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Q: What Is Mark to Market?

Mark to market or mark-to-market is an accounting method that’s used to measure the value of assets based on current market conditions. Mark to market accounting seeks to determine the real value of assets based on what they could be sold for right now.

Q: Can You Mark Assets to Market?

It’s possible to use mark to market principles when making trades. If you’re trading futures contracts, for instance, mark-to-market adjustments are made to your cash balance daily, based on the settlement price of the securities you hold.

Nov

2023

What Is Mark to Market and How Does It Work?

Mark to Market Definition and Uses in Account & Investing

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

The term “mark to market” refers to an accounting method used to measure the value of assets based on current market conditions. Mark to market accounting seeks to determine the real value of assets based on what they could be sold for right now.

That can be useful in a business setting when a company is trying to gauge its financial health or get a valuation estimate ahead of a merger or acquisition. Aside from accounting, mark to market also has applications in investing when trading stocks, futures contracts, and mutual funds. For traders and investors, it can be important to understand how this concept works.

Key Points

• Mark to market is an accounting method used to determine the current value of assets based on market conditions.

• It is used in business to assess financial health and valuation, as well as in investing for trading stocks, futures contracts, and mutual funds.

• Mark to market accounting adjusts asset values based on current market conditions to estimate their potential sale value.

• Pros of mark to market accounting include accurate valuations for asset liquidation, value investing, and establishing collateral value for loans.

• Cons include potential inaccuracies, volatility skewing valuations, and the risk of devaluing assets in an economic downturn.

What Is Mark to Market?

Mark to market is, in simple terms, an accounting method that’s used to calculate the current or real value of a company’s assets, as noted. Mark to market can tell you what an asset is worth based on its fair market value.

Mark to market accounting is meant to create an accurate estimate of a company’s financial status and value year over year. This accounting method can tell you whether a company’s assets have increased or declined in value. When liabilities are factored in, mark to market can give you an idea of a company’s net worth.

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How Mark to Market Accounting Works

Mark to market accounting works by adjusting the value of assets based on current market conditions. The idea is to determine how much an asset — whether it be a piece of equipment or an investment — could be worth if it were to be sold immediately.

If a company were in a cash crunch, for example, and wanted to sell off some of its assets, mark to market accounting could give an idea of how much capital it might be able to raise. The company would try to determine as accurately as possible what its marketable assets are worth.

In stock trading, mark to market value is determined for securities by looking at volatility and market performance. Specifically, you’re looking at a security’s current trading price then making adjustments to value based on the trading price at the end of the trading day.

There are other ways mark to market can be used beyond valuing company assets or securities. In insurance, for example, the mark to market method is used to calculate the replacement value of personal property. Calculating net worth, an important personal finance ratio, is also a simple form of mark to market accounting.

Mark-to-Market Accounting: Pros and Cons

Mark to market accounting can be useful when evaluating how much a company’s assets are worth or determining value when trading securities. But it’s not an entirely foolproof accounting method.

Mark to Market Pros	Mark to Market Cons
• Can help establish accurate valuations when companies need to liquidate assets • Useful for value investors when making investment decisions • May make it easier for lenders to establish the value of collateral when extending loans	• Valuations are not always 100% accurate since they’re based on current market conditions • Increased volatility may skew valuations of company assets • Companies may devalue their assets in an economic downturn, which can result in losses

Mark to Market Pros

Mark to Market Cons

• Can help establish accurate valuations when companies need to liquidate assets

• Useful for value investors when making investment decisions

• May make it easier for lenders to establish the value of collateral when extending loans

• Valuations are not always 100% accurate since they’re based on current market conditions

• Increased volatility may skew valuations of company assets

• Companies may devalue their assets in an economic downturn, which can result in losses

Pros of Mark to Market Accounting

There are a few advantages of mark to market accounting:

• It can help generate an accurate valuation of company assets. This may be important if a company needs to liquidate assets or it’s attempting to secure financing. Lenders can use the mark to market value of assets to determine whether a company has sufficient collateral to secure a loan.

• It can help mitigate risk. If a value investor is looking for new companies to invest in, for example, having an accurate valuation is critical for avoiding value traps. Investors who rely on a fundamental approach can also use mark to market value when examining key financial ratios, such as price to earnings (P/E) or return on equity (ROE).

• It may make it easier for lenders to establish the value of collateral when extending loans. Mark to market may provide more accurate guidance in terms of collateral value.

Cons of Mark to Market Accounting

There are also some potential disadvantages of using mark to market accounting:

• It may not be 100% accurate. Fair market value is determined based on what you expect someone to pay for an asset that you have to sell. That doesn’t necessarily guarantee you would get that amount if you were to sell the asset.

• It can be problematic during periods of increased economic volatility. It may be more difficult to estimate the value of a company’s assets or net worth when the market is experiencing uncertainty or overall momentum is trending toward an economic downturn.

• Companies may inadvertently devalue their assets in a downturn. If the market’s perception of a company, industry, or sector turns negative, it could spur a sell-off of assets. Companies may end up devaluing their assets if they’re liquidating in a panic. This can have a boomerang effect and drive further economic decline, as it did in the 1930s when banks marked down assets following the 1929 stock market crash.

Mark to Market in Investing

In investing, mark to market is used to measure the current value of securities, portfolios or trading accounts. This is most often used in instances where investors are trading futures or other securities in margin accounts.

Futures are derivative financial contracts, in which there’s an agreement to buy or sell a particular security at a specific price on a future date. Margin trading involves borrowing money from a brokerage in order to increase purchasing power.

Understanding mark to market is important for meeting margin requirements to continue trading. Investors typically have to deposit cash or have marginable securities of $2,000 or 50% of the securities purchased. The maintenance margin reflects the amount that must be in the margin account at all times to avoid a margin call.

In simple terms, margin calls are requests for more money. FINRA rules require the maintenance margin to be at least 25% of the total value of margin securities. If an investor is subject to a margin call, they’ll have to sell assets or deposit more money to reach their maintenance margin and continue trading.

