Investing Archives | Page 101 of 191

Oct

2023

What Are Cyclical Stocks?

By Rebecca Lake | Financial Independence, Growing Wealth, invest, Investing | Comments Off

Cyclical stocks are stocks that tend to follow trends in the broader economic cycle, with returns fluctuating as the market moves through upturns and downturns. A cyclical stock is the opposite of a defensive stock, which tends to offer more consistent returns regardless of macroeconomic trends.

Investing in cyclical stocks could be rewarding during periods of economic prosperity. During a recession, however, certain types of cyclical stocks may suffer if consumers are spending less.

What Is a Cyclical Stock?

The stock market is not static; it moves in cycles that often mirror the broader economy. To understand cyclical stocks, it helps to understand how the market changes over time, with the understanding that this has a different impact on different types of stocks.

A single stock market cycle involves four phases:

Accumulation (trough)

After reaching a bottom, the accumulation phase signals the start of a bull market and increased buying activity among investors.

Markup (expansion)

During the markup phase more investors may begin pouring money into the market, pushing stock valuations up.

Distribution (peak)

During this phase, investors begin to sell the securities they’ve accumulated, and market sentiment may begin to turn neutral or bearish.

Markdown (contraction)

The final phase of the cycle stock is a market downturn, when prices begin to significantly decline until reaching a bottom, at which point a new market cycle begins.

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Cyclical Stocks Examples

The cyclicality of a stock depends on how they react to economic changes. The more sensitive a stock is to shifting economic trends, the more likely investors would consider it cyclical. Some of the most common cyclical stock examples include companies representing these industries:

• Travel and tourism, including airlines

• Hotels and hospitality

• Restaurants and food service

• Manufacturing (i.e. vehicles, appliances, furniture, etc.)

• Retail

• Entertainment

• Construction

Generally, consumer cyclical stocks represent “wants” versus “needs” when it comes to how everyday people spend. That’s because when the economy is going strong, consumers may spend more freely on discretionary purchases. When the economy struggles, consumers may begin to cut back on spending in those areas.

Cyclical Stocks vs Noncyclical Stocks

Cyclical stocks are the opposite of non cyclical or defensive stocks. Noncyclical stocks don’t necessarily follow the movements of the market. While economic upturns or downturns can impact them, they may be more insulated against negative impacts, such as steep price drops.

Non Cyclical stocks examples may include companies from these sectors or industries:

• Utilities, such as electric, gas and water

• Consumer staples

• Healthcare

Defensive or non cyclical stocks represent things consumers are likely to spend money on, regardless of whether the economy is up or down. So that includes essential purchases like groceries, personal hygiene items, doctor visits, utility bills, and gas. Real estate investment trusts that invest in rental properties may also fall into this category, as recessions generally don’t diminish demand for housing.

Cyclical stocks may see returns shrink during periods of reduced consumer spending. Defensive stocks, on the other hand, may continue to post the same, stable returns or even experience a temporary increase in returns as consumers focus more of their spending dollars on essential purchases.

Dive deeper: Cyclical vs Non-Cyclical Stocks: Investing Around Economic Cycles

Pros and Cons of Investing in Cyclical Stocks

There are several reasons to consider investing in cyclical stocks, though whether it makes sense to do so depends on your broader investment strategy. Cyclical stocks are often value stocks, rather than growth stocks. Value stocks are undervalued by the market and have the potential for significant appreciation over time. Growth stocks, on the other hand, grow at a rate that outpaces the market average.

If you’re a buy-and-hold investor with a longer time horizon, you may consider value cyclical stocks. But it’s important to consider how comfortable you are with investment risk and riding out market ups and downs to see eventual price appreciation in your investment. When considering cyclical stocks, here are some of the most important advantages and disadvantages to keep in mind.

Pros of Cyclical Stocks

• Return potential. When a cyclical stock experiences a boom cycle in the economy, that can lead to higher returns. The more money consumers pour into discretionary purchases, the more cyclical stock prices may rise.

