many brokerages have eliminated trading fees, and few still require account minimums, although there may be other costs associated with your investments. It’s important to understand what you’re being charged, because even small amounts add up over time and can reduce investment returns.

Research Stocks or ETFs

There are thousands upon thousands of securities to choose from, and many different types of markets and exchanges. When first starting out, it’s easy to get overwhelmed by all the choices.

Thankfully, online brokerages offer tools to help investors get started. There is also an abundance of free information online about investing. There are numerous sources that provide news and analysis on a daily basis to help investors learn and stay informed about new market opportunities.

Recommended: Investing Guide 101

Determine Which Type of Order to Use

It might be common to assume there are only two types of orders: a buy order and a sell order. In actuality, there are many different types of orders.

The type of order that likely comes to mind for most new investors is known as a market order. This is simply an order to buy or sell a security at whatever price it’s trading at right now.

Another type of buy order is a limit order. This is an order to buy at or below a specific price. The order can remain on the books for a day, sixty days, or until canceled, and will be filled whenever the security falls to the specified price.

This can help investors wait to buy a security at a cheaper price without having to monitor things. Limit orders also help protect against sudden spikes in price. If a market order is used just before a large price increase, an investor could pay more for a security than expected.

A stop-loss order can help traders limit losses. Like a limit order, a stop-loss gets triggered when a security falls to a specific price. But as you might have guessed, unlike a limit buy order, a stop-loss order will initiate a sell when triggered.

Recommended: What Is the Average Stock Market Return?

Consider Tax Implications

Buying securities usually doesn’t invoke any tax liability. But selling does generate a taxable event. Selling at a gain often requires an investor to pay capital gains tax, while selling at a loss could result in a capital loss, which investors can sometimes use to reduce their taxable income.

The subject of taxes and investing is long and involved. New investors might want to consider researching the tax implications of buying and selling securities on their own and consult with a tax professional.

The Risks of Online Trading

In addition to the convenience that electronic trading offers investors, it does come with some risks. The main caveat of online trading is that it gives investors the opportunity to try new strategies (like options trading) or explore new types of investments without the benefit of expert guidance.

All investments come with the risk of loss, meaning you can lose all the money you’ve invested, or more, in some cases. It’s important to balance the opportunities with the downsides when electing to explore new investments.

The Takeaway

The era of online or electronic trading is here to stay, thanks to its lower cost structure as well as the overall convenience and ease-of-use that online platforms provide for investors. Now investors can set up and manage a wide range of portfolios — from day trading to retirement — right from their own computers.

Electronic trading does have its limitations, though. Things move quickly, fees can add up, and sometimes there are investment options available that require more time and expertise, which may not be available through an online platform.

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).

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


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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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

Claw Promotion: Customer must fund their Active Invest account with at least $50 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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What is Deflation and Why Does it Matter?

What Is Deflation and Why Does It Matter?

Deflation is the opposite of inflation. It occurs when the prices consumers pay for goods and services go down. That means that consumers can purchase more with the same amount of money.

There are many factors that cause deflation, which happens when the supply of goods and services is higher than the demand for them. While deflation can have some benefits to consumers, it’s often a sign of trouble for the overall economy.

Key Points

•   Deflation, marked by falling prices, can lead to economic stagnation and business closures.

•   Government interventions, including fiscal and monetary policies, help combat deflation and stabilize the economy.

•   Deflation often follows financial crises and is influenced by consumer confidence, technology, and lower production costs.

•   Negative impacts include reduced business revenues, increased unemployment, and decreased consumer demand.

•   The Great Depression exemplifies how deflation caused business failures and unprecedented unemployment.

What Happens During Deflation?

In addition to knowing what inflation is, it’s important to understand how it impacts the economy. In a deflationary economy, prices gradually drop and consumers can purchase more with their money. In other words, the value of a dollar rises when deflation happens.

It’s important not to confuse deflation with disinflation. Disinflation is simply inflation decelerating. For example, the annual inflation rate may change from 5% to 3%. This variation still means that inflation is present, just at a lower rate. By contrast, deflation lowers prices. So, instead of prices increasing 3%, they may drop in value by 2%.

Although it may seem advantageous for consumer purchasing power to increase, it can accompany a recession. When prices drop, consumers may delay purchases on the assumption that they can buy something later for a lower price. However, when consumers put less money into the economy, it results in less money for the service or product creators.

