Aug
19
2024

What Are Banks? Definition and Explanation

By | money, Terminology | Comments Off on What Are Banks? Definition and Explanation

You may think of a bank as simply a safe place to put your money. But banks do a lot more than accept deposits. They also extend loans, facilitate payments, exchange currency, set monetary policy, and provide a range of other financial services to individuals, businesses, and governments. Here are key things to know about banks, including how they work, how they make money, and the different products and services they offer.

What Is a Bank?

By definition, a bank is an institution that accepts deposits in checking and savings accounts and makes loans. In serving both functions, banks act as intermediaries between depositors (who essentially lend money to the bank) and borrowers (to whom the bank lends money). The money the bank pays to depositors and charges on loans is called interest.

Banks also offer a range of other financial products and services, including:

•   Credit cards

•   Investment accounts

•   Wealth management services

•   Individual retirement accounts (IRAs)

•   High-yield savings accounts

•   Certificates of deposit (CDs)

•   Money market accounts

•   Currency exchange

•   Safe deposit boxes

Banks also facilitate payments — from employers to employees, buyers to sellers, and taxpayers to the government — and play a major role in the nation’s economy. There are also many different types of banks, including retail banks, corporate banks, and central banks.

How Do Banks Make Money?

Banks typically generate revenue through a variety of channels. These include:

•   Interest on loans: Banks lend money to individuals and businesses at higher interest rates than what they pay on deposits, earning the interest rate spread.

•   Fees: Banks may charge fees for various services, including account maintenance, overdrafts, wire transfers, and out-of-network ATM usage.

•   Investment income: Banks may invest in securities, bonds, and other financial instruments, earning returns on these investments.

•   Interchange fees: When customers use their debit or credit cards, banks earn fees from merchants processing the transactions.

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A Brief History of Banks

The concept of banking dates back to ancient civilizations, when temples were used as safe places to store valuable items and grain, and priests would lend these resources to local farmers and merchants. The temples were also responsible for keeping records of these transactions, laying the groundwork for bookkeeping.

The first modern banks emerged in Renaissance Italy, with institutions like the Medici Bank setting the standard for banking operations. Over centuries, banks evolved, expanding their products and services and adopting technological advancements to meet the growing demands of consumers and businesses. Today, banks are integral to the global economy.

Modern Bank Products for Consumers

Modern banks offer a variety of products tailored to meet the financial needs of consumers. Common banking products include:

Loans

Banks provide various types of consumer loans, such as mortgages, personal loans, and auto loans. These loans help individuals finance large purchases and manage their cash flow.

Savings and Checking Accounts

Savings and checking accounts are fundamental banking products. A savings account is designed to hold cash you don’t need right away and allow you to earn interest and grow your money over time.

Checking accounts are set up to offer easy access to funds for everyday transactions. They come with checks and typically a debit card that can be used for purchases or to withdraw funds at an ATM. Checking accounts generally earn little or no interest, though some banks now offer high-yield checking accounts.

Mortgages

Banks offer mortgage loans to help individuals purchase homes. These long-term loans typically come with fixed or variable interest rates and generally require you to use the property being purchased as collateral for the loan. Mortgage terms are typically 15, 20, or 30 years.

Investing Accounts

Many banks offer investment accounts, including IRAs and taxable brokerage accounts. These accounts enable customers to invest in stocks, bonds, mutual funds, and other financial instruments designed for long-term growth.

Credit Cards

Credit cards provide consumers with a revolving line of credit, allowing them to make purchases and pay for them over time. Banks earn interest and fees from credit card users, making it a significant revenue source.

Certificates of Deposit (CDs)

CDs are time deposits that offer a fixed interest rate for a specified term. You agree to leave your money in the account for a set period of time (which generally range from three months to five years). In return, these accounts typically pay a higher interest rate than a standard savings account.

Money Market Accounts

A money market account is a hybrid account that offers competitive interest on your balance, along with the conveniences of a checking account, such as a debit card and checks. However, you may be limited to a certain number of withdrawals per month. Some money market accounts also have minimum balance requirements.

