Investing Archives | Page 95 of 191

Nov

2023

What Are Variation Margins? How Do They Work?

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

Margin variation is money needed to maintain margin level in a margin account. Variation margins serve as collateral or security against potential losses. Another way to think of it is as unrealized profit or loss in open derivative positions.

When a margin account balance drops below the brokerage’s specified limits, the brokerage can extend a margin call to request a futures variation margin payment. If a trader does not have the funds to meet the margin call, the brokerage may sell securities in their account to make up the difference.

What Is Variation Margin?

Variation margin is a collateral payment made by one party to a counterparty to cover any change in value of underlying assets used in futures contracts.

Traders may make these payments on a day-to-day or intraday basis as directed by the clearing house. Variation margin serves as a risk management tool for the clearing house. By collecting these payments, the clearing house can sustain its targeted risk level while allowing traders to have margin debt in their accounts.

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

Margin Trading Basics

To understand variation margins, it’s helpful to review some of the basics of margin trading. When an investor trades on margin, it essentially means they’re trading using borrowed money. So, for example, an investor who wants to purchase futures contracts may invest 50% of their own money and borrow the remaining 50% from their brokerage.

In exchange, the brokerage requires investors to maintain an initial margin, maintenance margin, and variation margin amount in liquid funds. Each one represents a different balance threshold. Margin accounts require investors to meet the minimum requirements.

Recommended: How Does a Margin Account Work?

How Do Variation Margins Work?

Variation margin works by filling gaps in margin account balance levels. When trading futures, variation margin allows clearing houses to continue facilitating trades while managing risk. Understanding stock volatility can help with understanding how variation margin works.

Equity prices fluctuate as volatility ebbs and flows in the markets. Changing prices can directly affect investor profits or losses, and trading equity derivatives on margin can amplify those profits and losses.

Variation margins work by accounting for changes in the prices of financial securities being traded. Traders make these payments, typically in cash, from the party who lost value to the party that’s gained value in a margin transaction. The amount due depends on the type of security being traded, expected price movements for that security and overall market conditions. That’s why it’s called variation margin, as the amount may vary from transaction to transaction.

Variation Margin Example

Here’s a simple example of how variation margin works. Assume an investor purchases 100 shares of stock for $30 each. The initial margin for the purchase is set at 50%. This would mean the broker would need to have $1,500 in their account at all times in order to make trades (50% of 100 x $30). Meanwhile, the maintenance margin is $1,000.

If the stock’s share price were to fall to $20, then the brokerages would deduct $1,000 in losses from the initial margin balance. Now the initial margin balance is $500. The new initial margin amount required becomes $1,000 (50% of 100 shares x $20 per share). So the investor would have to add $500 to their account as a variation margin payment to meet the new initial margin requirement.

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Variation Margin Calculation

Calculating variation margin depends on the type of security being traded and its price movements. So it’s something that must be done on a transaction-by-transaction basis, since every security is different.

But there is a simple variation margin formula that can be used for calculations:

VM = Initial margin – Margin balance

So to calculate variation margin, an investor needs to know three things:

• Initial margin requirement

• Maintenance margin requirement

• Current price of the underlying security

Finding variation margin means doing some math to determine how much the new initial margin requirement works out to when the price of the underlying security drops. But as the previous variation example illustrates, it’s not overly complicated.

Initial Margin vs Variation Margin

Initial margin and variation margin are often mentioned together when discussing margin trading but they’re not the same thing. Initial margin refers to the amount of money an investor can borrow inside a margin account.

Regulation T of the Federal Reserve Board allows investors to borrow up to 50% of the purchase price of securities being traded on margin. Though some brokerages may require a larger deposit to satisfy initial margin requirements.

Initial Margin	Variation Margin
Money that must be paid upfront to purchase securities on margin	Money that’s paid when a security being traded on margin loses value
Paid in cash prior to purchasing securities	Paid daily or intraday, typically in cash
Federal regulations set at initial margin at a minimum of 50% of the security’s price, though brokerages may set the amount higher	Amounts due for variation margin can depend on the type of security, its price movements, and market conditions.

Variation Margin and Maintenance Margin

Maintenance margin is another term often used in discussions of margin trading and it’s often used synonymously with variation margin. The maintenance margin represents the minimum amount of equity a trader must maintain in a margin account at all times. Equity is the difference between the value of securities held in the account and any amounts owed to the brokerage.

Under Financial Industry Regulatory Authority (FINRA) rules, maintenance margin must be at least 25% of the total market value of margin securities being held. Brokerage firms set the bar higher, however, requiring investors to meet a 30% or 40% margin maintenance requirement.