The combination of these two factors can yield higher unemployment and interest rates. Historically, after the financial crises of 1890, 1893, 1907, and the early-1930s, the United States saw deflationary periods follow.

How Is Deflation Measured?

Economists measure deflation the same way they measure inflation, by first gathering price data on goods and services. The Bureau of Economic Analysis (BEA) and the Bureau of Labor Statistics (BLS) record and monitor this type of data in the United States. They collect pricing information that they then put into buckets reflecting the types of goods and services consumers generally use.

While these buckets do not include every product and service, they offer a sample of items and services consumed. In the United States, economists incorporate these prices into an indicator known as the Consumer Price Index (CPI).

Then, economists can compare the CPI to previous years to determine whether the economy is experiencing inflation or deflation. For example, if the prices decrease in a period compared to the year before, the economy is experiencing deflation. On the other hand, if prices increase compared to the previous year, the economy is experiencing inflation.

What Causes Deflation?

Deflation comes from a swing in supply and demand. Typically, when demand dwindles and supply increases, prices drop. Factors that may contribute to this shift include:

Rising Interest rates

When the economy is expanding, the Federal Reserve may increase interest rates. When rates go up, consumers are less likely to spend their money and may keep more in high-interest savings accounts to capitalize on the increase in rates.

Also, the cost of borrowing increases with the rise of interest rates, further discouraging consumers from spending on large items.

Decline in Consumer Confidence

When the country is experiencing economic turbulence, like a recession, consumers spend less money. Because consumers tend to worry about the direction of the economy, they may want to keep more of their money in savings to protect their financial well-being.

Innovations in Technology

Technological innovation and process efficiency ultimately help lower prices while increasing supply. Some companies’ increase in productivity may have a small impact on the economy. While other industries, such as oil, can have a drastic impact on the economy as a whole.

Lower Production Costs

When the cost to produce certain items, such as oil, decreases, manufacturers may increase production. If demand for the product stagnates or decreases, they may then end up with excess supply. To sell the product, companies may drop prices to encourage consumer purchases.

Why Does Deflation Matter?

Although falling prices may seem advantageous when you need to purchase something, it’s not always a good sign for the economy. Many economists prefer slow and unwavering inflation. When prices continue to rise, consumers have an incentive to make purchases sooner, which further boosts the economy.

One of the most significant impacts of deflation is that it can take a toll on business revenues. When prices fall, businesses can’t make as much money.

The drop in business profits makes it challenging for companies to support their employees, leading to layoffs or pay cuts. When incomes go down, consumers spend less money. So deflation can create a domino effect impacting the economy at many different levels, including lower wages, increased unemployment, and falling demand.

Deflation During The Great Depression

The Great Depression is a significant example of the potential economic impact of a deflationary period. While the 1929 stock market crash and recession set this economic disaster off, deflation heavily contributed to it. The rapid decrease in demand along with cautious money hoarding led to falling prices for goods and services. Many companies couldn’t recover and shut down. This caused record-high unemployment in the United States, peaking at 25%, and in several other countries as well.

During this time, the economy continued to experience the negative feedback loop associated with deflation: cash shortages, falling prices, economic stagnation, and business shutdowns. While the United States has seen small episodes of deflationary periods since the Great Depression, it hasn’t seen anything as substantial as this event.

How to Manage Deflation

So, what can the government do to help regulate inflation? For starters, the Federal Reserve can lower interest rates to stimulate financial institutions to lend money. The Fed may also purchase Treasury securities back to increase liquidity that may help financial institutions loan funds. Those initiatives can increase the circulation of the money in the economy and boost spending.

Another way to manage deflation is with changes in fiscal policy, such as lowering taxes or providing stimulus funds. Putting more money in consumers’ pockets encourages an increase in spending. This, in turn, creates a chain effect that may increase demand, increase prices, and move the economy out of a deflationary period.

The Takeaway

Deflation refers to a period that can be thought of as the opposite of inflation. It occurs when the prices consumers pay for goods and services go down, which means that consumers can purchase more with the same amount of money.

When the economy is experiencing some turbulence, some investors may choose to keep their money in savings. On the other hand, other investors may see falling prices as an opportunity to purchase securities at a discount, either to hold or to sell when the economy recovers. Like any other investment strategy, investors must base their investment decisions on their personal preferences since there are no guaranteed results.