Useful Bank Features

In addition to products, banks offer various services to help customers manage their money. Here are some features you may want to look out for when exploring different bank options.

Customer Support

Banks typically offer customer support through various channels, including phone, email, online chat, and in-person assistance. Whether you need assistance with your checking account or help choose between two banking products, a customer service rep can generally point you in the right direction.

Credit Score Checkers

Many banks offer tools that allow customers to monitor their credit scores for free. This service allows you to stay informed about your credit health and, if necessary, take steps to build your scores. Having strong credit can help you unlock credit cards, mortgages, and other types of loans with attractive rates and terms.

ATMs

Whether you open an account at a traditional brick-and-mortar institution or an online-only bank, you’ll typically have access to a wide network of fee-free automated teller machines (ATMs). This allows you to withdraw cash or make deposits without needing to visit a branch during business hours.

Online/Mobile Banking

Online banking and mobile banking apps allow you to monitor your accounts, transfer money, pay bills, and deposit checks from your computer or mobile device.

Financial Planning Tools

Many banks offer financial planning tools that help customers budget, save, and invest wisely. These tools can include calculators, goal-setting features, and personalized financial advice.

Bank Regulations

While banks are typically privately owned entities that must answer to their shareholders, banking is a highly regulated industry. Regulatory bodies, such as the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC), oversee banks’ operations, ensuring they adhere to laws and maintain sufficient capital reserves. This is to minimize disruptions and ensure the U.S. banking system runs smoothly.

The majority of U.S. banks are also insured by the FDIC. This covers deposit accounts up to $250,000 per insured bank, per depositor. Co-owners of joint accounts at the same bank are typically each insured up to $250,000. The agency’s BankFind site can help you identify FDIC-insured banks throughout the country.

Types of Banks

There are several different types of banks, each serving different purposes and customer bases. The large global banks often operate separate arms or divisions for each of these categories.

Retail Banks

Retail banks focus on individual consumers, rather than businesses or other banks. They provide personal banking services, such as checking and savings accounts, personal loans, mortgages, auto loans, short-term loans like overdraft protection, and credit cards. They may also offer access to investment products, such as mutual funds and IRAs.

While some retail banks offer in-person services through brick-and-mortar locations, others operate exclusively online. Due to lower overhead costs, online banks tend to offer higher yields on savings accounts and charge lower (or no) fees.

Recommended: What Is Neobanking and How Does it Work?

Corporate Banks

Corporate banks (also known as commercial banks) cater to large businesses and corporations. They also serve government agencies and institutions like colleges and universities. Along with business checking and savings accounts, these banks offer business loans and lines of credit, letters of credit, payment processing, foreign exchange transactions, and more for their clients.

Investment Banks

Investment banks serve as intermediaries in large, complex financial transactions. They specialize in initial public offerings (IPOs), raising capital, facilitating mergers and acquisitions, and providing advisory services to corporations and governments. Unlike retail banks, they do not take deposits from or provide loans to the general public.

Central Banks

Central banks manage a nation’s monetary policy, regulate the banking industry, and act as a lender of last resort. The central bank in the U.S. is the Federal Reserve (a.k.a, “the Fed”). The Fed sets the federal funds rates, which impacts everything from the annual percentage yields (APYs) you earn on savings accounts to the interest rates you pay on credit card balances and loans. Unlike the banks types listed above, central banks do not deal directly with the public.

Pros and Cons of Banks

Retail and commercial banks offer myriad benefits, but they also have some downsides. Here’s a look at how the pros and cons stack up.

Pros

 Cons
Safe and secure Potential fees for various services
Easy access to funds Lower interest rates on deposits
Wide range of services Potentially complex fee structures
Highly regulated Potential for poor customer service

Pros

•   Safety: Banks provide a secure place to store money, reducing the risk of theft or loss. Deposits in most banks are federally insured (up to certain limits), which means that even if the bank were to fail, customers will still recover their funds, up to the insured limit.

•   Convenient access to funds: Banks offer easy access to funds through a network of branches, ATMs, and digital banking platforms.