In futures trading, mark to market is used to price contracts at the end of the trading day. Adjustments are made to reflect the day’s profits or losses, based on the closing price at settlement. These adjustments affect the cash balance showing in a futures account, which in turn may affect an investor’s ability to meet margin maintenance requirements.

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Mark to Market Example

Futures markets follow an official daily settlement price that’s established by the exchange. In a futures contract transaction you have a long trader and a short trader. The amount of value gained or lost in the futures contract at the end of the day is reflected in the values of the accounts belonging to the short and long trader.

So, assume a farmer takes a short position in 10 soybean futures contracts to hedge against the possibility of falling commodities prices. Each contract represents 5,000 bushels of soybeans and is priced at $5 each. The farmer’s account balance is $250,000. This account balance will change daily as the mark to market value is recalculated. Here’s what that might look like over a five-day period.

Day	Futures Price	Change in Value	Gain/Loss	Cumulative Gain/Loss	Account Balance
1	$5				$250,00
2	$5.05	+0.05	-2,500	-2,500	$247,500
3	$5.03	-0.02	+1,000	-1,500	$248,500
4	$4.97	-0.06	+3,000	+1,500	$251,500
5	$4.90	-0.07	+3,500	+5,000	$255,000

Since the farmer took a short position, a decline in the value of the futures contract results in a positive gain for their account value. This daily pattern of mark to market will continue until the futures contract expires.

Conversely, the trader who holds a long position in the same contract will see their account balance move in the opposite direction as each new gain or loss is posted.

Mark to Market in Recent History

Mark to market accounting can become problematic if an asset’s market value and true value are out of sync. For example, during the financial crisis of 2008-09, mortgage-backed securities (MBS) became a trouble spot for banks. As the housing market soared, banks raised valuations for mortgage-backed securities. To increase borrowing and sell more loans, credit standards were relaxed. This meant banks were carrying a substantial amount of subprime loans.

As asset prices began to fall, banks began pulling back on loans to keep their liabilities in balance with assets. The end result was a housing bubble which sparked a housing crisis. During this time, the U.S. economy would enter one of the worst recessions in recent history.

The U.S. Financial Accounting Standards Board (FASB) eased rules regarding the use of mark to market accounting in 2009. This permitted banks to keep the values of mortgage-backed securities on their balance sheets when the value of those securities had dropped significantly. The measure meant banks were not forced to mark the value of those securities down.

Can You Mark Assets to Market?

The FASB oversees mark to market accounting standards. These standards, along with other accounting and financial reporting rules, apply to corporate entities and nonprofit organizations in the U.S. But it’s possible to use mark to market principles when making trades.

If you’re trading futures contracts, for instance, mark to market adjustments are made to your cash balance daily, based on the settlement price of the securities you hold. Your cash balance will increase or decrease based on the gains or losses reported for that day.

If the market moves in your favor, your account’s value would increase. But if the market moves against you and your futures contracts drop in value, your cash balance would adjust accordingly. You’d have to pay attention to maintenance margin requirements in order to avoid a margin call.

Which Assets Are Marked to Market?

Generally, the types of assets that are marked to market are ones that are bought and sold for cash relatively quickly — otherwise known as marketable securities. Assets that can be marked to market include stocks, futures, and mutual funds. These are assets for which it’s possible to determine a fair market value based on current market conditions.

When measuring the value of tangible and intangible assets, companies may not use the mark to market method. In the case of equipment, for example, they may use historical cost accounting which considers the original price paid for an asset and its subsequent depreciation. Meanwhile, different valuation methods may be necessary to determine the worth of intellectual property or a company’s brand reputation, which are intangible assets.

Mark to Market Losses

Mark to market losses occur when the value of an asset falls from one day to the next. A mark to market loss is unrealized since it only reflects the change in valuation of asset, not any capital losses associated with the sale of an asset for less than its purchase price. The loss happens when the value of the asset or security in question is adjusted to reflect its new market value.

Mark to Market Losses During Crises

Mark to market losses can be amplified during a financial crisis when it’s difficult to accurately determine the fair market value of an asset or security. When the stock market crashed, for instance, in 1929, banks were moved to devalue assets based on mark to market accounting rules. This helped turn what could have been a temporary recession into the Great Depression, one of the most significant economic events in stock market history.

Mark to Market Losses in 2008

During the 2008 financial crisis, mark to market accounting practices were a target of criticism as the housing market crashed. The market for mortgage-backed securities vanished, meaning the value of those securities took a nosedive.

Banks couldn’t sell those assets, and under mark to market accounting rules they had to be revalued. As a result banks collectively reported around $2 trillion in total mark to market losses.

The Takeaway

Mark to market is, as discussed, an accounting method that’s used to calculate the current or real value of a company’s assets. Mark to market is a helpful principle to understand, especially if you’re interested in futures trading.

When trading futures or trading on margin, it’s important to understand how mark to market calculations could affect your returns and your potential to be subject to a margin call. As always, if you feel like you’re in the weeds, it can be beneficial to speak with a financial professional for guidance.

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FAQ

Is mark to market accounting legal?

Mark to market account is a legal accounting practice, and is overseen by the FASB. Though it has been used in the past to cover financial losses, it remains a legal and viable method.

Is mark to market accounting still used?

Yes, mark to market accounting is still used both by businesses and individuals for investments and personal finance needs. In some sectors of the economy, it may even remain as one of the primary accounting methods.

What are mark to market losses?

Mark to market losses are losses that are generated as a result of an accounting entry, as opposed to a loss generated by the sale of an asset. The loss is incurred, under mark to market accounting, when the value of an asset declines, not when it is sold for less than it was purchased.

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Nov

2023

Guide to Calculating EPS and Why It Matters

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

Earnings per share (EPS) tells investors a company’s ability to produce income for shareholders, and relates to its profitability. To calculate EPS, investors can use a ratio that takes a company’s quarterly or annual net income and divide it by the number of outstanding shares of stock on the market.

