What is the Yield to Maturity?

The yield to maturity (YTM), also known as the redemption or bond yield, is the estimated interest rate investors earn when holding a fixed-rate investment like a bond at market value until it reaches maturity or full value.

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Nov

2024

Guide to Yield to Maturity (YTM)

By Austin Kilham | Growing Wealth, invest, Investing, Terminology | Comments Off

When investors evaluate which bonds to buy, they often take a look at yield to maturity (YTM), the total rate of return a bond will earn over its life, assuming it has made all interest payments and repaid the principal.

Calculating YTM can be complicated. Doing so takes into account a bond’s face value, current price, number of years to maturity and coupon, or interest payments. It also assumes that all interest payments are reinvested at a constant rate of return. With these figures in hand, they will be better equipped to understand the bond market and which bonds will offer the greatest yield if held to maturity.

Key Points

• Yield to Maturity (YTM) represents the total return expected from holding a bond until it matures, factoring in interest payments and principal repayment.

• Calculating YTM involves the bond’s coupon rate, face value, current market price, and the time to maturity, making it a complex formula.

• YTM is useful for comparing bonds with different characteristics, helping investors anticipate returns and understand interest rate risks associated with bond investments.

• Limitations of YTM include assumptions about reinvestment of interest payments and the neglect of taxes, which can significantly affect actual returns.

• Investors can utilize YTM as a tool for decision-making but should consider diversifying their portfolios and possibly consulting financial professionals for guidance.

What Is Yield to Maturity (YTM)?

The yield to maturity (YTM) is the estimated rate investors earn when holding a bond until it reaches maturity or full value. The YTM is stated as an annual rate and can differ from the stated coupon rate.

The calculations in the yield to maturity formula include the following factors:

• Coupon rate: Also known as a bond’s interest rate, the coupon rate is the regular payment issuers pay bondholders for the right to borrow their money. The higher the coupon rate, the higher the yield.

• Face value: A bond’s face value, or par value, is the amount paid to a bondholder at its maturity date.

• Market price: A bond’s market price refers to how much an investor would have to pay for a bond on the open market currently. The price buyers pay on the secondary market may be higher or lower than a bond’s face value. The higher the price of the bond, the lower the yield.

• Maturity date: The date when the issuer repays the principal is known as the maturity date.

The YTM formula assumes all coupon payments are made as scheduled, and most calculations assume interest will be reinvested.

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How to Calculate Yield to Maturity

Calculating yield to maturity can be done by following a formula — but fair warning, it’s not simple arithmetic!

Yield to Maturity (YTM) Formula

To calculate yield to maturity, investors can use the following YTM formula:

In this calculation:

C = Interest or coupon payment
FV = Face value of the investment
PV = Present value or current price of the investment
t = Years it takes the investment to reach the full value or maturity

Example of YTM Calculation

Here’s an example of how to use the YTM formula.

Suppose there’s a bond with a market price of $800, a face value of $1,000, and a coupon value of $150. The bond will reach maturity in 10 years, with a coupon rate of about 14%.

By using this formula, the estimated yield to maturity would calculate as follows:

The Importance of Yield to Maturity

Knowing a bond’s YTM can help investors compare bonds with various maturity and coupon rates, and ultimately, what their dividend yield could look like. For example, consider two bonds of varying maturity: a five-year bond with a 3% YTM and a 10-year bond with a 2.5% YTM. Investor’s can easily see that the five-year bond is more valuable.

YTM is particularly useful when attempting to compare older bonds sold in a secondary market, which can be priced at a premium or discounted — meaning they cost more or less than the bond’s face value. Understanding the YTM formula also helps investors understand how market conditions can impact their portfolio based on the investment they select. Since yields rise when prices drop (and vice versa) as seen on a yield curve, investors can forecast how their investment will perform.

Additionally, YTM can help investors understand how likely they are to be affected by interest rate risk — the danger that the value of a bond may be adversely affected due to the changes in interest rate. Current YTM is inversely proportional to interest rate risk. That means, the higher the YTM, the less bond prices will be affected should interest rates change, in theory.

Yield to Maturity vs Yield to Call

With a callable, or redeemable bond, issuers can choose to repay the principal amount before the maturity date, halting interest payments early. This throws a bit of a wrench into the YTM calculation. Instead, investors may want to use a yield to call (YTC) calculation. To do so, they can use the YTM calculation, substituting the maturity date for the soonest possible call date.