•   One-stop shop: Banks provide a variety of financial services beyond basic checking and savings accounts, allowing you to manage all aspects of your finances under one roof.

•   Regulatory protection: Banks are heavily regulated by government agencies. These regulations protect consumers from fraud, ensure the safety of deposits, and promote ethical banking practices.

Cons

•   Fees: Banks often charge fees for their services, including fees for account maintenance, overdrafts, and wire transfers.

•   Low interest rates: Many banks offer relatively low interest rates on savings accounts and other deposit accounts. These rates often fail to keep pace with inflation, which can diminish the purchasing power of your savings over time.

•   Complex fee structures: The complexity of bank fees can create confusion for customers and result in unexpected expenses.

•   Potential for poor customer service: Large banks may offer impersonal or poor customer service due to their size and scale.

Banks vs Credit Unions

While banks and credit unions offer similar financial services, there are key differences between them. Here’s a closer look:

Ownership

Banks,typically, are owned by shareholders and operate for profit. Credit unions, by contrast, are owned by their members and operate on a not-for-profit basis. The main goal of a credit union is to benefit its members.

Fees and Interest Rates

Credit unions often offer lower fees and better interest rates on loans and savings accounts compared to traditional banks, as they are not driven by maximizing profits.

Membership

Banks are open to the general public. Credit unions require membership, which may be based on specific criteria such as employment, geographic location, or affiliation with a particular organization.

Customer Service

Credit unions tend to provide more personalized customer service due to their smaller size and member-focused approach. While small banks can also offer personalized customer service, larger banks may lack the personal touch.

Getting Started Banking With SoFi

A bank is an excellent resource to help manage your money. You can deposit funds for safekeeping, manage everyday spending, and invest for the future. Understanding the products, services, and perks offered by different banks can help you find the institution for your needs.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.


Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.00% APY on SoFi Checking and Savings.

FAQ

How do banks make money?

Banks primarily make money by lending out deposits at higher interest rates than they pay to depositors, earning the interest rate spread. They also earn money from the fees they charge for account maintenance, overdrafts, and transactions. Additionally, banks may invest in securities and earn returns.

Why do they call it a bank?

The term “bank” is thought to originate from the Italian word “banca,” which means bench or counter. In medieval times, moneylenders conducted their business on benches in marketplaces, and the term evolved to represent financial institutions.

What is a bank, simply put?

Simply put, a bank is a financial institution that accepts deposits and makes loans. Banks also play a key role in a nation’s economy, facilitating the management and movement of money for individuals, businesses, and governments.

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SoFi members with direct deposit activity can earn 4.00% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a recurring deposit of regular income to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government benefit payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, or are non-recurring in nature (e.g., IRS tax refunds), do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate. SoFi members with direct deposit are eligible for other SoFi Plus benefits.

As an alternative to direct deposit, SoFi members with Qualifying Deposits can earn 4.00% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant. SoFi members with Qualifying Deposits are not eligible for other SoFi Plus benefits.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.00% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 12/3/24. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

*Awards or rankings from NerdWallet are not indicative of future success or results. This award and its ratings are independently determined and awarded by their respective publications.

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

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

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Aug
13
2024
How Does a Stock Exchange Work?

How Does a Stock Exchange Work?

By | Growing Wealth, invest, Investing, Terminology | No Comments

Stock exchanges are platforms that allow investors to buy and sell stocks in a venue that is regulated and transparent. These exchanges enable investors of all stripes to trade stocks and other securities, potentially benefiting from a stock’s share price appreciation and dividend payments.

Stock exchanges help the stock market work, and are a big part of the overall economy. Understanding stock exchanges and how they work may help you how they affect you and your investments.

What Is a Stock Exchange?

A stock exchange is a marketplace where the shares of publicly-traded companies are bought and sold between investors.

Exchanges are generally organized by an institution or association that hosts the market, like the New York Stock Exchange or Nasdaq. These organizations and government regulators – like the Securities and Exchange Commission (SEC) in the U.S. – set up the rules and regulations of what companies investors can trade on a stock exchange.