Knowing a stock’s earnings per share can be a valuable portfolio benchmarking tool. Think of EPS as GPS for where a public company is on the value map, based on how profitable it has been. Further, knowing an investment’s EPS gives investors — and portfolio managers — a good indicator of a stock’s performance over a specific period of time and its potential share price performance in the near future.

Key Points

• Earnings per share (EPS) is a ratio that measures a company’s ability to generate income for shareholders.

• EPS is calculated by dividing a company’s net income by the number of outstanding shares of stock.

• EPS is a valuable tool for benchmarking a company’s profitability and assessing its potential share price performance.

• Basic EPS includes all outstanding stock shares, while diluted EPS considers additional assets like convertible securities.

• EPS may help investors evaluate a company’s financial health, make investment decisions, and assess risk.

What Is Earnings Per Share (EPS)?

The starting point for any conversation about the EPS ratio is the earnings report companies issue to regulators, shareholders, and potential investors. Earnings reports play a major role, if not the starring role, during earnings season.

Publicly traded companies must, by law, report their earnings quarterly and annually. Earnings represent the net income a company generates (after taxes and after expenses are deducted), along with an estimate of what profits or losses can be expected going forward.

Typically, investment analysts, money managers and investors look at earnings as a major component of a company’s profit potential, with earnings per share a particularly useful measurement tool when gauging a company’s financial prospects.

While a company’s earnings call represents a publicly traded company’s revenues, minus operating expenses, earnings per share is different.

EPS indicates a firm’s earnings for investors, divided by the company’s number of remaining shares. Earnings per share is perhaps most optimal when comparing EPS rates of publicly traded firms operating in the same industry.

It is likely not, however, the only investment measurement tool when researching stocks and funds. Other key indicators, like share price, market share, market capitalization, dividend growth, and historical performance may also be added to the investment assessment mix. In all, though, it’s an important tool that can help determine the investing risk at play when making investing decisions.

If you’re wondering how to find earnings per share, investors can find a company’s quarterly and yearly EPS by visiting the firm’s investor relations page on its website or by plugging in the stock’s ticker symbol on major business and finance media platforms.

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Basic and Diluted EPS

When companies report earnings per share, they may do so in two forms: basic EPS or diluted EPS. Each has key distinctions that investors should know about. Basic EPS is a good barometer of a firm’s financial health, while diluted EPS represents a deeper dive into a company’s financial metrics and its use of alternative assets like convertible securities.

Basic

Basic earnings per share, or basic EPS, includes all of a publicly traded company’s outstanding stock shares.

Diluted

Diluted earnings per share, or diluted eps, includes all of a company’s outstanding stock shares, plus its investable assets, like stock options, stock warrants, and other forms of convertible investments tied to a company’s financial performance that could become common stocks one day.

One big takeaway for both EPS models is that any major deviation between basic and diluted EPS calculations should be considered a warning sign to investors, as it indicates that a company’s use of convertible securities is complicated and still in flux.

That scenario may indicate that the company isn’t in an ideal position to provide accurate share value to the investing public at a given time.

Why Is EPS Important to Investors

EPS calculations are not only a snapshot of a company’s profit performance, but they can also be used to evaluate a company’s stock price going forward. Even a moderate increase in EPS may indicate that a company’s profit potential is on the upside, and investors may take that as a sign to buy the company’s stock.

Conversely, a small decrease in a company’s EPS from quarter to quarter may trigger a red flag among investors, who could view a downward EPS trend as a larger profit issue and shy away from buying the company’s stock.

In short, the higher the EPS, the more attractive that company’s stock generally is to investors. But the higher a stock’s EPS, the more expensive its shares are likely to be.

Once investors have an accurate EPS figure, they can decide if a stock is priced fairly and make an appropriate investment decision.

What Is Considered a Good EPS Ratio?

There’s no hard and fast figure to point to when trying to determine a good EPS ratio. It’s perhaps better practice to look, in general, for a higher number. Context is important, too, because whether an EPS is good may depend on the expectations surrounding it.

Companies grow at different rates, and some are in different stages of growth than others. With that in mind, you might expect a different EPS for, say, a tech startup than you would for a decades-old auto manufacturer. So, there are differences and contexts to take into consideration.

But again, it may be best to look for a high number — or, to do some research to figure out what analysts and experts are looking for in terms of a specific company’s EPS. Again, this can all help you determine whether a stock is right for your portfolio and strategy in accordance with your tolerance for risk.

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Earnings Per Share Ratio Considerations

Investors should prepare to dig deeper and examine what factors influence EPS figures. These factors are at the top of that list:

• EPS numbers can rise or fall significantly based on earnings’ rise or fall, or as the number of company shares rises or falls.

• A company’s earnings may rise because sales are surging faster than expenses, or if company managers succeed in curbing operations costs. Additionally, investors may get a “false read” on EPS if too many company expenses are shed from the EPS calculation.

• A company’s number of outstanding shares may fall if a company engages in significant stock share buybacks. Correspondingly, shares outstanding may jump when a firm issues new stock shares.

• A company’s profit margins are also a big influencer on EPS. A company that is losing money usually has a negative EPS number. (Then again, that may send a wrong signal to investors. The company could be on the path to profits, and that trend may not show up in an EPS calculation.)

• A price to earnings ratio is another highly useful metric to evaluate a stock’s share growth potential. Investors can find a P/E ratio through a proper calculation of EPS (“P” is the price per share; “E” refers to EPS), though it’s easy to look up a P/E ratio on any site that aggregates stock information.

EPS can be reported for each quarter or fiscal year, or it can be projected into the future with a forward EPS.

How to Calculate EPS

The EPS formula is fairly simple, and it can be used in a couple of different methods, too. The most common way to accurately gauge an EPS figure is through an end-of-period calculation.