The maintenance margin is not the same thing as minimum margin. Minimum margin is the minimum amount required to open a margin account. FINRA requires this amount to be $2,000 or 100% of the purchase price of margin securities, whichever is less.

💡 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.

The Takeaway

To recap, variation margin is a collateral payment made by one party to a counterparty to cover any change in value of underlying assets when discussing futures contracts. It’s a fairly high-level concept, and many investors may not need to worry much about it, or even encounter it if they stick to a relatively simple investment strategy.

With that said, margin trading can potentially yield significant returns for investors, though it has more risks than traditional trading. Understanding variation margin and margin requirements can help traders manage that risk.

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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

Is variation margin a derivative?

Variation margin is not a derivative, but is a factor in derivatives markets. It’s one of the chief types of collateral that is required to protect investors or other parties in the market.

Is variation margin the same as mark to market?

Variation margin is a type of collateral, and is determined, in part, but the size of a party’s exposure in a trade – that, too, depends on mark-to-market value of the derivatives at play. As such, the two are not the same.

Can variation margin be negative?

It is possible for variation margin to be negative, and in that case, it would mean that there’s been a loss.

Is variation margin collateral?

Variation margin is a type of collateral, and is payment made by one party to a counterparty to cover any change in value of underlying assets used in futures contracts.

Why is variation margin important?

For investors or traders, variation margin is important as it informs them of the amount of funds that they need to solidify margin levels in order to trade.

Photo credit: iStock/Prostock-Studio

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Nov

2023

What Is a Margin Loan? Definition & Examples

Margin Loans: Definition, Examples, Pros & Cons

By Samuel Becker | Growing Wealth, invest, Investing | Comments Off

Margin loans are a type of loan that an investor takes out from a brokerage to buy investments. An investor typically borrows from a brokerage if they don’t have the cash balance in their trading account to cover the cost of a trade or investment – so, they use credit from their brokerage to cover the costs.

While there are risks associated with using margin and margin loans, they can also increase an investor’s purchasing power and bolster potential returns.

What Is a Margin Loan?

A margin loan is a loan from your brokerage to pay for securities that you can’t cover with cash. Similar to any other loan, you must apply for the account and be approved before you can borrow funds; and your brokerage will charge interest on any funds you borrow.

Having a margin account by definition enables you to take out a margin loan (the two are synonymous in many ways). Having the flexibility to buy securities on margin gives many traders the ability to take positions they might not have been able to afford otherwise. In fact, margin loans are a cornerstone to putting together effective day trading strategies, for advanced investors.

💡 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.

Understanding Margin Loans

Understanding margin trading can be tricky, but for the average investor, all you really need to know is that a margin loan is essentially a short-term financing solution. If you want to buy securities, but don’t have the cash in your account, your brokerage may allow you to buy those securities using credit. It’s similar to a line of credit, in that way.

So, that’s what margin debt is: The result of a margin loan, in which a trader borrows money to buy securities.

How Margin Loans Work

While we’ve mostly been discussing margin loans in terms of trading and investing, they could be used for any purpose. But almost always, a margin loan is used to buy securities.

As for the process of how they actually work: A margin loan is more or less like any other loan. To get one, you’ll need to apply and qualify for margin on your brokerage account (typically called a “margin account”).

Margin Accounts and How They Work

Like other forms of lending, margin loans have strict criteria. In addition, these accounts are governed by industry regulations as well as the policies of individual institutions, so be sure to understand how your desired margin account works. Each brokerage has different rules and eligibility requirements, and FINRA, for example, also requires you to deposit a minimum of $2,000 or 100% of the security’s purchase price, whichever is less. This is the “minimum margin.” Some firms may require you to deposit more than $2,000.

If you’re approved for a margin account, you’re able to trade using a margin loan — up to a certain amount. According to Regulation T of the Federal Reserve Board, you may borrow up to 50% of the purchase price of securities that can be purchased on margin.

This is known as the “initial margin.” Some firms require you to deposit more than 50 percent of the purchase price. (Also be aware that not all securities can be purchased on margin. Only those deemed “marginable” can be traded on margin.)

If you have $5,000 in your brokerage account, and you want to buy Stock X, which is valued at $50 per share, with a 50% margin you could buy 50% more than your cash balance: 200 shares instead of 100. But half of those (100 shares) would’ve been purchased on margin — so, you’d need to settle up your account at some point, if or when you decide to sell your shares (hopefully for a profit).