If a company is “listed” on an exchange, it means that the company can be traded on that exchange. Not all companies are listed because each exchange regulates which companies meet their requirements. Companies not listed on the exchange are traded over-the-counter, or OTC for short.

Investors who want to buy or sell stocks commonly trade through an investment broker, a person or entity licensed to trade on the exchanges. Brokers aim to buy or sell stock at the best price for the investor making the trade, usually earning a commission for the service. Most investors will now use online brokerage firms for this service, paying little to no commissions for trades.

Historically, stock exchanges were physical locations where investors came together on a trading floor to frantically buy and sell stocks, like what you may have seen in the movies or on TV. However, these days, more often than not, stock exchanges operate through an electronic trading platform.

Major Stock Exchanges

10 Largest Stock Exchanges by Market Capitalization of Listed Companies
Exchange Location Market capitalization (in trillions)*
New York Stock Exchange (NYSE) U.S. $28.8
Nasdaq U.S. $25.43
Euronext Europe $7.15
Shanghai Stock Exchange China $6.52
Tokyo Stock Exchange Japan $6.25
London Stock Exchange U.K. $5.63
Shenzhen Stock Exchange China $4.29
National Stock Exchange of India India $4.53
Hong Kong Exchanges Hong Kong $3.97
Saudi Stock Exchange Saudi Arabia $2.86
*As of August 2024

Why Do We Have Stock Exchanges?

Stock exchanges exist because they provide a place for buyers and sellers to come together and trade stocks. Stock exchanges are also important because they provide a way for businesses to raise money. When companies issue stock to raise capital, investors will then trade the company’s shares on the stock exchange in which it is listed.

The individual stock exchanges set the rules for how stocks are traded. Stock exchanges are also regulated markets, which means that a government agency oversees the activity on the exchange. These rules and regulations provide a level of safety for investors and help to ensure that the market is fair, transparent, and liquid.

💡 Not sure what a stock is? Here we explain what stocks are and how they work.

What Is the Stock Market?

The stock market is made up of a network of different stock exchanges, including OTC markets, and the companies that are traded on these exchanges.

When you hear mentions of the stock market and its performance, it is usually in reference to a particular stock market index, like the S&P 500 or Dow Jones Industrial Average. However, the stock market is more than the specific companies that make up these stock market indices.

Generally, stock markets facilitate the buying and selling of shares between companies and institutional investors through initial public offerings (IPOs) in the primary market. Once a company has an IPO, the company’s shares are traded in secondary markets, like stock exchanges.

Stock Market Volatility

Volatility in the stock market occurs when there are big swings in share prices. Share prices can change for various reasons, like a new product launch or the most recent earnings report. And while volatility in the stock market usually describes significant declines in share prices, volatility can also happen to the upside.

Pros of the Stock Market

As mentioned above, the stock market allows companies to raise capital by issuing shares to investors. Raising money was one of the main reasons why stock issuances and trading began. It allows businesses to raise money to expand a business without taking out a loan or issuing bonds.

And because investors can own shares of companies, they can benefit from the growth and earnings of a business. Investors can profit from a company’s dividend payments, realize a return when the stock’s price appreciates, or benefit from both. This helps investors build wealth.

The relationship between stock markets, companies, and investors has arguably led to more economic efficiency, allowing money to be allocated in more productive ways.

Cons of the Stock Market

For companies, issuing shares on the stock market may be onerous and expensive due to rules and regulations from the stock exchanges and government regulators. Because of these difficulties, companies may be wary of going through the IPO process. Instead, they are more comfortable raising money in the private markets.

There are several potential risks associated with investing in the stock market. For example, the stock market is subject to market volatility, resulting in losses. Investors must be willing to take on the risks of losing money for the possibility of gains in the future.

Additionally, there is the potential for stock market fraud and manipulation by companies and investors, which harms individual investors, companies, and the economy.

💡 Recommended: How Many Companies IPO Per Year?