EPS Formula

The EPS formula is a company’s net income, minus its preferred dividends, divided by the number of shares outstanding. It looks like this:

EPS = (net income – preferred dividends) / outstanding shares

EPS is perhaps usually calculated using preferred dividends, but it can be calculated without them, too. Here are a couple of examples:

Example With Preferred Dividends

Investors can calculate EPS by subtracting a stock’s total preferred dividends from the company’s net income. Then divide that number by the end-of-period stock shares that are outstanding.

Basic EPS = (net income – preferred dividends) / weighted average number of common shares outstanding

For example, ABC Co. generates a net income of $2 million in a quarter. Simultaneously, the company rolls out $275,000 in preferred dividends and has 12 million outstanding shares of stock. In that calculation, knowing that shares of common stock are equal in value, the company’s earnings per share is $0.14.

(2,000,000 – 275,000) ÷ 12,000,000＝ 0.14

Example Without Preferred Dividends

For smaller publicly traded companies with no preferred dividends, the EPS calculation is more straightforward.

Basic EPS = net income / weighted average number of common shares outstanding

Let’s say DEF Corp. has generated a net income of $50,000 for the year. As the company has no preferred shares outstanding and has 5,000 weighted average shares on an annual basis, its earnings per share is $10.

50,000 ÷ 5,000＝ 10

In any EPS calculation, preferred dividends must be severed from net income. That’s because earnings per share is primarily designed to calculate the net income for holders of common stock.

Additionally, in most EPS end-of-period calculations, a company is mostly likely to calculate EPS for end-of-year financial statements. That’s because companies may issue new stock or buy back existing shares of company stock.

In those instances, a weighted average of common stock shares is required for an accurate EPS assessment. (A weighted average of a company’s outstanding shares can provide more clarity because a fixed number at any given time may provide a false EPS outcome, as share prices can be volatile and change quickly on a day-to-day basis.)

The most commonly used EPS share model calculation is the “trailing 12 months” formula, which tracks a company’s earnings per share by totaling its EPS for the previous four quarters.

The Takeaway

Earnings per share (EPS) can be calculated by investors to get a better sense of a company’s ability to produce income for shareholders. To calculate EPS, investors can use a ratio that takes a company’s quarterly or annual net income and divide it by the number of outstanding shares of stock on the market. There are different variations of the calculation, too.

Earnings trends, up or down, make earnings per share one of the most valuable metrics for assessing investments. Four or five years of positive EPS activity is considered an indicator that a company’s long-term financial prospects are robust and that its share growth should continue to rise.

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FAQ

How do you calculate EPS by year?

To calculate EPS by year, investors can use the formula that subtracts preferred dividends from net income, and then divide that number by the weighted average of common shares outstanding for the given year.

What is a good EPS ratio?

Each company is different, as is the context surrounding it, so there is no general rule about what makes a “good” EPS ratio for any given stock. Instead, investors should gauge analyst expectations, and consider a company’s age, among other things, to determine if its EPS is good or bad.

What are the two ways to calculate EPS?

Earnings per share (EPS) can be calculated with preferred dividends, or without preferred dividends, depending on the specific company.

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Nov

2023

Capital Appreciation on Investments

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

The term capital appreciation refers to an investment’s value rising over time. Theoretically, capital, meaning money or funds, appreciates, or goes up (as opposed to depreciates) after an investor initially purchases it, and that rise in value is what’s referred to as capital appreciation.

Of course, capital can also depreciate, but investors aren’t usually looking for negative returns. This is an important concept for investors to grasp, too, as capital appreciation is likely the main goal of most investors’ overall strategies.

Key Points

• Capital appreciation refers to the increase in an investment’s value over time.

• Calculating capital appreciation involves comparing the current market price of an asset to its original purchase price.

• Factors such as company performance, economic conditions, and monetary policy can influence capital appreciation.

• Assets like stocks, real estate, mutual funds, ETFs, and commodities are commonly associated with capital appreciation.

• Capital appreciation is an important component of long-term wealth-building strategies, along with income from dividends and interest.

What Is Capital Appreciation?

As noted, capital appreciation refers to a rise in the price of an investment. Essentially, it is how much the value of an asset has increased since an investor purchased it. Analysts calculate capital appreciation by comparing the asset’s current market price and the original purchase price, also called the cost basis.

Example of Capital Appreciation

Capital appreciation can be understood by analyzing an example from stock market investing.

If an investor purchases 100 shares of Company A for $10 a share, they are buying $1,000 worth of stock. If the price of this investment increases to $12 per share, the initial 100 share investment is now worth $1,200. In this example, the capital appreciation would be $200, or a 20% increase above the initial investment.

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What Causes Capital Appreciation?

The value of assets can rise and fall for various reasons. These include factors specific to individual investments and those affecting the economy and financial world as a whole.

Asset Fundamentals

In the most traditional sense, the price of an asset will increase because of a rise in the fundamental value of the underlying investment. When investors see that a company is doing well and expect it to keep doing well, they will invest in the company’s stock. This activity pushes the stock price up, resulting in capital appreciation if an investor holds shares in the company.

For a real estate asset, the value of a property could go up after a homeowner or landlord renovates a structure. This capital improvement increases the property’s market value.

Macroeconomic Factors

When the economy is booming, it can buoy all kinds of financial assets. In a strong economy, people typically have good jobs and can afford to spend money. This helps many companies’ bottom lines, which causes investors to put money into shares of the company. The opposite of this scenario is also true. When the economy endures a downturn, asset prices may fall.

Recommended: Understanding Economic Indicators

Monetary Policy

Central banks like the Federal Reserve play a significant role in how the financial markets operate. Because of this, the monetary policy set by central banks can play a prominent role in capital appreciation.

For example, when a central bank cuts interest rates, corporations can usually borrow money at a lower cost. Businesses often use this injection of cheap money to invest in and grow their business, which may cause investors to pour into the stock market and push share prices higher. Additionally, companies may take advantage of lower interest loans to borrow money to buy shares of their stock, known as a stock buyback. These moves may push share prices higher, further leading to capital appreciation.