Typically a bond issuer will call a bond only if it will result in a financial gain. For example, if the interest rate drops below a coupon rate, the issuer may decide to recall the bond to borrow funds at a lower rate. This situation is similar to when interest rates drop and homeowners refinance their home loans.

For investors that use callable bonds for income, yield to call is significant. Suppose the issuer decides to call the bond when the interest rates are lower than when the investor purchases it. If an investor decides to reinvest their payout, they may have a tough time finding a comparable bond that offers the yield they need to support their lifestyle. They may feel it necessary to take on more risk, looking to high-yield bonds.

💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.

Yield to Maturity vs Coupon Rate

While a bond’s coupon rate is another important piece of information that investors need to keep in mind, it’s not the same as yield to maturity. The coupon rate tells investors the annual amount of interest that a bond’s owner is set to receive — the two may be the same when a bond is initially purchased, but will likely diverge over time due to changing economic and market conditions.

Limitations of Yield to Maturity

The yield to maturity calculation does have limitations.

Taxes

It’s important to note that YTM calculations exclude taxes. While some bonds, like municipal bonds and U.S. Treasury bonds, may be tax exempt on a federal and state level, most other bonds are taxable. In some cases, a tax-exempt bond may have a lower interest rate but ultimately offer a higher yield once taxes are factored in.

As an investor, it can be especially helpful to consider the after-tax yield rate of return. For example, suppose an investor in the 35% federal tax bracket who doesn’t pay state income taxes is considering investing in either Bond X or Bond Y. Bond X is a tax-exempt bond and pays a 4% interest rate, while Bond Y is taxable and pays 6% interest.

While the 4% yield for Bond X remains the same, the after-tax yield for Bond Y is 3.8%. While it seemed like the less lucrative of the two options up front, Bond X should ultimately yield a higher return after taxes.

Presuppositions

Another YTM limitation is that it makes assumptions about the future that may not necessarily come to fruition. Specifically, it assumes that a bondholder will hang on to the bond until its maturity date, which may or may not actually happen. It also assumes that profits from the investment will be reinvested in a uniform manner — again, that may or may not be the case.

The Takeaway

Using the yield to maturity formula can help investors compare bond options with different coupon and maturity rates, market and par values, and determine which one offers the potential for a higher yield. But calculating the YTM is not an exact science, especially when you’re gauging the return on a callable bond, say, or adding the impact of taxes to the mix.

YTM is just one tool investors can use to determine which bond may best serve their financial needs and goals. One alternative to choosing individual bonds is to invest in bond mutual funds or bond exchange-traded funds (ETFs). Investors can also speak with a financial professional for guidance.

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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

What is a bond’s yield to maturity (YTM)?

A bond’s yield to maturity is the total return an investor can anticipate receiving if the bond is held to its maturity date. YTM calculations assume that all interest payments will be made by the issuer and reinvested by the bondholder at a constant rate of interest.

What is the difference between a bond’s coupon rate and its YTM?

A bond’s coupon, or interest, rate is fixed from the moment an investor buys it. However, the same bond’s YTM can fluctuate over time depending on the price paid for it and other interest prices available on the market. If YTM is lower than the coupon rate, it may indicate that the bond is being sold at a premium to its face value. If it’s lower, it may be that the bond is priced at a discount to face value.

What is yield to maturity and how is it calculated?

Yield to maturity refers to the total return an investor can expect or anticipate from a bond if they hold it to maturity. It’s calculated using variables including the time to maturity, a bond’s face value, its current price, and its coupon rate.

Why is yield to maturity important?

The yield to maturity formula can give investors an idea of what they can expect in terms of returns from their bond holdings. But again, there are some assumptions the calculation takes into account, so an investor’s mileage may vary.

Is a higher YTM better?

A higher YTM may be better under certain circumstances. For example, since a higher YTM may indicate a bond is being sold for less than its face value, it may represent a valuable opportunity to invest. However, if the bond is discounted because the company that offered it is in trouble or interest rates offered by other investments are more appealing, then a high YTM might not be such a good thing. Investors must research investments carefully and understand the full story before they buy.

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Nov

2024

When Is the Stock Market Closed?

By Emma Diehl | Growing Wealth, invest, Investing, Terminology | Comments Off

The stock market is closed on weekends and many holidays. Accordingly, in a general sense, investors can buy and sell stocks Monday through Friday between 9:30am-4pm ET, but the exact schedule can vary based on time zone, market, and holiday season. Additionally, the major stock exchanges may close or stop trading unexpectedly due to several reasons, like natural disasters or technical glitches. It’s all a part of how the stock markets work.