The Takeaway

A stock exchange is a marketplace where investors can buy and sell stocks or other securities, and where companies can list shares to try and raise capital. There are numerous stock exchanges, but the biggest in the U.S. are the New York Stock Exchange, and the Nasdaq.

Knowing the ins and outs of stock exchanges and how they influence the broader stock market may help you become a better-informed investor. Further, by learning about stock exchanges, their different rules, and their advantages and disadvantages, you may better understand the stock market as a whole. This may allow you to invest confidently and prepare for future stock market volatility.

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


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

FAQ

What is the stock market?

The stock market is a collection of markets where stocks are traded between investors. It usually refers to the exchanges where stocks and other securities are bought and sold.

What are the benefits of investing in the stock market?

Some benefits of investing in the stock market include the potential for earning income through dividend payments, experiencing share price appreciation, and diversifying one’s financial portfolio beyond cash. Note, however, that there are significant risks associated with investing in the stock market, too.

SoFi Invest®

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1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Aug
08
2024
scale

Overweight Stock, Explained

By | Growing Wealth, invest, Investing, Terminology | Comments Off on Overweight Stock, Explained

When a financial analyst rates a stock as overweight, it means that the analyst believes an overweight stock will likely outperform other stocks in its industry over the next six to 12 months. Conversely, if they describe a stock as underweight, they believe that it will perform poorly in the future.

It may be helpful to think of these terms as pointers: as if an industry specialist were saying, “You might want to overweight Stock X in your portfolio” or “maybe you should under-weight Stock Y.” These ratings are typically the result of factors in the news or pertaining to a specific company’s prospects. But the terms “overweight” and “underweight” also refer to a stock’s weighting in a relevant index or benchmark.

Key Points

•   An overweight stock rating indicates that analysts expect the stock to outperform its industry peers within the next six to twelve months.

•   The terms overweight and underweight also refer to a stock’s proportion in an investment portfolio, guiding investors on how much to hold.

•   Different market indexes apply unique weighting systems, influencing how stocks are rated as overweight or underweight based on market capitalization or stock price.

•   Investors should be cautious, as an overweight stock may not always lead to significant gains and could lead to portfolio imbalance if not managed properly.

•   The context of both the market and individual portfolios is crucial when interpreting overweight ratings, emphasizing the need for careful investment decisions.

What Is an Overweight Stock?

As noted, an overweight stock is one that analysts believe will outperform others in its sector or market segment in the near future. Similarly, overweight stock is a moniker that may also describe a specific security’s weighting in a portfolio, and one that analysts think investors should buy more of – so, its meaning can be contextual in certain situations.

💡 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.

Types of Ratings and Where They Came From

To understand stock ratings related to weight, it’s important to know that market indexes assign a weight to the investments they track to be sure that the index accurately reflects the performance of that market sector.

For example, the S&P 500® tracks 500 large-cap U.S. companies. The companies in the index — called the constituents — are weighted by market capitalization. A company’s market cap is calculated by multiplying the current share price by the total number of outstanding shares.

Companies in that index are weighted based on the proportion of the overall index their market cap represents. Other indexes may use a different weighting system. The Dow Jones Industrial Average, for example, tracks 30 blue chip companies and weights them based on stock price. Companies with a higher share price are given more weight than those with lower prices.

Because of these different weighting systems, it’s important to understand that an overweight to a particular stock with regards to one index may not be the same when it comes to another.

Overweight Stocks

When an analyst rates Stock X as overweight, it’s generally a positive sign. First, they believe Stock X is likely to outperform its benchmark index, or even the market as a whole, depending on market conditions, so investors should consider holding more of the stock.

Bear in mind that an “overweight stock” rating doesn’t necessarily mean that stock is a juggernaut. In a down market, being overweight could simply mean the company might not lose as much ground as its peers, or it might grow less slowly than its peers.

Underweight Stocks

When an analyst rates Stock Y as underweight, the analyst believes that Stock Y is likely to underperform its benchmark, and investors should consider holding less of this stock.

Equal Weight Stocks

When an analyst gives an equal weight rating to a stock, that simply means it’s in line with the overall benchmark. Again, when considering these ratings it’s important to keep in mind the overall context of the market, and what these ratings mean to analysts.