• Predictability. Cyclical stocks often follow market trends, making it easier to forecast how they may react under different economic conditions. This could be helpful in deciding when to buy or sell cyclical stocks in a portfolio.

• Value. Cyclical stocks may be value stocks, which can create long-term opportunities for appreciation. This assumes, of course, that you’re comfortable holding cyclical stocks for longer periods of time.

Cons of Cyclical Stocks

• Volatility. Cyclical stocks are by nature more volatile than defensive stocks. That means they could post greater losses if an unexpected market downturn occurs.

• Difficult to time. While cyclical stocks may establish their own pricing patterns based on market movements, it can still be difficult to determine how long to hold stocks. If you trade cyclical stocks too early or too late in the market cycle, you could risk losing money or missing out on gains.

• Uneven returns. Since cyclical stocks move in tandem with market cycles, your return history may look more like a rollercoaster than a straight line. If you’re looking for more stable returns, defensive stocks could be a better fit.

💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.

How to Invest in Cyclical Stocks

When considering cyclical stocks, it’s important to do the research before deciding which ones to buy. Having a basic understanding of fundamental analysis and technical analysis can help.

Fundamental analysis means taking a look under a company’s hood, so to speak, to measure its financial health. That can include looking at things like:

• Assets

• Liabilities

• Price to earnings (P/E) ratio

• Earnings per share (EPS)

• Price to earnings growth (PEG)

• Book to value ratio

• Cash flows

Fundamental analysis looks at how financially stable a company is and how likely it is to remain so during a changing economic environment.

Technical analysis, on the other hand, is more concerned with how things like momentum can affect a stock’s prices day to day or even hour to hour. This type of analysis considers how likely a particular trend is to continue.

Considering both can help you decide which cyclical stocks may be beneficial for achieving your short- or long-term investment goals.

The Takeaway

Cyclical stocks are stocks that tend to follow trends in the broader economic cycle, with returns fluctuating as the market moves. Cyclical stocks could be a good addition to your portfolio if you’re interested in value stocks, or you want to diversify with companies that may offer higher returns in a strong economy.

Investing in cyclical stocks does have its pros and cons, however, like investing in just about any other type or subset of securities. Investors should make sure they know the risks, and consider talking to a financial professional before making a decision.

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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.

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.

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

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Oct

2023

A Guide To Derivatives Trading

By Brian Nibley | Growing Wealth, invest, Investing | Comments Off

“Derivative” is an umbrella term that refers to any kind of financial security that derives its value from another asset. A derivative exists as a contract between two parties, and its value fluctuates in direct relation to its underlying asset. Some of the most commonly used assets that derivative contracts focus on include commodities, stocks, bonds, and currencies.

Futures and options contracts are examples of widely known derivatives. Credit-default swaps (CDS) are a lesser used, and riskier, form of derivatives, since they’re traded off of exchanges and the contract parties in that case do not own the underlying asset.

What Is a Trading Derivative?

A trading derivative is any contract that derives its value from an underlying asset. The nature of the relationship between the derivative and the underlying asset varies depending on the type of derivative.

Investors engage in trading derivatives for three main reasons:

• to hedge a position

• to gain leverage on a position

• to speculate on the future price of an asset

They’re a common tool for institutional investors, and also often used as a day trading strategy.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

Types of Derivatives

Here are a few examples of different kinds of derivatives and how they work.

Options

An option gives the owner the right (but not the obligation) to buy or sell an asset at a certain price in a specific timeframe. Savvy investors can use options to make a profit regardless of whether the market is going up or down.

The two most basic types of options are call options and put options. Call options give the owner the option to buy an asset at a specific price over a set time frame, while put options give the owner the right to sell an asset at a specific price over a set time frame.

The two main aspects of a put or call option are the strike price and the expiry date. The strike price is the price at which the owner intends to buy or sell the security, and the expiry date is the date by which the option must either expire or be exercised. Employee stock options are one type of derivative, in which the employees can (but do not have to) purchase shares of their company in the future at a price set today.