While a person can always access stock market data, the stock exchanges have strict operating hours during a typical work week. Knowing the stock market schedule and when the stock market is closed may help investors make better investment decisions.

Key Points

• The stock market operates Monday through Friday, with core trading hours from 9:30 AM to 4 PM ET, and is closed on weekends and holidays.

• Major U.S. holidays when the stock market is closed include New Year’s Day, Independence Day, Thanksgiving, and Christmas, among others.

• The stock market may also close unexpectedly due to crises, technical issues, or to honor significant events, such as the passing of notable figures.

• Trading curbs, which temporarily halt trading, are triggered by significant drops in the S&P 500 Index, with varying levels based on the severity of the decline.

• Extended trading hours are available for premarket and after-hours trading, but these periods carry higher risks due to lower liquidity and increased volatility.

U.S. Stock Market Holidays

Even with standard operating hours, stock markets will close their markets completely for certain holidays. The New York Stock Exchange and Nasdaq recognize the following holidays:

• New Year’s Day

• Martin Luther King, Jr. Day

• Washington’s Birthday

• Good Friday

• Memorial Day

• Juneteenth National Independence Day

• Independence Day

• Labor Day

• Thanksgiving Day

• Christmas Day

Additionally, the stock market closes early (at 1pm ET) on the following dates:

• Black Friday

• Christmas Eve, if the holiday falls on a weekday

Stock exchanges in other countries might have different national holidays and operating schedules. Investors can buy and sell stocks or other securities during open market hours outside of these major holidays.

Is the Market Closed the Following Monday After a Holiday?

For holidays with a fixed date, like Juneteenth (June 19), Independence Day (July 4), and Christmas (Dec. 25), the stock market will be closed on the preceding Friday if the holiday falls on a Saturday or the following Monday if the holiday falls on a Sunday.

However, if New Year’s Day (Jan. 1) falls on Saturday, the holiday is not observed; the stock market will be open on the preceding Friday and the following Monday.

Other Times the Stock Market Closes or Is Halted

In addition to planned holidays, historically, the stock market has closed trading in times of crisis or technical challenges.

For example, at the beginning of the Covid-19 pandemic in early 2020, markets were halted multiple times due to unprecedented drops in the market. Called trading curbs or circuit breakers, these are temporary pauses mandated by the Securities and Exchange Commission in 2012. Each level follows different criteria:

• Level 1: A 7% drop in the S&P 500 Index compared to closing the day before will trigger the market to be paused for at least 15 minutes.

• Level 2: A 13% drop in the S&P 500 compared to closing the day before will trigger at least a 15-minute pause in the market.

• Level 3: A 20% drop in the S&P 500 compared to closing the day before will trigger a premature close on trading for the rest of the day.

Trading curbs can occur for a single stock and a whole market. It’s more common for the curb to be tripped on a single stock, but unprecedented events can spark a whole market pause. Covid-19 caused three trading curbs in just over a week.

The stock market may also close unexpectedly due to unprecedented events. For example, the terrorist attacks of Sept. 11, 2001, caused the NYSE to close for a week, while Superstorm Sandy forced the NYSE to close for two days in Oct. 2012.

Additionally, the markets may close down to honor the death of a world figure, as was the case with George H.W. Bush and Martin Luther King Jr.

The market has also closed unexpectedly due to technical glitches and cybersecurity threats; in July 2015, the NYSE temporarily stopped trading because of a technical issue on the floor.

Stock Market Operating Hours

In the United States, the major stock exchanges are generally open Monday through Friday, with core trading hours between 9:30am-4pm ET. The stock market does not operate during the weekend.

Because the different stock exchanges operate on eastern time, these trading hours are different throughout the U.S., depending on time zones and daylight savings time.

However, with so many global stock exchanges, a market may always open if an investor is interested in trading in foreign markets. Most markets operate during their time zone’s business hours.

Recommended: Pros & Cons of Global Investments

Why Does the Stock Market Close Each Day?

The stock market closes each day for several reasons, notably because it allows for the settlement of all trades that have occurred. The close gives market professionals time to calculate the day’s trading results and prepare for the next day.

Additionally, the stock market close is helpful for investment brokers and traders to catch up on paperwork and other administrative tasks.

While the stock market closes each day at 4pm in the United States, other markets, like cryptocurrency and foreign exchange markets, offer trading 24 hours a day.

Recommended: Is 24/7 Stock Trading Available?

When Does the Market Open for Premarket Trading?

The market opens for premarket trading at 4 am ET and operates until 9:30 am ET.