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How Margin Interest Works

The other important thing to remember about margin loans is that they are, like pretty much all loans, subject to interest charges. Your brokerage is going to charge you for the money you borrow.

Margin interest is a big topic unto itself, but the key takeaway is to know that you’ll be on the hook for paying your brokerage back for the money you borrow, plus interest charges.

You’re probably thinking: “Can I avoid paying margin interest?” The answer is that it depends on how fast you can pay your margin balance back. Most brokerages will charge interest by the day and add the charges to your account monthly. So, if you have cash or can sell securities and pay your balance off before interest accrues, it’s possible.

💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.

Margin Loan Pros and Cons

Marginal loans can be highly useful for traders and investors. But like almost any financial instrument, margin loans have their pros and cons.

The biggest upside of margin is that it can open up a new swath of investing choices for traders. That means increasing their buying power, and allowing them to buy securities that may have otherwise been too expensive. This can increase potential profitability, too.

Conversely, traders who aren’t careful can’t quickly find themselves in debt if one of their trades backfires.

There are also interest charges to consider, as discussed. And if things really go sideways, some traders may experience a “margin call,” which is when your brokerage sells your assets without warning to settle up or get your account balance back within its requirements.

Here’s a quick rundown:

Margin Loans: Pros & Cons

Pros	Cons
Increased trading capacity	Traders can accumulate debt
Traders can buy pricier securities	Interest charges
Increased potential gains	Potential margin calls

Typical Margin Loan Rates

Margin loan rates, or, the interest rate charged by a brokerage for using margin, vary. Brokerages make the information available to traders and investors, so finding what types of margin loan rates you’re subjected to usually just requires a little research (or a call to your broker).

As mentioned, a brokerage will probably charge different interest rates depending on your overall margin balance, and how much you’ve borrowed. Lower balances are typically charged higher interest rates.

Here are some hypothetical examples: Let’s say Brokerage ABC’s margin interest rates vary between 4% and 8%, depending on the trader’s balance. Traders using up to $24,999 in margin will be subject to the highest interest rate (8%), whereas traders with more than $1 million in margin debit are subject to the 4% rate.

Brokerage B, however, has a different scale, with traders in margin debt up to $24,999 subject to 8.5% interest, and those with balances between $500,000 and $999,999 subject to 6.5%.

So, while brokerages do vary in what they charge for margin loan rates, they tend to be similar. To know your exact rate, contact your brokerage, or look up the current rate schedule on the company’s website.

The Takeaway

Margin loans are similar to any other type of loan, but are typically used for the purpose of buying stocks or other securities. Once you’ve applied for and been approved for a margin account, which is akin to adding a line of credit to your existing brokerage account, you’ll have the flexibility to buy more investments than if you were relying only on cash.

That said, you’re on the hook for repaying the money you’ve borrowed, with interest. If you’ve made a profitable investment, this shouldn’t be a problem. But if you invest in Stock X on margin, say, and the price drops, you would still owe the full amount you’d borrowed to buy the stock, plus interest.

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

Can you withdraw a margin loan?

Yes, it’s possible to withdraw a margin loan, although the specifics will depend on an individual brokerage, as will any applicable interest charges.

Are margin loans a good idea?

Margin loans can be useful for many investors and traders, and whether or not they’re a good idea will depend on the specific individual considering taking one out. They do have risks, but upsides, too.

How do I pay back my margin loan?

The simplest ways to pay back margin loans are to either deposit cash into your brokerage account to get the balance back to zero, or to sell holdings that will result in a positive or neutral balance.

How much collateral is required for a margin loan?

The collateral required to take out a margin loan depends on a specific brokerage, but it’s not uncommon for brokerages to require somewhere between 30%, 40%, or 50%.

What happens if you can’t pay back a margin loan?

If you can’t pay back a margin loan, the brokerage will likely reach out to see what can be done, or lock you out of your account. Further, it could end up liquidating securities in your portfolio in order to cover the debt.

Photo credit: iStock/Sergey Nazarov

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Nov

2023

Pros & Cons of Consolidating Your 401(k)

By Pam O’Brien | Growing Wealth, Investing | No Comments

The nature of work is no longer what it used to be. Gone are the days of working for just one employer for an entire career. Now, it’s more common to move between lots of jobs.

According to a recent study by the Bureau of Labor Statistics, the average person will have more than 12 jobs during the course of their career. That’s a lot of jobs – and potentially, a lot of 401(k) accounts.

That’s because instead of the pensions that many workers in previous generations had, the average worker today is likely to have self-funded retirement accounts like 401(k)s through each new employer.

This means that as employees move between jobs, many will be left with a hodgepodge of old 401(k)s and other retirement accounts.