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).

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


About the author

Ashley Kilroy

Ashley Kilroy

Ashley Kilroy is a seasoned personal finance writer with 15 years of experience simplifying complex concepts for individuals seeking financial security. Her expertise has shined through in well-known publications like Rolling Stone, Forbes, SmartAsset, and Money Talks News. Read full bio.



Photo credit: iStock/eclipse_images

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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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

Claw Promotion: Customer must fund their Active Invest account with at least $50 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Investing in Small Cap Stocks

Investing in Small-Cap Stocks

Small-cap stocks are stocks in smaller companies, typically those worth between $250 million and $2 billion. Small-cap stocks often have high growth potential, which could make them an attractive investment. However, while these stocks may provide the opportunity to see higher returns over time, they also come with higher volatility and risk levels.

For investors considering adding small-cap stocks to their portfolios, it’s essential to understand how these stocks work and the advantages and disadvantages that come with this type of investment.

Key Points

•   Small-cap stocks have a market capitalization of $250 million to $2 billion, offering significant growth potential.

•   Higher risks and volatility are common due to less established business models and financial challenges.

•   Limited analyst coverage can lead to undervaluation, presenting investment opportunities.

•   Financial institutions may not heavily invest, affecting market liquidity and trading ease.

•   Diversifying through mutual funds or ETFs can help mitigate risks and balance returns.

What Are Small-Cap Stocks?

Small-cap stocks are shares of companies with a market cap between $250 million and $2 billion, and are usually moderately young companies. Small-cap stocks typically have some growth potential, but they may not have a longstanding market history. Therefore, these stocks are considered to be riskier than mid-cap stocks or large cap stocks.


💡 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.

Understanding Market Capitalization

Market capitalization, or market cap, is a measure of an individual company’s value. The market cap represents the value of total outstanding shares. Investors can use this value to compare similar companies as well as consider future growth predictions.

To calculate a company’s market cap, multiply the total number of outstanding shares by the current share price. For example, let’s say a company has 15 million outstanding shares at a share price of $25 per share. Using this calculation, the company’s market cap would be $375 million.

Due to share price fluctuations, the market cap fluctuates over time. To find the number of outstanding shares, investors can review the “capital stock” numbers on a company’s balance sheet. This information is updated during the quarterly filings with the Securities and Exchange Commission (SEC).

Are Small-Cap Stocks a Good Investment?

Small-cap stocks may be a good investment as part of a diversified portfolio, but there are risks. The market cap of a company can give investors an idea of the risk and reward of purchasing individual stocks. Purchasing small-cap stocks may be riskier than buying stocks of larger companies because the companies are often still in growth mode. In addition, small-cap companies often have fewer resources than large-cap companies, and may have less access to liquidity.

Due to these factors, any market dip can negatively impact small-cap stocks. Conversely, smaller companies often have higher upside potential, and small-cap growth stocks may deliver higher returns than their peers. Still, investors who choose these investments may have to weather market volatility along the way to growth.

Pros of Investing in Small-Cap Stocks

There are several benefits to allocating some of your portfolio into small-cap stocks.

Growth Potential

When comparing large-cap stocks to small-cap stocks, small-cap stocks tend to have a higher growth potential over the long-term. For much of the stock market’s history, small-cap stocks had higher returns than large-cap stocks, and other asset classes.

This growth potential makes small-cap stocks an attractive investment choice for investors. They tend to perform particularly well after recessions, during periods of economic expansion.

They’re Often Undervalued

Analysts usually spend less time analyzing small-cap stocks, so they get less attention from investors, which can lead to lower demand — and lower prices. Therefore, investors may be able to leverage the inefficiencies of the market for potentially better returns.

Financial Institutions Don’t Increase Stock Prices

Specific regulations may not allow financial institutions such as hedge funds and mutual funds to heavily invest in small-cap stocks. Therefore, it’s unlikely that large investments from financial institutions will artificially increase the stock price.

Cons of Investing in Small-Cap Stocks

While small-cap stocks have their benefits, there are also several drawbacks that investors should consider.

High Risk

Investing in small-cap stocks tends to have significant risk for investors. Since they’re often younger companies, small-cap companies do not always have a time-tested business model. If the company’s management can not make appropriate adjustments to the business model, it may yield poor financial or operational results.