While most stock trading occurs during the normal 9:30am-4pm ET operating hours, investors can also take advantage of extended-hours trading. Investors may be interested in trading during the premarket because of the release of economic data, company earnings reports, and other major news events.

Investors must use an alternative trading system known as electronic communication networks (ECNs) to make trades during premarket trading.

However, investors must be aware of the risks associated with premarket trading. Because fewer buyers and sellers operate during the early hours, there is lower liquidity and higher volatility.

Premarket trading probably isn’t for a beginner investor; if you don’t need to buy or sell a stock immediately, you might prefer to wait until regular trading hours.

After-Hours Trading

The closing bell for the major U.S. stock exchanges might ring promptly at 4 pm ET, but there’s still after-hours trading: it’s possible to buy, sell, and trade stocks between 4pm-8pm ET. Electronic trading tools like ECNs mentioned above make it possible to conduct business after hours, but making moves during after-hours trading comes with its own risks, just like during premarket trading.

The Takeaway

Investors should be aware that the stock market is closed on weekends, designated holidays, and for world events and other disruptive circumstances. When the stock market is open, the exchanges generally operate on a 9:30am-4pm ET schedule, Monday through Friday.

Knowing when the stock market is open and closed can allow investors to strategize the best time to make trades and investments.

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 the stock market closed on holidays?

The stock market is generally closed on New Year’s Day, Martin Luther King Jr. Day, Presidents’ Day, Good Friday, Memorial Day, Juneteenth National Independence Day, Independence Day, Labor Day, Thanksgiving Day, and Christmas Day.

When is the stock market closed and opened?

The stock market in the United States is closed on weekends and some holidays. The stock market is generally open Monday through Friday from 9:30am-4pm ET.

Is the stock market open for extended hours?

The stock market is open for extended hours, from 4am-9:30am ET for premarket trading and 4pm-8pm for after-hours trading. However, trading during this period can be risky.

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Nov

2024

What Is Spoofing in Trading?

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

In the financial space, the term “spoofing” refers to an illegal form of stock market and exchange trickery that is often used to change asset prices. Given that the stock markets are a wild place, and everyone is trying to gain an advantage, spoofing is one way in which some traders bend the rules to try and gain an advantage.

Spoofing is also something that traders and investors should be aware of. This tactic is sometimes used to change asset prices — whether stocks, bonds, or cryptocurrencies.

Key Points

• Spoofing is an illegal trading tactic where traders place and cancel orders to manipulate asset prices, influencing market supply and demand dynamics.

• Traders often use algorithms to execute high volumes of fake orders, creating a false perception of demand that can inflate or deflate security prices.

• The practice of spoofing is a criminal offense in the U.S., established under the Dodd-Frank Act, with serious penalties for those caught engaging in it.

• Significant fines have been imposed on both institutions and individual traders for spoofing, highlighting the risks of detection and legal consequences.

• Investors should remain vigilant against spoofing, as it can distort market activity and impact trading strategies, particularly for active traders and day traders.

What Is Spoofing?

Spoofing is when traders place market orders — either buying or selling securities — and then cancel them before the order is ever fulfilled. In a sense, it’s the practice of initiating fake orders, with no intention of ever seeing them executed.

Spoofing means that someone or something is effectively spamming the markets with orders, in an attempt to move security prices.

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What’s the Point of Spoofing?

Because stock market prices are determined by supply and demand — for instance, the more demand there is for Stock A, the higher Stock A’s price is likely to go, and vice versa — they can be manipulated to gain an advantage. That’s where spoofing comes in.

By using bots or an algorithm to make a high number of trades and then cancel them before they go through, it’s possible for spoofers to manipulate security prices. For a trader looking to buy or sell a certain security, those valuations may be moved enough to increase the profitability of a trade.

Spamming the markets with orders creates the illusion that demand for a security is either up or down, which is then reflected in the security’s price. Because it would require an awful lot of “spoofed” orders to move valuations, spoofers might rely on an algorithm to place and cancel orders for them, rather than handle it manually. For that reason, spoofing is typically associated with high-frequency trading (HFT).

Is Spoofing Illegal?

If it sounds like spoofing is essentially cheating the system, that’s because it is. In the United States, spoofing is illegal, and is a criminal offense. Spoofing was made illegal as a part of the Dodd-Frank Act, which was signed into law in 2010. Specifically, spoofing is described as a “disruptive practice” in the legislation, straight from the U.S. Commodity Futures Trading Commission (CFTC), which is the independent agency responsible for overseeing and policing spoofing on the markets:

Dodd-Frank section 747 amends section 4c(a) of the CEA to make it unlawful for any person to engage in any trading, practice, or conduct on or subject to the rules of a registered entity that —

(A) violates bids or offers;

(B) demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period; or

(C) is, is of the character of, or is commonly known to the trade as ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).