Is it best to leave them as they are, or to consolidate 401(k) accounts? And if so, how do you consolidate them?

Read on to learn how to consolidate 401(k) accounts, along with the pros and cons of the most popular consolidation options.

What You Need to Know About 401(k) Plans

A 401(k) is a workplace-sponsored retirement plan. If you sign up for a 401(k), contributions are deducted from your paycheck to go into your 401(k) account. Often 401(k) plans are offered to employees as a workplace benefit, like vacation days and healthcare coverage.

Some companies offer a 401(k) match. This is where a company contributes money to an employee’s 401(k) to match the amount of money the employee has contributed, up to a certain amount. A company match program can make a 401(k) a lucrative way to save money for retirement.

In addition, 401(k) plans are considered an advantageous way to save retirement money because they have certain tax advantages. For instance, 401(k) accounts are referred to as “tax-deferred” because income taxes are deferred until later, when you take the money out in retirement.

The taxation of retirement accounts is an important consideration in long-term financial planning. Taxation also acts as a guide for knowing what retirement account types can be combined, and which types cannot be combined with other retirement account types.

Because all 401(k) accounts share the same tax status (tax-deferred), they can be combined. Traditional IRAs are also tax-deferred and can be combined with a 401(k) account. This process is called a rollover.

A Roth IRA is another popular retirement account type. A Roth IRA cannot be rolled over or combined with a 401(k) or a traditional IRA account, however, because it has a different tax status. With a Roth IRA, you pay the taxes upfront (meaning you make the contributions with after-tax dollars) and your qualified withdrawals are not taxed

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Should I Combine My 401(k) Accounts?

You might be at the point during your career where you’ve got at least one 401(k) account from a previous job that you’re no longer contributing to. If you are wondering whether to consolidate your 401(k) accounts, here are a few of your options:

1. Transfering the 401(k) account(s) into your active 401(k), meaning the one you have with your current employer).

2. Rolling the 401(k) account(s) into a Traditional IRA at an institution of your choosing.

3. Doing nothing, and leaving the account(s) as is.

Everyone’s financial situation is different, so evaluate the pros and cons of each option when trying to decide what is best for you. When weighing your options, here are some things you might consider:

Option 1: Rolling Over into Your Active 401(k)

Your first option with a 401(k) with a former employer is to transfer the money into your active 401(k) account with your current employer.

Pros:

1. A single place for your tax-deferred money

By transferring old 401(k) accounts into an existing 401(k), you are consolidating those tax-deferred accounts in one place. You may find managing just one account an ideal scenario.

2. Consolidating your investment strategy

Consolidation may make it easier to keep track of your money and manage a cohesive investment strategy. It can be challenging to manage a bunch of different retirement accounts.

Cons:

1. Limited investing options

Sometimes 401(k) plans have limited investing options. If this is the case with your current active 401(k), consolidating your other 401(k)s into the plan may limit your investing choices overall. Look at the investment option information provided by your plan to help make an informed decision.

2. Additional fees

Some 401(k) accounts have additional fees on both the accounts and investments themselves. Check to see if fees are assessed at a flat rate, or if they are assessed as a percentage of the amount invested. This may influence your decision to transfer your other 401(k)s into your active 401(k).

How to do it:

How to consolidate 401(k) accounts starts with contacting the institution that holds your old 401(k) and requesting a rollover to your active 401(k). The customer service representative should likely be able to help you on the phone or direct you to the paperwork online. It can be smart to clarify that this is a rollover to another tax-deferred account.

Ideally, the company is able to transfer the funds electronically to your active 401(k). If they are not able to do this, they may request an address to send a check. Get the address of the financial institution where your 401(k) is located and have it ready before making the call.

Option 2: Rolling into an IRA

Rolling old 401(k) accounts into a Traditional IRA of your choosing is a popular choice that allows you maximum control over the investments within the account.

Pros:

1. You choose the institution

You get to choose where to open your individual retirement account. By selecting the institution, you can choose a place that fits your needs. You will have control over your investment choices and whether to use an institution that charges for certain services.

This may be especially important if the institution that holds your current 401(k) charges account maintenance fees or only offers high-cost investment products.

2. You’ll control it

You open a Traditional IRA on your own and without an employer—therefore, a Traditional IRA is yours. Some people may find it helpful to think of a Traditional IRA as a “home base” for their tax-deferred money. As you move through your career, you can roll old 401(k) accounts into a Traditional IRA that’s not going anywhere—it’s your home base.