There are also many complex options trading strategies that include multiple “legs,” or multiple options contracts on the same underlying security. Some investors use “naked options,” which are a riskier form of option, in which the trader does not own the underlying security or have cash set aside to meet the obligation at expiration.

Futures Contracts

Often referred to simply as “futures,” futures contracts represent an obligation between a buyer and seller to exchange an asset for a fixed price on a selected date. Most futures trades take place on large exchanges and involve commodities such as oil, soybeans, or copper.

Farmers have used futures since the 1850s to reduce investment risk over future price fluctuations for their crops. Today, futures exist for many commodities and financial markets. These derivatives are mostly used as a form of speculation, where traders seek to make a quick profit.

Futures are sold on stock exchanges and have a standard form regulated by the U.S. Commodity Futures Trading Commission (CFTC).

Forward Contracts

Forward contracts are similar to futures contracts. But unlike futures, forward contracts are customized between the two parties entering into an agreement, as opposed to being standardized by regulators. Forwards are over-the-counter (OTC) derivatives and are not traded on exchanges. This market is private and unregulated.

Is Derivative Trading Profitable?

Derivatives tend to have high investment risk, but also offer high potential rewards. Large profits can be made quickly, but bets can go bad just as easily.

Depending on how they’re used, derivatives can range from simple speculation to being an integral part of an advanced, sophisticated strategy that incorporates many different types of investments.

Derivatives trading is especially risky for new investors who might not understand the bets they are making. Derivatives contracts involve many more variables than simply buying shares of a stock, and placing trades on an exchange can be confusing.

💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.

What Is a Derivative Trading Example?

Imagine an investor has their eye on a particular stock that they think will rise in price soon. One way to profit would be to buy shares. Another way would be to buy a derivative, such as a call option.

Our imaginary investor decides to buy a call option contract on ABC company. The strike price could be ten dollars higher than the current price, while the expiry date could be three months from now.

This could create a profit for the investor in two possible ways. The stock price could rise above the strike price of the call option, at which point the investor can sell the contract for more than it was purchased for.

Or, the investor can wait for the expiry date to come, at which point she will receive shares of the underlying stock at a price lower than their current market value.

How Are Derivatives Valued?

On the most basic level, the market values derivatives according to simple supply-and-demand dynamics as well as variables specific to the option itself, i.e. strike price and expiration date.

An options contract, for example, might be worth whatever people are willing to pay for it. This can change quickly and sometimes dramatically based on market conditions and news. Investors consider an option “out of the money” if its strike price is lower than the market price of the underlying asset.

On a more advanced level, investors can determine what the actual value of a derivative should be, as opposed to its current market value at any given moment.

One method for valuing derivatives is the Black Scholes model, a mathematical formula for determining market value for European call options. This formula takes into account several variables such as the implied volatility of an option, time left until expiration, and the present value of the option.

How Can Derivatives Be Used to Earn Income?

Investors use a variety of derivatives trading strategies. One common approach is a cash-secured put.

This derivatives trading strategy involves selling an out-of-the-money put option while also putting aside the money necessary to buy the underlying stock if it falls to the option’s strike price. The goal is typically to acquire shares of the stock at a price lower than it is trading at today, but investors also earn income in the form of a premium.

A premium is the price an investor pays for acquiring an options contract. Premiums are determined by the relationship between the underlying stock price and the strike price of the option, the length of time until the option expires, and how much the price of the stock fluctuates.

A premium of $0.20 per option contract, for example, would amount to $20 per contract, if one options contract represents 100 shares ($0.20 x 100 = $20).

So, if an investor were to place a cash-secured put with a strike price of $40 for a stock that currently trades at $50, they would need to set aside $4,000 and sell (or “write”) the associated put option.

Recommended: Guide to Writing Put Options

Then, if the price falls to $40 before the expiration time, the investor would buy shares at that price and keep the premium. Or, if the price doesn’t fall to the $40 level, the option will expire, worthless, and the investor will also keep the premium.