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Example of an Overweight Stock

A very simple example of an overweight stock could be when a stock, Stock X, is selling for $50, but experts and analysts think it’s undervalued and should trade for $75, it could be overweight.

Further, an overweight stock rating can be taken in two ways: First, that the stock will outperform its benchmark index and second that investors may want to take advantage of the increase in price.

When an analyst indicates their belief that a stock will appreciate, they may also state a potential time frame and price target for the stock. So, if Stock X is trading at $75 per share, and the company releases new earnings data that’s positive, an analyst might rate the stock as overweight, with a price target of $100 per share in the coming year.

💡 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 Downside of Weighting Stocks

One critique of this rating system is that no analyst, of course, can recommend how many shares investors should buy. It’s simply not possible for analysts to know whether Investor A’s portfolio might benefit from an additional 100 shares of Stock X, while Investor B might want to buy 1,000 shares of Stock X.

As a result, it’s incumbent on individual investor’s themselves to keep an eye on how relevant an overweight stock rating might be for their specific allocation. Buying more of Stock X could, in theory, create an imbalance and reduce a portfolio’s overall diversification. So while an overweight stock might be a good thing, an overweight portfolio usually is not.

How Can Investors Interpret Overweight Stocks?

At first glance, the terms overweight and underweight may seem more or less synonymous with “buy” and “sell” — in that case, why don’t analysts use these more straightforward terms?

In fact, the terms overweight and underweight do have a slightly different connotation than simply to buy or sell a security. Rather, the terms suggest a recommendation that a portfolio hold more or less of a particular position than an index or other benchmarks would suggest.

It may mean acquiring more, or selling some, of a particular investment. But it wouldn’t necessarily mean buying something new or selling all of a position. For example, if your portfolio has an allocation to tech stocks, and an analyst recommends overweighting one of those stocks, you may want to buy more of that company. Or you may not need more growth in your tech holdings, so you might look for an overweight stock.

Also, analysts aren’t always comfortable giving specific directions to buy or sell certain securities. The terms overweight and underweight are more like offering guidance: “Here’s what I think of Stock X or Stock Y. I’ll let the investor take it from here.”

In many cases an overweight or underweight recommendation might not be very useful for investors. For example, if an analyst recommends an overweight to a certain commodity but an investor’s portfolio doesn’t hold any commodities, this information may not have much bearing on their situation.

Can a Portfolio Be Considered Overweight?

Overweight can refer to a portfolio that holds more of a stock or other investments than it theoretically should. For individual investors, this might mean that more of a portfolio is allocated to stock than the investor intended.

For example, say an investor has a portfolio allocation in which 70% of its allocation is held in stock and 30% is held in bonds. If the stock market goes up, the proportion of the portfolio held in stock may grow beyond the 70% mark. At that point, the portfolio may be described as overweight in stocks, and an investor may want to rebalance to bring it in line with their initial allocation plan.

It may come as no surprise that the opposite of an overweight allocation is an underweight allocation. For example, if the stock allocation in the portfolio above fell below 70%, that allocation could be described as underweight in stocks.

The term can also apply in a narrower sense. For example, a stock portfolio could hold too much stock in one company, sector, or geographical region. In each case the holding could be described as overweight.

Professional fund managers may also use overweight to describe portfolios they work with that are off track with their index, including mutual funds, exchange-traded funds, and index funds. From time to time, a fund may get out of line with its benchmark index by holding more or less of an investment that index tracks.

For example, say an index fund is built to track the S&P 500. To track the index, fund managers will usually attempt to hold every stock in the index. Additionally, they will try to match the proportion of each individual company their fund holds to the index as well. So if stock A represents 5% of the original index, the fund will also hold 5% of stock A.

Some funds have a little bit of wiggle room in terms of how far they can stray from the index. Some might be allowed to hold more or less stocks if they think the stocks will outperform or underperform. When they hold more than the index, the managers are taking an overweight position. And when they hold less than the index, the managers are taking an underweight position.