Also, because small-cap companies may lack the resources such as capital or access to financing that larger companies have, they may struggle to expand the business or fill in cash flow gaps, especially if the economic conditions tighten.

Research May Be Time-Consuming

Due to the limited availability of research and analysis done on small-cap stocks, investors may have to spend a significant amount of time researching each investment option.

Minimal Liquidity

Small-cap stocks tend to have less liquidity than large cap company stocks. Since there are fewer shares available, investors may not be able to purchase the stock. Conversely, investors may not be able to sell their shares at a reasonable price. The liquidity of small-cap stocks adds to the risk of investing in this type of stock.

How to Invest in Small-Cap Stocks

Investors can purchase small-cap stocks through a brokerage firm or an individual investment account. Since there’s often less public information available about small-cap stocks, investors must do their own due diligence in researching companies to understand their potential risks and returns.

Investors who don’t have the time or expertise to determine which individual small-cap stocks to buy can invest in small-cap companies by purchasing mutual funds or exchange-traded funds (ETFs) that track a broader range of small-cap indexes. Some funds may also have unique characteristics within them, such as growth- or value-oriented stocks.

Buying mutual funds and ETFs allow investors to pool funds with other investors to sell and buy buckets of market securities. This type of investing aims to mitigate risks by diversifying investments. Instead of investing in a single company, fund investors are purchasing shares in dozens or hundreds of companies. Investing in mutual funds and ETFs is more of a passive investment strategy that doesn’t require investors to make trades actively.


💡 Quick Tip: Are self directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

Diversifying With Small-Cap Stocks

Even though small-cap mutual funds and ETFs provide diversification within a specific asset class, investors can further reduce their risk exposure by expanding portfolio diversification into a broader mix of assets.

Depending on market conditions, different types of stocks may perform differently. The concept can apply to stocks of companies that vary in sizes. Depending on what the market is doing, small, medium, and large companies may either beat the market returns or underperform.

When diversifying a portfolio, investors may start by determining their investment goals, risk tolerance, and time horizon. Then, by assessing these factors, they can decide an appropriate asset allocation to determine the portfolio’s percentage that may include stocks. A typical example is a portfolio composed of 60% stocks and 40% bonds.

Investors use the same factors (time horizon, goals, and risk tolerance) to decide the mix of stocks that will go into the portfolio’s stock percentage portion. Then, as market fluctuations happen, allocations of the portfolio will perform inversely.

For instance, as small-cap stocks are rising, mid-cap stocks may fall. In this case, small-cap stock prices’ upward movement can offset the decrease in mid-cap stock prices, thus mitigating losses.

The Takeaway

Small-cap stocks are shares of companies with market caps ranging from $250 million to $2 billion. Although small-cap stocks have the potential for long-term growth, they tend to come with more risk. With this in mind, building a diversified portfolio with a broader range of investments can help minimize your risk exposure.

But, attempting to build an entire portfolio from scratch and keep it balanced can be time-consuming and a risky venture if you’re an average investor. Instead, many investors choose to get small-cap exposure by purchasing mutual funds and exchange-traded funds (ETFs), which mimic the returns of indices that track stocks meeting certain criteria.

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).

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 a small-cap stock?

Small-cap stocks are shares of companies with market capitalizations between $250 million and $2 billion, making them relatively small.

What are some of the advantages to investing in small-cap stocks?

The primary advantages of investing in small-cap stocks are the potential for growth, share values tend to be relatively low, and share prices may not get pumped up due to large institutional investor activity.

What are the risks of investing in small-cap stocks?

Small-cap stocks tend to be riskier investments than some of their larger counterparts. They may take additional time to research and study, and they may also lack the same levels of liquidity as larger-cap stocks.


About the author

Ashley Kilroy

Ashley Kilroy

Ashley Kilroy is a seasoned personal finance writer with 15 years of experience simplifying complex concepts for individuals seeking financial security. Her expertise has shined through in well-known publications like Rolling Stone, Forbes, SmartAsset, and Money Talks News. Read full bio.



Photo credit: iStock/Erikona

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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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

Claw Promotion: Customer must fund their Active Invest account with at least $50 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

Third Party Trademarks: Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®

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