Additionally, there are laws and rules related to spoofing under rules from the Securities and Exchange Commission (SEC), and the Financial Industry Regulatory Authority (FINRA), too.

Example of Spoofing

A hypothetical spoofing scenario isn’t too difficult to dream up. For instance, let’s say Mike, a trader, has 100,000 shares of Firm Y stock, and he wants to sell it. Mike uses an algorithm to place hundreds of “buy” orders for Firm Y shares — an algorithm that will also cancel those orders before they’re executed, so that no money is actually spent.

The influx of orders is read by the market as an increase in demand for Firm Y stock, and the price starts to increase. Mike then sells his 100,000 shares at an inflated price — an artificially inflated price, since Mike effectively manipulated the market to increase his profits.

Consequences of Spoofing

Because spoofing is a relatively easy way to manipulate markets and potentially increase profits, it’s also a fairly common practice for some traders and firms, despite being against the law. That transgression can cost spoofers if and when they’re caught.

For example, one financial institution was fined nearly $1 billion by the SEC during the fall of 2020 after the company was caught conducting spoofing activity in the precious metals market.

But it’s not just the big players that can be on the receiving end of a smack down by the authorities. During August of 2020, an individual day trader was caught manipulating the markets through spoofing activity — actions that netted the trader roughly $140,000 in profits. The trader was ultimately ordered by the CFTC to pay a fine of more than $200,000.

Despite the cases that make headlines, it’s generally hard to identify and catch spoofers. With so many orders being placed and executed at once (especially with algorithmic or computer aid) it’s difficult to identify fake market orders in real time.

How to Protect Against Spoofing

There are a number of parties that are constantly and consistently trying to gain an edge in the markets, be it through spoofing or other means. For investors, it’s worth keeping that in mind while sticking to an investing strategy that works for you, rather than investing with your emotions or getting caught up in the news cycle.

In a time when a single social media post or errant comment on TV can send stock prices soaring or into the gutter, it’s critical for investors to understand what’s driving market activity.

The Takeaway

Spoofing is meant to gain advantage in the markets, but as such it’s illegal and penalties can be steep. Beyond the spoofers trying to manipulate the market, spoofing has the potential to affect all investors.

If spoofers are manipulating prices for their own gain, that can cause traders and investors to react, not realizing what is going on behind the scenes. While this is more of an issue for active investors or day traders, it’s something to be aware of.

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.

You may also be interested in:

Market Manipulation: An Overview for Retail Investors

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

What Is a Dark Pool in Trading?

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Nov

2024

What Is a Stock Market Crash?

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

Table of Contents

What Happens When the Stock Market Crashes?
What Causes the Market to Crash?
Examples of Past Stock Market Crashes
What Are the Effects of a Crash?
Preventing Stock Market Crashes
Investment Tips During a Market Crash

The specter of a stock market crash weighs on the mind of many investors. After all, stock market crashes have played a substantial role in the United States during the 20th and 21st centuries. But knowing what is a stock market crash as well as the history and effects of stock market crashes can help investors weather the storm when the next one occurs.

Key Points

• A stock market crash occurs when major indices experience significant declines, usually driven by panic selling rather than specific company issues.

• Key factors that can trigger a crash include economic crises, natural disasters, and investor behavior, often exacerbated by rapid declines in stock prices.

• Historical crashes, such as those in 1929, 1987, 2000, 2008, and 2020, illustrate the profound impact of bubbles and external shocks on the market.

• Crashes can lead to bear markets and recessions, as declining stock values negatively affect corporate growth and consumer spending.

• Strategies for navigating crashes include maintaining long-term focus, diversifying investments, and considering opportunities to buy undervalued stocks during downturns.

What Happens When the Stock Market Crashes?

A stock market crash occurs when broad-based stock indices like the S&P 500, Dow Jones Industrial Average, or the Nasdaq Composite experience double-digit declines over a single or several days. This means that the stocks of a wide range of companies sell off rapidly, generally because of investor panic and macroeconomic factors rather than company-specific fundamentals.

While no specific percentage decline defines a stock market crash, investors generally know one is occurring while it’s happening.

💡 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.

What Causes the Market to Crash?