Another monetary policy tool is quantitative easing (QE), which refers to a method of central bank intervention where central banks purchase long-term securities to increase the supply of money and encourage investment and lending. Like a low interest rate policy, this method can lead to rising asset prices because more money is being added to the economy — money that flows into assets, bidding their prices higher.

Speculation

Another potential cause of capital appreciation is speculation. Speculation occurs when many investors perceive the value of a particular asset as being higher than it is and start buying the asset in anticipation of a higher price. This activity may lead to the price of an asset being pushed higher. After a frenzy, the price of the asset eventually drops as investors sell in a panic when they realize there’s no fundamental reason to keep holding the asset. This type of speculation is fueled by investors’ emotions, rather than financial fundamentals.

Assets Designed for Capital Appreciation

There are several categories of assets that are designed for returns through price appreciation. Investors generally hold these investments for the long term hoping that prices will rise. This isn’t an exhaustive list, but it provides a good overview.

Stocks

Stocks are a type of financial security that represents equity ownership in a corporation. They can be thought of as little pieces of a publicly-traded company that investors can purchase on an exchange, with hopes that the price of the shares will go up.

Real Estate

Real estate is a piece of land and anything attached to that land. Many people build wealth through homeownership and capital appreciation, buying a house at a specific price with an expectation that it will appreciate in value by the time they are ready to sell.

Residential real estate is just one area of real estate investment. Investors may also look to put money into commercial, industrial, and agricultural real estate activities. Investors can invest in various real estate investment trusts (REITs) to get exposure to returns on real estate.

Mutual Funds

A mutual fund consists of a pool of money from many investors. The fund might invest in various assets, including stocks, bonds, commodities, or anything else. In the context of a mutual fund, capital appreciation occurs when the value of the assets in the fund rises.

ETFs

Similar to mutual funds, exchange-traded funds (ETFs) are investment vehicles that contain a group of different stocks, bonds, or commodities. ETFs can track stocks in one particular industry, e.g., gold mining stocks, or track all the stocks in an entire index such as the S&P 500. As the name suggests, ETFs are bought and sold on exchanges just like stocks.

Commodities

Commodities are an investment that has a tangible economic value. This means that the market values these raw materials because of their different use cases. For example, commodities like oil and wheat are desired because they can power automobiles and be used for food, respectively. Commodities markets can be highly volatile, but many investors take advantage of the volatility to see the capital appreciation on both a short-term and long-term time horizon.

💡 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.

Capital Appreciation Bonds

Capital appreciation bonds are municipal securities backed by local government agencies. With these bonds, investors hope to receive a significant return in the future by investing a small amount upfront.

Like all bonds, capital appreciation bonds yield interest, which is a primary reason that investors buy them. But instead of paying out interest annually, the interest gets compounded regularly until maturity. This gives the investor one lump sum payout at the end of the bond’s lifetime.

Unlike other assets that experience capital appreciation, the price of the capital appreciation bond does not rise. Instead, capital appreciation refers to the compounded interest paid out to the bondholder at maturity.

Capital Appreciation vs Capital Gains

Though the terms are sometimes used interchangeably, there is a difference between capital appreciation and capital gains.

Capital appreciation occurs when the value of an investment rises above the purchase price while the investor owns the asset. In contrast, capital gains are the profit made once an investment is sold. Appreciation is, in effect, an “unrealized” gain. It becomes “realized” once the investment is sold for a profit.

Capital appreciation alone does not have tax implications; an investor doesn’t have to pay taxes on the price growth of an investment when they own it. But when an investor sells an investment and realizes a profit, they must pay capital gains taxes on the windfall.

Capital Appreciation vs Income

Capital appreciation is one piece of the puzzle in an investment strategy. Another critical component to build wealth is investing in assets that pay out dividends, interest, and other income sources.

A dividend is a portion of a company’s earnings paid out to the shareholders. For every share of stock an investor owns, they get paid a portion of the company’s profits.

Interest income is typically earned by investing in bonds, otherwise known as fixed-income investments. The interest payment is determined by the bond’s yield or interest rate. Investors can also be paid interest by putting money into savings accounts or certificates of deposit (CDs).

For real estate investors, rents paid by tenants can also act as a regular income payout.

Investing in assets that pay out regular income can supplement capital appreciation. The combination of capital appreciation with income returns is the total return of an investment.

Risks Associated With This Type of Investment

Assets intended for capital appreciation tend to be riskier than those intended for capital preservation, like many types of bonds.

Investing in stocks for capital appreciation alone is also known as growth investing. This strategy is typically focused on investing in young or small companies that are expected to increase at an above-average rate compared to the overall market.

The returns with a growth investing strategy can be high, but the risk involved is also high. Because they don’t have a long track record, these small and young companies can struggle to grow their business and lead to bankruptcy.

The Takeaway

Capital appreciation refers to the rise in value, or price, of an investment in an investor’s portfolio. It’s paramount to the whole concept of investing, as most investors invest in an effort to generate returns, or appreciation, on their money.

Capital appreciation is one part of a long-term wealth-building strategy. Along with income from dividends, interest, and rent, capital appreciation is part of the total return of an investment that investors need to consider.

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

FAQ

What is the difference between capital growth and capital appreciation?

The difference between the terms capital growth and capital appreciation is merely semantics. Both terms refer to an increase in value of an investment over time, and effectively mean the same thing.

How much tax do you pay on capital appreciation?

Investors do not pay taxes on capital appreciation, as an investment gaining value does not trigger a taxable event. They do pay taxes on capital gains, which are realized when an investor sells an asset.

What is the difference between dividend and capital appreciation?

A dividend is a payout to shareholders from a company’s profits. Capital appreciation is the rise in market value of an investment or asset, so they are two completely different things.

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Nov

2023

Wash Trading: What Is It and How Does It Work?