The Takeaway

Overweight stocks are those that may be undervalued by the market. When an analyst gives a stock an overweight rating, broadly speaking it could be a good thing. If the analyst is correct, and the stock is indeed poised to perform better than its benchmark — maybe even better than the market as a whole — investors may want to buy that stock.

But the necessary caveat is that it all depends on context — the context of the market, and the context of an investor’s portfolio overall. You don’t want to buy a stock that could throw your allocation off, and make your portfolio overweight in a way that’s not ideal.

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

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

FAQ

Is overweight stock good?

An overweight stock can be good for investors looking for a relative deal, but it may not be a good thing if the investor already owns shares of the stock.

What is the difference between overweight and outperform stocks?

Outperform stocks and overweight stocks are similar, and the terms are often used interchangeably. But generally, “outperform” may describe a stock that’s undervalued or expected to offer solid returns in the future, but perhaps perform not quite as well as an “overweight” stock.

What is the difference between buy and overweight?

On an analysts’ rating system, “buy” and “overweight” stocks are rated differently, with “buy” being a higher rating – though both ratings are positive.

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Aug
08
2024
Understanding Bond Valuation

What Is Bond Valuation?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is Bond Valuation?

Bond valuation is a way of determining the fair value of a bond. Bond valuation involves calculating the present value of the bond’s future coupon payments, its cash flow, and the bond’s value at maturity (or par value), to determine its current fair value or price. The price of a bond is what investors are willing to pay for it on the secondary market.

When an investor buys a bond from the issuing company or institution, they typically buy it at its face value. But when an investor purchases a bond on the open market, they need to know its current value. Because a bond’s face value and interest payments are fixed, the valuation process helps investors decide what rate of return would make that bond worth the cost.

Key Points

•   Bond valuation is the process of determining a bond’s fair value by calculating the present value of future coupon payments and its value at maturity.

•   Investors must consider the bond’s current price, which may differ from its face value, as it reflects market conditions and the issuing company’s creditworthiness.

•   The valuation involves discounting the bond’s future cash flows using a realistic discount rate, which is essential due to the time value of money.

•   Changes in interest rates significantly affect bond pricing; rising rates usually decrease bond prices, while falling rates can increase them.

•   Investing in bonds can diversify a portfolio, as they tend to be less risky than stocks and provide a predictable income stream through fixed payments.

How Bond Valuation Works

First, it’s important to remember that bonds are generally long-term investments, where the par value or face value is fixed and so are the coupon payments (the bond’s rate of return over time) — but interest rates are not, and that impacts the present or fair value of a bond at any given moment.

To determine the present or fair value of a bond, the investor must calculate the current value of the bond’s future payments using a discount rate, as well as the bond’s value at maturity to make sure the bond you’re buying is worth it.

Some terms to know when calculating bond valuation:

•   Coupon rate/Cash flow: The coupon rate refers to the interest payments the investor receives; usually it’s a fixed percentage of the bond’s face value and typically investors get annual or semi-annual payments. For example, a $1,000 bond with a 10-year term and a 3% annual coupon would pay the investor $30 per year for 10 years ($1,000 x 0.03 = $30 per year).

•   Maturity: This is when the bond’s principal is scheduled to be repaid to the bondholder (i.e. in one year, five years, 10 years, and so on). When a bond reaches maturity, the corporation or government that issued the bond must repay the full amount of the face value (in this example, $1,000).

•   Current price: The current price is different from the bond’s face value or par value, which is fixed: i.e. a $1,000 bond is a $1,000 bond. The current price is what people mean when they talk about bond valuation: What is the bond currently worth, today?

The face value is not necessarily the amount you pay to purchase the bond, since you might buy a bond at a price above or below par value. A bond that trades at a price below its face value is called a discount bond. A bond price above par value is called a premium bond.

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How to Calculate Bond Valuation

Bond valuation can seem like a daunting task to new investors, but it is not that onerous once you break it down into steps. This process helps investors know how to calculate bond valuation.