The Takeaway

Derivatives trading strategies provide a more advanced way to trade and speculate in the markets, earn income, or hedge a portfolio. Derivatives trading is more complex than simply buying and selling securities, comes with greater risk, and can potentially earn greater rewards. It’s common in certain sectors, such as precious metals or currency trading.

Given their complexities, derivatives may not be the best focus for beginner investors. They are complicated and risky, and it’s easy to find yourself in over your head. It may be a good idea to talk to a financial professional if you do want to explore your options, however.

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

Photo credit: iStock/solidcolours

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.

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

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Oct

2023

Pros & Cons of Using a Moving Average to Buy Stocks

By Kate Ashford | Growing Wealth, Investing, Terminology | Comments Off

The moving average is a tool that can help investors decide whether and when to buy or sell a stock. It presents a smoothed-out picture of where a stock’s price has been in the past and where it’s trending now. Investors may compute moving averages over a variety of time frames, and they are useful to both long-term and short-term investors.

What Is a Moving Average?

A moving average is a metric often used in technical analysis. For a stock, it’s a constantly updated average price.

Unlike trying to track a stock price day-to-day, a moving average smooths price volatility and is an indicator of the current direction a price is headed. A moving average reflects past prices — usually a stock’s closing price — so it’s not a predictor of future direction, just what’s happening now or in the past.

You can compute moving averages using almost any time frame. Common time frames include 20-day, 30-day, 50-day, 100-day and 200-day moving averages.

While a moving average is useful on its own when analyzing different types of investments, it also forms the basis of other types of technical indicators, such as the Moving Average Convergence Divergence (MACD) and the McClellan Oscillator.

💡 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.

Types of Moving Averages

There are three common types of moving averages that investors might consider when deciding when to buy or sell a stock:

Simple Moving Average:

As the name states, this is the simplest type of moving average. You can calculate the simple moving average by finding the arithmetic mean of a set of data points. For instance, if you had an average daily price for a stock each day for the last 30 days, you would add them all together and divide by the number of days.

The Simple Moving Average (SMA) formula is as follows:

P = Price on a given date

n = The time period

Example: Suppose you were trying to find the simple moving average of a stock price over 10 days.

N = 10 days

Prices (in dollars) = 11, 12, 15, 13, 12, 7, 10, 11, 13, 12

SMA = (11 + 12 + 15 + 13 + 12 + 7 + 10 + 11 + 13 + 12) / 10

SMA = 11.6

Weighted Moving Average

A weighted moving average (WMA) gives more weight to certain price prices. If you overweight recent prices, for example, the measure becomes more responsive to recent price moves and less prone to the lag effect.

Exponential Moving Average:

An exponential moving average is a type of weighted moving average that calculates changes in a price cumulatively, rather than based on previous average. That means that all previous data values impact the EMA, since there is less variation over time.

Why Would an Investor Use a Moving Average?

Using a moving average to analyze a stock can help you filter out the “noise” that comes from random price fluctuations. By looking at the direction of the moving average, you can get a sense of whether the price is generally moving up or generally moving down. If a moving average is moving sideways (neither up nor down), the price is probably sticking within a window and not fluctuating much.

A moving average is sometimes plotted as a line by itself on a price chart to illustrate price trends. And different moving average lines can be used in tandem to spot changes in direction. For instance, an investor might be looking at a faster moving average (one with a shorter period, such as 10 days) versus a slower moving average (one with a longer period, such as 200 days). When these lines cross each other, it’s called a moving-average crossover, and can indicate that the trend is changing or is about to change.

Moving averages can also indicate support or resistance levels. Support levels are a price level where a downward trending line would be predicted to pause, due to demand or buying interest. A resistance level is a price ceiling where an upward trending line would be expected to plateau due to selling interest. Over time, watching moving averages can help investors identify these levels of support and resistance, and use them to make buy/sell decisions.

💡 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.

Pros of Using a Moving Average

A moving average offers several benefits to investors.

It smooths the data.

Day-to-day price swings can be confusing to track, and make it difficult to determine a stock’s direction. A moving average smooths out volatility, giving you a better look at how a stock is trending.