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

Wash trading is a practice which involves entering into securities transactions for the express purpose of giving the appearance that a trade has taken place although their portfolio has not substantially changed. Also referred to as round-trip trading, wash trading is a prohibited activity under the Commodity Exchange Act (CEA) and the Securities Exchange Act of 1934.

In some cases, wash trading is a direct attempt at market manipulation. In others, wash trading may result from a lack of investor knowledge. This may be the case with wash sales, in which an investor sells one financial instrument then replaces it with a similar one right away. It’s important to understand the implications of making a wash trade and what one looks like in action.

Key Points

• Wash trading involves investors engaging in the simultaneous buying and selling of securities to create the illusion of trading activity.

• Wash trading involves the simultaneous buying and selling of the same or similar securities.

• This practice can be a form of market manipulation or result from a lack of investor knowledge.

• The goal of wash trading is to influence pricing or trading activity, often through collaboration between investors and brokers.

• Wash trading is illegal and can result in penalties, including the disallowance of tax deductions for losses.

What Is Wash Trading?

Wash trading occurs when an investor buys and sells the same or a similar security investment at the same time. The Internal Revenue Service (IRS) also refers to this as a wash sale, since buying the same security cancels out the sale of that security. It’s also called round-trip trading, since you’re essentially ending where you began — with shares of the same security in your portfolio.

Wash trades can be used as a form of market manipulation. Investors can buy and sell the same securities in an attempt to influence pricing or trading activity. The goal may be to spur buying activity to send prices up or encourage selling to drive prices down.

Investors and brokers might work together to influence trading volume, usually for the financial benefit of both sides. The broker, for example, may benefit from collecting commissions from other investors who want to purchase a stock being targeted for wash trading. The investor, on the other hand, may realize gains from the sale of securities through price manipulation.

Wash trading can be a subset of insider trading, which requires the parties involved to have some special knowledge about a security that the general public doesn’t. If an investor or broker possesses insider knowledge they can use it to complete wash trades.

How Does Wash Trading Work?

On the surface level, a wash trade means an investor is buying and selling shares of the same security at the same time. But the definition of wash trades goes one step further and takes the investor’s intent (and that of the broker they may be working with) into account. There are generally two conditions that must be met for a wash trade to exist:

• Intent. The intent of the parties involved in a wash trade (i.e. the broker or the investor) must be that at least one individual involved in the transaction must have entered into it specifically for that purpose.

• Result. The result of the transaction must be a wash trade, meaning the investors bought and sold the same asset was bought and sold at the same time or within a relatively short time span for accounts with the same or common beneficial ownership.

Beneficial ownership means accounts that are owned by the same individual or entity. Trades made between accounts with common beneficial ownership may draw the eye of financial regulators, as they can suggest wash trading activity is at work.

A telling indicator of wash trading activity is the level of risk conveyed to the investor. If a trade doesn’t change their overall market position in the security or expose them to any type of market risk, then it could be considered a wash.

Wash trades don’t necessarily have to involve actual trades, however. They can also happen if investors and traders appear to make a trade on paper without any assets changing hands.

💡 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.

Example of a Wash Trade

Here’s a simple wash trade example:

Say an investor who’s actively involved in day trading owns 100 shares of ABC stock and sells those shares at a $5,000 loss on September 1. On September 5, they purchase 100 shares of the same stock, then resell them for a $10,000 gain. This could be considered a wash trade if the investor engaged in the trading activity with the intent to manipulate the market or to unfairly claim a tax deduction for the loss.

Is Wash Trading Illegal?

Yes. The Commodity Exchange Act prohibits wash trading. Prior to the passage of the Act, traders commonly used wash trading to manipulate markets and stock prices. The Commodity Futures Trade Commission (CFTC) also enforces regulations regarding wash trading, including guidelines that bar brokers from profiting from wash trade activity.

The IRS has rules of its own regarding wash trades. The rules disallow investors from deducting capital losses on their taxes from sales or trades of stocks or other securities that are the result of a wash sale. Under the IRS rules, a wash sale occurs when you sell or trade stocks at a loss and within 30 days before or after the sale you:

• Purchase substantially identical stock or securities

• Acquire substantially identical stock or securities in a fully taxable trade

• Acquire a contract or option to buy substantially identical stock or securities, or

• Acquire substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA

Wash sale rules also apply if you sell stock and your spouse or a corporation you control buys substantially identical stock. When a wash sale occurs, you’re no longer able to claim a tax deduction for those losses.

So, in short, yes, wash trading is illegal.

Difference Between Wash Trading & Market Making

Market making and wash trading are not the same thing. A market maker is a firm or individual that buys or sells securities at publicly quoted prices on-demand, and a market maker provides liquidity and facilitates trades between buyers and sellers. For example, if you’re trading through an online broker you’re using a market maker to complete the sale or purchase of securities.

Recommended: What Is a Brokerage Account?

Market making is not market manipulation. A market maker is, effectively, a middleman between investors and the markets. While they do profit from their role by maintaining spreads on the stocks they cover, this is secondary to fulfilling their purpose of keeping shares and capital moving. Without market makers, trades would take longer to execute and the markets could become sluggish.

How to Detect & Avoid Wash Trading

The simplest way to avoid wash trading as an investor is to be aware of what constitutes a wash trade or sale. Again, this can mean the intent to manipulate the markets by placing similar trades within a short time frame, or it can mean inadvertently executing a wash sale because you’re not familiar with the rules.

In the latter case, you can avoid wash trading or wash sales by being mindful of the securities you’re buying and selling and the time frame in which those transactions are completed. So selling XYZ stock at a loss, then buying it again 10 days later to sell it for a profit would likely constitute a wash sale, if you executed the trade in an attempt to be able to deduct the initial loss.

It’s also important to understand how the 30 days period works for timing wash sales. The 30 day rule extends to the 30 days prior to the sale and 30 days after the sale. So effectively, you could avoid the wash sale rule by waiting 61 days to replace assets that you sold in your portfolio to be on the safe side.