3. More investment options

As compared to some 401(K) plans, a Traditional IRA opened at an institution of your choosing may have more options for investing.

Some 401(k) plans may require that participants choose from a pre-selected list of options. If you open a Traditional IRA at a brokerage firm or other financial institution, you’ll have the benefit of a broker’s wisdom and experience should you wish to use a broker. Asking the right questions is key to making sure a broker is the right fit for you.

Cons:

1. You may still have multiple accounts to maintain

Even if you open a Traditional IRA, you may still want to contribute to your active 401(k). Therefore, you will need to maintain at least two retirement accounts. (And perhaps three, if you have a Roth IRA, which cannot be combined because it has a different tax status.)

(Still, having two accounts—an active 401(k) and a Traditional IRA—might be better for you than having many multiple 401(k) accounts scattered around at different financial institutions.)

2. It may complicate a “backdoor” Roth IRA

A backdoor Roth IRA is a way to contribute to a Roth IRA when your income is too high to contribute to one directly.

Though you’ll want to check with a tax professional, it is generally understood that a backdoor Roth IRA might be complicated if your Traditional IRAs contain a mix of pre and post-tax money that you put in.

If you want to pursue a backdoor Roth IRA, you may want to roll your old 401(k) assets into your current 401(k), or leave the account as it is. The greater the balance in your Traditional IRA, the greater the tax liability for the backdoor Roth IRA contributions since you can only contribute money that’s already been taxed to a Roth IRA.

How to do it:

If you do not already have one, you may want to open an IRA account at a financial institution of your choosing. This could be at a bank or other financial institution.

Once your Rollover IRA is active you can roll funds from your 401(k) into the Rollover IRA. The process is generally similar to that of rolling assets into an active 401(k) as noted above.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

Option 3: Doing Nothing

Lastly, you may opt to leave your 401(k) accounts exactly as they are. Here are some pros and cons of this strategy.

Pros:

1. You are happy with the financial institution and/or investments

If you like your current investment allocation and investment options and want to continue using them, you may choose to leave your 401(k) as it is.

Cons:

1. Difficult to manage

It could be hard to manage a cohesive investing strategy across multiple accounts. This may be the case for someone that has multiple accounts at different institutions.

2. Cannot add money to an old employer-sponsored 401(k)

It is not possible to contribute new money to an old 401(k) account that was previously tied to an employer. New money must go into a current 401(k) or some other self-directed retirement account, such as a Solo 401(k), Roth IRA, or Traditional IRA.

If you do not currently have access to an employer-sponsored 401(k), you may want to seek out another retirement account for which you can make contributions.

3. Possible maintenance fees

Old 401(k) accounts may charge monthly or annual fees such as account maintenance fees. By consolidating, it may be possible to eliminate all or most of these fees.

For example, a person could roll old 401(k) accounts that charge a maintenance fee into an account that has no such fee, whether that be their current 401(k) or a Traditional IRA.

4. Limited investing options

Because a person does not get to choose the bank that holds their employer-sponsored 401(k), they don’t get to determine the plan’s investing options, either. Therefore, it’s up to you to decide whether the available investment options in your old 401(k) are sufficient.

The Takeaway

People may benefit from consolidating their 401(k) accounts into their current 401(k) or into a Traditional IRA, if for no other reason than to consolidate their money under one roof.

It can be hard to manage a bunch of different accounts at different institutions, and may only get harder as individuals progress through their careers and end up with even more 401(k) accounts.

In general, a Traditional IRA can provide more flexibility and investing options than a 401(k). It means that you’ll be managing two accounts, yes, but it might be worth it to keep a Traditional IRA as a home base to roll all old 401(k) accounts into over time.

When you open an IRA, you’ll want to find a bank or financial institution that meets your needs. Many investors prefer institutions where they will not be charged with unnecessary fees and have access to low-cost investing options.

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

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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.

SoFi Invest®

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

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Nov

2023

6 Investment Risk Management Strategies

By Samuel Becker | Growing Wealth, invest, Investing | Comments Off

All investing involves some level of risk, and how much any individual investor is willing to take on will depend on their risk tolerance. There are also numerous investment risk strategies out there that they can use to try and limit losses and increase their returns.

But it all comes down to the specific investor. Some have higher risk tolerances, and think less about investment risk management than others. Either way, investors can take measures to protect themselves against the inevitability of a correction or a bear market by using various risk management strategies.

Strategies to Help Manage Investment Risk

Before learning more about the numerous risk management strategies out there, it can be helpful to get a deeper understanding of the level of risk a person is comfortable taking when building an investment portfolio.