It’s a simple gauge.

As an analytical tool, a simple moving average is easy to interpret. If a stock’s current price is higher than an upward trending moving average line, the stock is headed up in the short-term. If a stock’s price is lower than a downward trending moving average line, the stock is headed down in the short-term.

Easy to calculate.

A moving average is a relatively easy metric, so the average investor can calculate it on their own.

Cons of Using a Moving Average

It’s important to keep the drawbacks of moving averages in mind when using them to determine whether to buy shares of a company.

They’re not predictive.

As with all investments, past performance is not an indicator of future performance, so a moving average — no matter which type you use — can’t tell you what a stock will do next.

There’s a lag.

The longer the period your moving average covers, the greater your lag — meaning how responsive your moving average is to price changes. A 10-day exponential moving average, for instance, will react quickly to price turns, while a 200-day moving average is more sluggish and slower to react to changes.

There’s trouble with price turbulence.

If prices are trending in one direction or another, a moving average may be a helpful metric. But if prices are choppy or volatile, the moving average becomes less useful, since it will swing along with the price. Allowing for a lengthier time frame may resolve this issue, but it can still occur.

Simple moving averages weigh all prices equally. This can be a disadvantage if a stock’s price has taken a significant but recent shift.

Weighted moving averages may send false signals.

Since WMAs put more weight on more recent data, they’re faster to react to price swings, which can occasionally be misleading.

The Takeaway

Moving averages are just one metric you can use to evaluate a stock. They can help quiet the noise of price fluctuations and show you what a stock is doing over time. That said, in some environments or with specific price patterns, moving averages may lag or send a misleading signal.

With that in mind, knowing what a moving average is can be helpful when learning how to size-up potential investments. It’s critical to consider the pros and cons, of course, but moving averages can be another tool in an investor’s tool chest.

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

Photo credit: iStock/nilakkus

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

Sep

2023

What Happened During Tulip Mania?

By Ashley Kilroy | Growing Wealth, invest, Investing | Comments Off

One of the most famous instances of an asset bubble was the “Tulip Mania” that erupted in Holland during the 17th century. It was the first recorded major financial bubble, during which demand for tulips exploded, and prices for the flowers followed suit.

This led some investors to speculatively purchase tulips, resulting in losses when prices fell back down. Despite Tulip Mania occurring centuries ago, it can still be used as a history lesson for current traders and investors.

What Was Tulip Mania?

Tulip Mania was a speculative frenzy that erupted in Holland during the 17th century. The Dutch were newly independent of Spain and building themselves into prosperous traders. The mid-1600s was a period of wealth for them, as they benefited from rare imports brought through the Dutch East India Company.

Interest in exotic items was at an all-time high, and collectors became fascinated with not just tulips, but “broken” tulips. These tulips came from bulbs and grew into striped or multicolored patterns. As demand grew, more companies began selling bulbs.

The most famous tales about Tulip Mania sound like something out of a book. People of all walks of life bought the flowers in a frenzy at sometimes extremely high prices. They hoped for significant returns and to escape their social classes, but they met financial disaster. Those investors fell into ruin when the tulip bubble burst in 1637 – similar to the dotcom bubble in more recent times – and some of the stories even detail tragic endings; people losing everything and drowning themselves in the canals. All because a tulip-incited mass hysteria that created a financial crisis.

But, is it really true?

💡 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.

What Really Happened During Tulip Mania?

The “mania” in the story of Tulip Mania comes from an 1841 account by a Scottish author named Charles MacKay. His Memoirs of Extraordinary Popular Delusions and the Madness of Crowds detailed a “tulipomania” where people poured years of salaries into the speculative tulip trade. From farmers, to nobles, to chimney-sweeps, he documented every class buying in. Then, the memoir described mayhem following the market collapse in 1637. Ultimately, MacKay created a dramatic tale that was more fiction than fact.

There was a Dutch tulip bulb market during the Dutch Golden Age. However, traders were limited to buyers with the finances to invest in luxury items. Typically, this group included merchants, artisans, and the upper class.