💡 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.

Wash Trading in Crypto Trading

Cryptocurrency can be a target for wash-trading activity. In the EOS case, wash trades were suspected of being used as a means of driving up investor interest surrounding the cryptocurrency during its initial offering. High-frequency trading has also been a target of scrutiny, as some believe it enables wash trading in the crypto markets. Whether wash trading rules and regulations specifically apply to crypto, however, is a bit murky.

The Takeaway

Wash trading involves selling certain securities and then replacing them in a portfolio with identical or very similar securities within a certain time period. This is done so as to avoid making substantial changes in your portfolio. Wash trading is illegal in practice but it’s also avoidable if you’re investing consciously and with a strategy in place.

Understanding when wash sale rules apply can help you to stay out of trouble with the IRS. If you’re unclear about it, you can consult with a financial professional for guidance.

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/mapodile

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

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Nov

2023

How Much Retirement Money Should I Have at 40?

By Pam O’Brien | Budgeting & Goals, Growing Wealth, invest, Investing, Preparing for Retirement | No Comments

At some point or another, you’ve probably wondered if you have enough money for the future and asked yourself, “how much retirement should I have at 40?”

It’s an important question. Hopefully, you’re already saving some money for retirement. However, you might not be saving enough to retire when you want.

There are different ways to save money for retirement. The sooner, the better—so that it can start adding up. Here’s how to maximize your retirement savings at age 40 and beyond.

Understanding Your Retirement Savings at 40

Now, to answer the question: How much money should I have saved by 40? A general rule of thumb recommended by many financial advisors is to have about three times your annual salary saved in retirement money by the time you’re 40.

Knowing this general benchmark is helpful for your retirement planning.

What Does the Average 40-Year-Old Have Saved?

According to a recent study from Northwestern Mutual, people in their forties say they currently have $77,400 saved for retirement. However, that’s a long way from the amount they expect to need for retirement, which is $1.28 million.

How Your Retirement Savings Compare to National Averages

Compared to the guideline of having three times your annual salary saved by the time you’re 40, if you only have the amount reported by the respondents in the Northwestern study — $77,400 — you’ve got some work to do. The good news is, you’ve probably got around 20 years or more to help get where you need to be by the time you’re ready to retire.

Factors Influencing Your Retirement Savings So Far

As you reach your 40s, it’s likely that your income is increasing, but so are the obligations that are tied to your money.

You might be saving money for your kids’ college; you probably have mortgage payments and existing debt, including your own student loans; you may even be taking care of aging parents. It’s a lot of financial multitasking and you have to prioritize.

In addition to all that, inflation over the past couple of years has made many prices higher, which could increase your cost of living. Overall, prices are 13% higher than they were two years ago, according to Consumer Price Index data. You might also be dealing with unemployment or a job layoff. All these factors can make saving for retirement more challenging.

The Right Retirement Savings Path for You

To map out a savings plan that makes sense, you can start by estimating how much money you’ll need for retirement. It’s also a good idea to look at your goals. That includes figuring out when you might want to retire, what kind of lifestyle you want in retirement, and how much money you might have coming in during your golden years. That will help you determine how much you need to save.

Projecting Your Retirement Needs

Start by thinking about the kind of lifestyle you’d like to have in retirement. Will you move to a smaller home? If so, you may save money on housing costs. On the other hand, if you’d like to travel frequently, your expenses may increase.

Also, estimate what your budget as a retiree might be. Include housing, utilities, insurance, food, transportation, clothes, and so on. And don’t forget entertainment expenses like movies, concerts, and meals out.

Next, factor in healthcare expenses. Health-related costs can be significant in retirement, depending on your medical situation.

Retirement Savings Rate: How Much of Your Income to Save

While each person’s situation and needs are unique, there are some general guidelines that can help project your financial needs during retirement.

For instance, according to Fidelity, you should try to save 15% of your pre-tax income each year if you plan to retire at age 67.

Another rule, known as the 80% rule, says you should have enough money by the time you retire to cover 80% of your pre-retirement income.

Milestones for Retirement Savings By Decade

As discussed, when you plan to retire and what kind of lifestyle you’d like to have in retirement are two of the main factors that affect how much money you’ll need to save. The milestones below are general, but they will give you an idea about how much to save at various ages.

Retirement Savings By:

• Age 30: 1x your annual income

• Age 40: 3x your annual income

• Age 50: 6x your annual income

• Age 60: 8x your annual income

• Age 67: 10x your annual income

Maximizing Your Retirement Savings in Your 40s

If you haven’t saved 3 times your annual income by your 40s, or even if you have, here are some ways to make the most of your retirement funds in this decade.

Benefits of a Roth 401(k) and When to Consider It

Some 401(k) plans give you the opportunity of choosing a Roth 401(k) to save for retirement. If your employer offers such a plan you may want to consider it.

The difference between a Roth 401(k) and a traditional 401(k) is that with a Roth 401(k), contributions are made using after-tax funds. That means they aren’t tax deductible, but the withdrawals you make in retirement are tax-free. In addition, you don’t pay taxes on your annual investment earnings in a Roth 401(k). With a traditional 401(k), the contributions you make are tax deductible, however, you will pay taxes on your retirement withdrawals. So a Roth 401(k) can be beneficial if you expect to be in a higher tax bracket by the time you retire.

The good news is, you can contribute to both a Roth 401(k) and a traditional 401(k) as long as your plan allows it. Just know that there are yearly limits on your contributions. Across both plans, individuals under age 50 can contribute $22,500 annually in 2023.

If you have a traditional 401(k), there are a number of strategies to max out your 401(k) that are worth looking into. For example, it makes sense to contribute at least enough to qualify for any employer matching that your company offers. Why lose out on the “free” money your employer is willing to contribute to your retirement savings?