That includes thinking deeply about an investor’s risk tolerance, which is usually determined by three main factors:

Risk capacity: How much can the investor afford to lose without it affecting actual financial security? Risk capacity can vary based on age, personal financial goals, and an investor’s timeline for reaching those goals.

Need: How much will these investments have to earn to get the investor where they want to be? (An investor who is depending heavily on investments may be faced with a careful balancing act between taking too much risk and not taking enough.)

Emotions: How will the investor react to bad news (with fear and panic? or clarity and control?), and what effect will those emotions have on investing decisions? Unfortunately, this can be hard to predict until it happens.

So, why is risk management important? Those who are able to preserve their capital during difficult periods will have a larger base to grow from when the market regains steam. With that in mind, here are some strategies investors sometimes use to manage the risk in their portfolio.

1. Reevaluating Portfolio Diversification and Asset Allocation

You’ve probably heard the expression “don’t put all your eggs in one basket.” Portfolio diversification — a strategy involving allocating money across many asset classes and sectors — could help with avoiding disaster in a downturn. If one stock tanks, others in different classes might not be so hard hit.

Investors might want to consider owning two or more mutual funds that represent different styles, such as large-cap, mid-cap, small-cap, and international stocks, as well as keeping a timeline-appropriate percentage in bonds. Those nearing retirement might consider adding a fund with income-producing securities.

But investors should beware of overlap. Investors often think they’re diversified because they own a few different mutual funds, but if they take a closer look, they realize those funds are all invested in the same or similar stocks.

If those companies or sectors struggle, investors could lose a big chunk of their money. Investors could avoid overlap by simply looking at a fund’s prospectus online.

To further diversify, investors also may want to think beyond stocks and bonds. Exchange-traded funds (ETFs), commodities, and real estate investment trusts (REITs) are just a few of the possibilities.

Investors could also diversify the way they invest. For instance, an investor might have a 401(k) through their employer, but also open a traditional IRA or Roth IRA online through a financial company.

💡 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.

2. Lowering Portfolio Volatility

One of the easiest ways to help reduce the volatility in a portfolio is to keep some percentage allocated to cash and cash equivalents. This may keep an investor from having to sell other assets in times of need (which could result in a loss if the market is down).

The appropriate amount of cash to hold may vary depending on an investor’s timeline and goals. If too much money is kept in cash for the long-haul, it might not earn enough to keep up with inflation.

There are other options, however. Here are a few.

Rebalancing

The goal of portfolio rebalancing is to lower the risk of severe loss by keeping a portfolio well-diversified. Over time, different assets have different returns or losses based on the movements of the market. Rebalancing helps get things back to the mix the investor wants based on personal risk tolerance.

Rebalancing can often feel counterintuitive because it can mean letting go of investments that have appreciated in value (the ones that have been fun to watch) and buying investments that are declining in value.

Forgetful investors may even be able to sign up for automatic rebalancing. Without rebalancing, a portfolio’s mix may become stock heavy or sector heavy, which may significantly increase risk.

Buying bonds

Unless investors are regularly rebalancing their portfolio (or are having it done automatically), their mix may be skewing more toward stocks than they think. Those who are concerned about market volatility might want to rebuild the bond side of their portfolio.

Bonds might not be completely safe investments, but bonds with a lower duration can still play a defensive role in a diversified portfolio. And bonds often can be used to produce a steady stream of income that can be reinvested or used for living expenses.

Municipal bonds can generate tax-free income. Bonds, bond ETFs, and treasuries can all serve a purpose when the market is going down.

Beta

The beta of a stock is a measure of the interrelationship between the stock and the stock market. A beta of one, for example, means the stock will react in tandem with the S&P 500. If the beta is below one, the stock is less volatile than the overall market.

A beta above one indicates the stock will have a more marked reaction. So, replacing high beta stocks with lower beta names could help take some of the menace out of market fluctuations.

3. Investing Consistently

For those looking for quick returns, picking the “right” stock and selling it at the “right” time is everything. Using a dollar-cost averaging strategy is different. It’s all about patience, discipline, and looking at the long term. And it can help investors keep emotions out of the process.

With dollar-cost averaging, investors contribute the same amount at regular intervals (usually once or twice a month) to an investment account. When the market is down, the money buys more shares. When the market is up, it buys fewer.

But because markets generally rise over time, investors who can keep their hands off the stash might build a pretty nice pot of money over the long term — especially compared to what they might get from a savings account or money market account.

Some investors hand over their cash every month and don’t pay much attention to where their 401(k) plan administrator or the bank with their IRA might put it. But carefully choosing the companies represented in a portfolio — focusing on those with sustained growth over time — could help make this strategy even stronger.