Additionally, the price increase was not consistent. Between December 1636 and February 1637, some highly sought-after bulbs experienced a price spike. Some of the most expensive went for 5,000 guilders, which equaled the value of a nice home in 1637. Or, there is evidence that the highest bid totaled out to 5,200 guilders. That matched 20 times the yearly salary of a skilled worker. But these prices were the exception, not the rule.

That leaves the final part of the story: the fallout.

Tulip Mania Bubble Burst

Tulip Mania is the classic and most well-known historical example of a financial bubble.

Traders bought into the bulbs with the intent to resell and earn a profit. However, the flowers’ held no inherent value. Their status as a luxury item determined their prices and pushed demand. In fact, demand grew so high that professional traders began bidding on the product on the Stock Exchange of Amsterdam. People even used margined derivative contracts to increase the number of tulips they could buy despite their financial limits.

But before spring even hit, the bubble burst. The mania fell away after the tulips lost their value when the supply of tulips increased due to warmer weather. With so many of the crops, bulb traders realized the product wasn’t as rare as they thought. An auction in Haarlem in February of 1637 seemed to solidify the thought when the auctioneers failed to sell any bulbs.

When the prices dropped, traders had to sell their holdings for a lower value. However, this led to a few broken relationships and lost reputations, not any tragic deaths.

So, there was no morbid end when the Tulip Mania bubble burst. MacKay reported that Holland’s national economy fell apart due to the volatile market crash, but those claims appear exaggerated. The bubble only impacted those who were involved in the Tulip trade, and most investors were in an easily salvageable position. They financially recovered relatively quickly. On the other hand, growers did struggle to replace the lost buyers when certain contracts fell through.

What Tulip Mania Reveals About Financial Markets

While the story is more straightforward than MacKay made many believe, it is still a valuable moment in economic history. It became a parable that explains the nature of bubbles and the crashes that occurred throughout the history of the stock market.

Part of its value as a lesson stems from its moment in time. Multiple bubbles followed Tulip Mania, including the railroad mania bubble during the 1840s, where commentators encouraged investors to buy into U.K. railway stocks or in the early 2000s when Americans began speculating in residential housing before that bubble burst.

The dynamics behind each of these events is similar to the dynamics of the tulip bubble. Speculators drive up the price of an asset beyond its intrinsic value until the bubble eventually busts and those who bought at the top of the market end up losing money in the market downturn.

The Takeaway

Tulip Mania is perhaps the penultimate example of a market bubble, which still resonates today, even though it occurred in Holland centuries ago. Bubbles can also occur in the pricing of individual securities, sectors, or the broader stock market, eventually leading to a crash in prices.

A stock market crash is an alarming time that can send many investors into a panic. They see the drop and move immediately to selling. However, panic selling in the face of market volatility can have disastrous effects on a portfolio. Either you sell when the market is struggling and earn lower returns as a result, or you miss out on the market rebound.

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.

SoFi Invest®

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

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Sep

2023

What Is a Leverage Ratio?

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

Leverage ratios are a collection of formulas commonly used to compare how much debt, or leverage, a company has relative to its assets and equity. It shows whether a company is using more equity or more debt to finance its operations. Understanding a company’s debt situation is a key part of fundamental analysis during stock research. Calculating its financial leverage ratio helps potential investors understand a company’s ability to pay off its debt.

A high leverage ratio could indicate that a company has taken on more debt than it can pay off with its current cash flows, potentially making the company a riskier investment.

How to Calculate Leverage

A company increases its leverage by taking on more debt, acquiring an asset through a lease, buying back its own stock using borrowed funds, or by acquiring another company using borrowed funds.

There are several types of leverage ratios, which compare a company’s or an individual’s debt levels to other financial indicators. Some commonly used ones are:

Debt-to-Assets Ratio

This ratio compares a company’s debt to its assets. It is calculated by dividing total debt by total assets. A higher ratio could indicate that the company has purchased the majority of its assets with debt. That could be a warning sign that the company doesn’t have enough cash or profits to pay off these debts.