Bond Valuation Formula

The bond valuation formula uses a discounting process for all future cash flows to determine the present fair value of the bond, sometimes called the theoretical fair value of the bond (since it’s calculated using certain assumptions).

bond valuation formula

The following steps explain each part of the formula and how to calculate a bond’s price.

Step 1: Determine the cash flow and remaining payments.

A bond’s cash flow is determined by calculating the coupon rate multiplied by the face value. A $1,000 corporate bond with a 3.0% coupon has an annual cash flow of $30. If it’s a 10-year bond that has five years left until maturity, there would be five coupon payments remaining.

Payment 1 = $30; Payment 2 = $30; and so on.

The final payment would include the face value: $1,000 + $30 = $1,030.

This is important because the closer the bond is to maturity, the higher its value may be.

Step 2: Determine a realistic discount rate.

The coupon payments are based on future values and thus the bond’s cash flow must be discounted back to the present (thanks to the time value of money theory, a future dollar is worth less than a dollar in the present).

To determine a discount rate, you can check the current rates for 10-year corporate bonds. For this example, let’s go with 2.5% (or 0.025, when expressed as a decimal).

Step 3: Calculate the present value of the remaining payments.

Calculate the present value of future cash flows including the principal repayment at maturity. In other words, divide the yearly coupon payment by (1 + r)t, where r equals the discount rate and t is the remaining payment number.

$30 / (1 + .025)1 = $29.26

$30 / (1 + .025)2 = 28.55

$30 / (1 + .025)3 = 27.85

$30 / (1 + .025)4 = 27.17

$1030 / (1 + .025)5 = 1,004.87

Step 4: Sum all future cash flows.

Sum all future cash flows to arrive at the present market value of the bond : $1,117.70

Understanding Bond Pricing

In this example, the price of the bond is $1,117.70, or $117.70 above par. A bond’s face or par value will often differ from its market value — and in this case its current fair value (market value) is higher. There are a number of factors that come into play, including the company’s credit rating, the time to maturity (the closer the bond is to maturity the closer the price comes to its face value), and of course changes to interest rates.

Remember that a bond’s price tends to move in the opposite direction of interest rates. If prevailing interest rates are higher than when the bond was issued, its price will generally fall. That’s because, as interest rates rise, new bonds are likely to be issued with higher coupon rates, making the new bonds more attractive. So bonds with lower coupon payments would be less attractive, and likely sell for a lower price. So, higher rates generally mean lower prices for existing bonds.

The same logic applies when interest rates are lower; the price of existing bonds tends to increase, because their higher coupons are now more attractive and investors may be willing to pay a premium for bonds with those higher interest payments.

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Is Investing in Bonds Right for You?

Investing in bonds can help diversify a stock portfolio since stocks and bonds trade differently. In general, bonds are seen as less risky than equities since they often provide a predictable stream of income. Investors can consider bonds as an investment, and those with a lower risk tolerance might be better served with a portfolio weighted highly in bonds.

Performing proper bond valuation can be part of a solid research and due diligence process when attempting to find securities for your portfolio. Moreover, different bonds have different risk and return profiles. Some bonds — such as junk bonds and fixed-income securities offered in emerging markets — feature higher potential rates of return with greater risk. “Junk” is a term used to describe high-yield bonds. You can take on higher risk with long-duration bonds and convertible bonds. Some of the safest bonds are short-term Treasury securities.

You can also purchase bond exchange-traded funds (ETFs) and bond mutual funds that own a diversified basket of fixed-income securities.

The Takeaway

Bond valuation is the process of determining the fair value of a bond after it’s been issued. In order to price a bond, you must calculate the present value of a bond’s future interest payments using a reasonable discount rate. By adding the discounted coupon payments, and the bond’s face value, you can arrive at the theoretical fair value of the bond.

A bond can be priced at a discount to its par value or at a premium depending on market conditions and how traders view the issuing company’s prospects. Owning bonds can help diversify your portfolio. Many investors also find bonds appealing because of their steady payments (one reason that bonds are considered fixed-income assets).

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

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

Photo credit: iStock/Tempura

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

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Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
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