4. Getting an Investment Risk Analysis

For years, financial professionals have mostly labeled investors’ risk tolerance as “aggressive,” “moderate,” or “conservative.” Those can be fairly subjective descriptions. The term “moderate,” for example, might mean one thing to a young investor and another to an older financial professional.

An investor might not even know how they’ll react to a market slump until it happens. Or a person might feel aggressive after inheriting some money but conservative after paying a big medical bill.

To help with clarity, many in the financial industry are now using software programs that can help pinpoint an investor’s attitude about risk, based on a series of questions. They can also better determine how an investor’s current portfolio matches up to a particular “risk score.”

And they can analyze and stress test the portfolio to show just how the client’s investments might do in a downturn similar to the ones that occurred in 2000 or 2008.

Identifying an investor’s current position and goals might make it easier to create a more effective plan for the future. This could involve identifying the proper mix of assets and realigning existing assets to relieve any pressure points in the portfolio.

💡 Recommended: SWOT Analysis, Explained: Definition and Examples

5. Requiring a Margin of Safety

“Buy low, sell high!” is a popular mantra in the financial industry, but actually making the concept work can be tricky. Who decides what’s high and what’s low?

Value investors may implement their own margin of safety by deciding that they’ll only purchase a stock if its prevailing market price is significantly below what they believe is its intrinsic value. For example, an investor who uses a 20% margin of safety would be drawn to a stock with an estimated intrinsic value of $100 a share but a price of $80 or less per share.

The greater the margin of safety, the higher the potential for solid returns and the lower the downside risk. Because risk is subjective, every investor’s margin of safety might be different — maybe 20%, 30%, or even 40%. It depends on what that person is comfortable with.

Determining intrinsic value can take some research. A stock’s price-to-earnings ratio (P/E) is a good place to start. Investors can find that number by dividing a company’s share price by its net income, then compare the result to the P/E ratio posted by other companies in the same industry.

The lower the number is in comparison with the competition, the “cheaper” the stock is. The higher the number, the more “expensive” it is.

6. Establishing a Maximum Loss Plan

A maximum loss plan is a method investors can use to cautiously manage their asset allocation. It’s designed to keep investors from making bad decisions based on their anxiety about movements in the market.

It gives investors some control over “maximum drawdown,” a measurement of decline from an asset’s peak value to its lowest point over a period of time, and it can be used to evaluate portfolio risk.

This strategy calculates a personal maximum loss limit and uses that percentage to determine appropriate asset allocation, but that asset allocation won’t necessarily be a good fit for someone else. It isn’t a one-size-fits-all plan.

Here are the basic steps:

1. Based on historic market numbers, the investor chooses an assumed probable maximum loss for equities in the stock market. For example, since 1926, there have been only three calendar years in which the S&P 500’s total return was worse than -30%. The worst year ever was 1931, at -44.20%. So the investor might choose 40% as a probable maximum loss number, or maybe 35% or 30%.

2. Next, based on personal feelings about market losses, the investor chooses the maximum amount they are willing to lose in the coming year. Again, it’s up to the individual to determine this number. It could be 20% or 30%, or somewhere in between.

3. Finally, the investor divides that personal portfolio maximum loss number by the assumed probable maximum loss number. (For example, .20 divided by .35 = .57 or 57%.)

In this example, the investor’s target equity asset allocation would be 57% when market valuations are average (or fair value).

The investor might raise or lower the numbers—and be more aggressive or conservative—depending on what’s happening in the market.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

The Best Offense Is a Great Defense

Risk management, and implementation of risk management strategies, is critical for most investors. All investments involve some level of risk, and instead of ignoring it, it can be helpful to gauge your individual risk tolerance, and choose risk management strategies that mesh with your tolerance.

Whatever strategy an investor chooses, risk management is critical to keeping hard-earned savings safer and losses to a minimum. Remember: As losses get larger, the return that’s necessary just to get back to where you were also increases. It takes an 11% gain to recover from a 10% loss. But it takes a 100% gain to recover from a 50% loss. That makes playing defense every bit as important as playing offense.

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

SOIN1023011

Oct

2023

5 Steps to Improving Personal Cash Flow

By SoFi Editors | Growing Wealth, invest, Investing | Comments Off

Your personal cash flow — or, how much money is coming and going through your personal budget on a regular basis — always has room for improvement. You can improve your cash flow, too, through various means, such as asking for a raise, starting a side hustle, and more. That, of course, paired with cutting excess spending, can help improve your financial standing.