Formula: Total debt / total assets

Debt-to-Equity Ratio (D/E)

The debt-to-equity ratio compares a company’s debt to its equity. It is calculated by dividing total debt by total equity. If this ratio is high, it could indicate that the company has been financing its growth using debt.

The appropriate D/E ratio will vary by company. Some industries require more capital and some companies may need to take on more debt. Comparing ratios of companies in the same industry can give you a sense of what the typical ranges are.

Formula: Total debt / total equity

Asset-to-Equity Ratio

This is similar to the D/E ratio, but uses assets instead of debt. Assets include debt, so debt is still included in the overall ratio. If this ratio is high, it means the company is funding its operations mostly with assets and debt rather than equity.

Formula: Total assets / total equity

Debt-to-Capital Ratio

Another popular ratio, this one looks at a company’s debt liabilities and its total capital. It includes both short- and long-term debt, as well as shareholder equity. If this ratio is high, this may be a sign that the company is a risky investment.

Formula: Debt-to-capital ratio: Total debt / (total debt + total shareholder equity)

Degree of Financial Leverage

This calculation shows how a company’s operating income or earnings before interest (EBIT) and taxes will impact its earnings per share (EPS). If a company takes on more debt, it may have less stable earnings. This can be a good thing if the debt helps the company earn more money, but if the company goes through a less profitable period it could have a harder time paying off the debt.

Formula: % change in earnings per share / % change in earnings before interest and taxes

Consumer Leverage Ratio

This ratio compares the average American consumer’s debt to their disposable income. If consumers go into more debt, their spending can help fuel the economy, but it can also lead to larger economic problems.

Formula: Total household debt / disposable personal income

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

Ways to Use Leverage Ratio Calculations

Understanding the definition of leverage ratio and the formulas for various types, is the first step toward using the measurement to make investing decisions. Investors use leverage ratios as a tool to measure the risk of investing in a company.

Simply put, they show how much borrowed money a company is using. Each industry is different, and the amount of debt a company has may differ depending on who its competitors are and other factors, such as its historical profits. In a very competitive industry or one that requires significant capital investment, it may be riskier to invest in or lend to a company with a high leverage ratio.

The interest rates companies are paying matters also, since debt at a lower rate has a smaller impact on the bottom line.

Regardless of industry, If a company can not pay back its debts, it may end up going bankrupt, and the investor could lose their money. On the other hand, if a company is using some leverage to fuel growth, this can be a good sign for investors. This means shareholders can see a greater return on equity when the company profits off of that growth. If a company can’t or chooses not to borrow any money, that could signal that they have tight margins, which may also be a warning sign for investors.

Investors can also use leverage ratios to understand how a potential change in expenses or income might affect the company.

How Lenders Use Leverage Ratios

In addition to investors, potential lenders calculate leverage ratios to figure out how much they are willing to lend to a company. These calculations are completed in addition to other calculations to provide a comprehensive picture of the company’s financial situation.

Overall, leverage ratio is one calculation amongst many that are used to evaluate a company for potential investment or lending.

How Leverage is Created

There are several different ways companies or individuals create leverage These include:

• A company may borrow money to fund the acquisition of another business by issuing bonds

• Large companies can take out “cash flow loans” based on their credit status

• A company may purchase assets such as equipment or property using “asset-backed lending”

• A company or private equity firm may do a leveraged buyout

• Individuals take out a mortgage to purchase a house

• Individual investors who trade options, futures, and margins may use leverage to increase their position

• Investors may borrow money against their investment portfolio

The Takeaway

All leverage ratios are a measure of a company’s risk. Understanding basic formulas for fundamental analysis is an important strategy when starting to invest in stocks. Such formulas can help investors weigh the risks of a particular asset investment and compare assets to one another.

There are numerous ways to use leverage ratios, and lenders can use them as well. In all, knowing the basics about them can help broaden your knowledge and understanding of the financial industry.

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Ways to Use Leverage Ratio Calculations

How Lenders Use Leverage Ratios

How Leverage is Created

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