Catch-Up Contributions: Leveraging Them When the Time Comes

Once you reach age 50, you can make catch-up contributions to your 401(k) plan, as long as your plan allows them, which could help you save even more for retirement. In 2023, the catch-up contribution is an additional $7,500. That means, in total, individuals 50 and older could contribute up to $30,000 to their 401(k) in 2023.

Knowing about catch-up contributions when you’re in your forties could help you plan and prepare for them when you reach 50. Catch-up contributions can help you make the most of your retirement plan.

Investment Strategies for Mid-Career Savers

There are many other ways to save for retirement, even beyond the employer-sponsored 401(k) and Roth 401(k).

Some people choose to put their retirement savings in more than one type of account. This is useful if you want to set aside more than the yearly contribution limits on 401(k) plans. In that case, it might make sense to open an IRA savings account to save beyond the 401(k) limits, as long as you meet the necessary criteria.

Recommended: A Look at Traditional IRAs vs Roth IRAs

The Role of Expenses in Retirement Planning

Figuring out how much your retirement living expenses will be is important for calculating how money you’ll need to save. These are some of the things you may want to consider and budget for.

Emergency Savings vs. Retirement Savings

Your retirement savings are extremely important. However, if you don’t have an emergency fund that can cover three to six months’ worth of living expenses, consider putting that at the top of your priority list.

Why? While retirement is still likely to be years away if you’re 40 now, an emergency could happen at any time. For instance, you may be faced with an unexpected medical procedure that you’ll need to pay for if insurance doesn’t cover it all. Or your heater might break in the middle of winter and need to be replaced. If you don’t have the emergency funds to cover these things, you risk taking on debt. And that could in turn limit your retirement savings as you work to pay off that debt.

Of course, if you can afford to contribute to both an emergency fund and your retirement savings, by all means, do so.

Planning for Healthcare Expenses in Retirement

As people grow older, their healthcare needs and costs typically increase. For many, healthcare can be one of the biggest retirement expenses.

Fidelity estimates that the average person may need $157,500 to cover healthcare costs in retirement. If you have a high-deductible health insurance plan, you might want to look into a Health Savings Account (HSA), which could potentially help you save money to cover some healthcare costs.

Incorporating Home Costs Into Retirement Savings

Housing costs are another major retirement expense. You may have mortgage payments, homeowner’s insurance, and home maintenance and repairs to pay for. If you rent, you’ll have to cover your monthly rental fee plus renters’ insurance.

Additionally, where you live — the city and state — can impact how much you pay for housing. In general, living on the coasts can be more expensive. You may want to take the cost of living into consideration when you’re thinking about where you want to live in retirement.

Family and Retirement: Balancing the Present and Future

Of course, along with saving for retirement, you have present-day expenses and events to pay for as well. This includes important family milestones, such as college and a child’s wedding. Fortunately, with proper budgeting and planning, it is possible to help cover these expenses and save for retirement at the same time.

Budgeting for College Savings While Prioritizing Retirement

To keep building a retirement nest egg while saving for college for your kids, consider some college-savings plans. One good option to consider: a 529 plan that you fund with after-tax dollars. You can contribute to the plan on a regular basis, or whenever you have extra money, and family members and friends can contribute as well. For instance, instead of birthday gifts, ask loved ones to contribute to your child’s 529 instead.

Virtually every state offers a 529 plan and you can shop around to find one that has the best tax benefits and lowest costs. Open the plan as early as you can when your child is young so that the money invested has more time to grow.

Weddings and Other Major Family Expenses

If you’d like to help pay for your child’s wedding, you could put some money in a savings or investment account so that it can grow over time. If the wedding is coming up relatively soon, you could put your money into a high-yield savings account, for instance, to get a higher interest rate than you’d get from a regular savings account. If the wedding is farther in the future, you might want to invest in mutual funds or a stock index fund, which could deliver more growth.

Expert Strategies to Increase Retirement Savings

There are a number of smart ways to maximize your savings and be on track for retirement. Here are a few strategies experts advise.

Salary Negotiations and Their Long-Term Impact on Savings

If it’s been a while since you’ve received a raise, this may be a good time to ask for one. By age 40, you’ve probably developed skills that make you valuable to your employer.

If you need some incentive for negotiating for a higher salary, consider this: Even an extra $100 a week invested for the next 20 years with a 10% annual return could give you approximately $300,000 more in retirement savings.

Building a Solid Financial Foundation with a Six-Month Emergency Fund

As we discussed earlier, having an emergency fund is critical for any unexpected expenses that arise. Ideally, it’s wise to have six months’ worth of expenses saved up. That can help tide you over in case of job loss or some other significant event that affects your income.

You can open a high-yield savings account for your emergency fund to help it grow. Consider automating your savings to make sure you’re contributing to your emergency fund regularly.

Then, once you’ve reached six month’s worth, you can allocate the money you had been contributing to the emergency fund to your retirement savings.

Why Prioritizing Roth Retirement Accounts Can Pay Off

Investing in a Roth IRA can be helpful if you want to withdraw money in retirement without paying taxes on it. After-tax accounts can be appealing to individuals who plan to achieve financial independence at a younger age and retire early. Unlike qualified plans, which place penalties on withdrawing funds before a certain age, an after-tax account is a pool of money that you can withdraw from without having to worry about penalties if you access the account before age 59 ½.

Even if you wait until age 67 to retire, if you expect to be in a higher tax bracket at retirement, a Roth IRA can make sense since you won’t have to pay taxes on retirement withdrawals.

For 2023, you can contribute up to $6,500 annually in a Roth IRA. Individuals 50 and older can contribute $7,500. That said, there are income limits on Roth IRAs. The amount you can contribute starts to phase out if you earn more than $138,000 as a single tax filer, or $218,000 for married couples who file jointly.

The Takeaway

While there are conventional rules of thumb as to how much money you should have saved by 40, the truth is everyone’s path to a comfortable retirement looks different. One piece of advice is universal, however: The sooner you start saving for retirement, the better your chances of being in a financially desirable position later in life.

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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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

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