In a sense, you’re your own chief financial officer, or CFO, and in charge of doing what you can to stay on top of your finances. With that, there are a multitude of things you can do to improve your personal cash flow. But if you want to pare that to-do list down, you can start with six key actions.

1. Ask for a Raise

A salary increase is perhaps the easiest and quickest way to improve your personal cash flow — and it requires the least amount of effort. But you must first muster the confidence to ask for one, and prepare yourself for a meeting with your boss to make sure you end up getting a raise.

Unfortunately, most employees may be reluctant to ask for a raise — in many cases, because they believe it’s awkward to talk about money with a manager. Managers, however, are not necessarily looking for ways to increase their expenses. So, if you want a raise, you’ll likely need to take action rather than waiting for one to fall out of the sky. That will require having an idea of what your market value is, and what your employer can realistically afford.

You can always look for another job, too.

2. Start a Side Hustle

A side hustle is simply a second or secondary job, and many people employ them to bolster their earnings. There can be many benefits to having a side hustle, with the extra cash, of course, likely being the most obvious.

For instance, by taking on additional projects, you’ll gain experience that will pad your resume and uncover opportunities to make new connections. You might even find yourself entertaining an offer for a new — and better paying — position. If you don’t know where to start, either, some low-cost side hustles include tutoring, flipping furniture, or even digital marketing.

💡 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.

3. Track Your Spending

Increasing your income is part of the equation, but slowing your cash outflows is also critical. That means tracking your spending, and finding ways to slow that spending in order to save more.

There are also services out there that can help you not only track your spending, but analyze that spending, too, and find opportunities to cancel services you barely or never use. An internet search will reveal several of them. Reviewing your bank statements, too, should help you find other areas where spending could potentially be cut.

You can also try measures such as only using cash to keep your spending under control, along with other strategies.

4. Simplify Your Life

Selling everything and moving to a tiny house may sound nice, but if you were to actually do it, you may find yourself missing some of the modern world’s creature comforts. With that in mind, if you want to simplify your life (and financial situation), it may sound like a good idea — but you should take some time to think about what you really need, and what you can do without.

For instance, many people could probably cut their clothing budget without too much trouble. But is it possible to also downsize and relocate to a new apartment in a less trendy but more affordable area? What about clearing out that storage unit that you’re spending money to rent? Simplifying your life could result in savings, but there’s a lot of thought that should go into any big life changes before they’re made.

5. Review Your Debt

Being your own CFO means that your finances — including your debt — are under your control. As such, you’ll need to know what debts you have racked up, including credit card debt, student loan debt, auto loans, personal loans, and more. It can be difficult to face your debts head-on, but if you’re serious about improving your financial standing, it’s a critical step to take.

Also, take a look at your debt to income ratio — your monthly debt payments divided by your gross monthly income. Let’s say your gross monthly income is $7,000, but each month you pay out $1,500 for rent, $600 for credit card bills, $500 for student loan payments, and $600 for other debt. Your debt to income ratio is 46% ( $3,200 divided by $7,000). A high debt to income ratio — typically over 43% — makes you riskier to potential lenders, and can cost you a new loan with a good rate.

Imagine bringing your rent down to $1200, knocking $200 off that credit card payment each month, and bringing your student loans down to $300; your debt to income ratio would decrease to just 36%.

Investing With SoFi

Improving your personal cash flow — a critical step to take if you want to be your own personal CFO — is important for just about everyone. Finding ways to increase your earnings or income, while also finding ways to pare down expenditures, should help you reach your financial goals in the long term. There will be hiccups along the way, of course, but with some discipline and know-how, it’s doable.

And don’t forget to share what you’ve learned; you probably know someone who could use the advice. Support and encourage your friends, and then help each other stick to individual goals. As always, if you want more guidance, you can get in touch with a financial professional.

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/visualspace

SoFi Invest®

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

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Increase your buying power with a margin loan from SoFi.

Borrow against your current investments at just 11%* and start margin trading.

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The Takeaway

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Strategies to Help Manage Investment Risk

1. Reevaluating Portfolio Diversification and Asset Allocation

2. Lowering Portfolio Volatility

Rebalancing

Buying bonds

Beta

3. Investing Consistently

4. Getting an Investment Risk Analysis

5. Requiring a Margin of Safety

6. Establishing a Maximum Loss Plan

The Best Offense Is a Great Defense

5 Steps to Improving Personal Cash Flow

1. Ask for a Raise

2. Start a Side Hustle

3. Track Your Spending

4. Simplify Your Life

5. Review Your Debt

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