Stock market crashes are usually unexpected and occur without warning. Often, crashes are caused by investor dynamics; when stocks start to sell off, investors’ fear takes over and causes them to panic sell shares en masse.

Though stock market crashes are usually unexpected, there are often signs that one could be on the horizon because a stock market bubble is inflating. A bubble occurs when stock prices rise quickly during a bull market, outpacing the value of the underlying companies. The bubble forms as investors buy certain stocks, driving prices up. Other investors may see the stocks doing well and jump on board, further raising prices and initiating a self-sustaining growth cycle.

The stock price growth continues until some unexpected event makes investors wary of stocks. This unexpected event causes investors to unload shares as quickly as possible, with the herd mentality of panic selling resulting in a stock market crash.

Catastrophic events such as economic crises, natural disasters, pandemics, and wars can also trigger stock market crashes. During these events, investors sell off risky assets like stocks for relatively safe investments like bonds.

Stock markets can also experience flash crashes, where the stock market plummets and rebounds within minutes. Computer trading algorithms can make these crashes worse by automatically reacting and selling stocks to head off losses. For example, on May 6, 2010, the Dow Jones Industrial Average fell 1,000 points in 10 minutes but recovered 70% of its losses by the end of the day.

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Examples of Past Stock Market Crashes

There have been several crashes in the stock market history, the most recent being the crash associated with the coronavirus pandemic in early 2020. The following are some of the most well-known crashes during the past 100 years.

Stock Market Crash of 1929

The most devastating stock market crash in the history of the United States occurred in October 1929. The crash occurred following a period of relative prosperity during the Roaring Twenties, when new investors poured money into the stock market.

The crash began on Thursday, October 24, when the Dow Jones Industrial Average declined about 11%, followed by a 13% decline on Monday, October 28, and a 12% drop on Tuesday, October 29. These losses started a downward trend that would continue until 1932, ushering in the Great Depression.

Black Monday Crash of 1987

On Monday, October 19, 1987, the Dow Jones Industrial Average plummeted nearly 23% in a single day. Known as Black Monday, this selloff occurred for various reasons, including the rise of computerized trading that made it easier for panicked investors to offload stocks quickly, and stock markets around the world crashed.

Dotcom Crash of 2000

The Dotcom crash between 2000 and 2002 occurred as investors started to pull money away from internet-based companies. The Nasdaq Composite index declined about 77% from March 2000 to October 2002.

In the mid to late 1990s, the internet was widely available to consumers worldwide. Investors turned their eyes to internet-based companies, leading to rampant speculation as they snapped up stocks of newly public internet companies. Eventually, startups that enthusiastic investors had fueled began to run out of money as they failed to turn a profit. The bubble eventually burst.

Recommended: Lessons From the Dotcom Bubble

Financial Crisis of 2008

The stock market crash of 2008 was fueled by rising housing prices, which came on the heels of the dot-com crash recovery. At the time, banks were issuing more and more subprime mortgages, which financial institutions would bundle and sell as mortgage-backed securities.

As the Federal Reserve increased interest rates, homeowners, who often had been given mortgages they couldn’t afford, began to default on their loans. The defaults had a ripple effect throughout the economy. The value of mortgage-backed securities plummeted, causing major financial institutions to fail or approach the brink of failure. This financial crisis spilled over into the stock market, and the S&P 500 fell nearly 60% from a peak in October 2007 to a low in March 2009.

Coronavirus Crash of 2020

As the coronavirus pandemic swept the United States in February 2020, the government responded with stay-at-home orders that shut down businesses and curtailed travel. The U.S. economy entered a recession, and the stock market plunged. The S&P 500 fell 30% into bear market territory in just one month, including a one day decline of 12% on March 16, 2020.

What Are the Effects of a Crash?

Stock market crashes can lead to bear markets, when the market falls by 20% or more from a previous peak. If the crash leads to an extended period of economic decline, the economy may enter a recession.

A market crash could lead to a recession because companies rely heavily on stocks as a way to grow. Falling stock prices curtail a company’s ability to grow, which can have all sorts of ramifications. Companies that aren’t able to earn as much as they need may lay off workers. Workers without jobs aren’t able to spend as much. As consumers start spending less, corporate profits begin to shrink. This pattern can lead to a cycle of overall economic contraction.

A recession is usually declared when U.S. gross domestic product, or GDP, shrinks for two consecutive quarters. There may be other criteria for declaring a recession, such as a decline in economic activity reflected in real incomes, employment, production, and sales.

💡 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.

Preventing Stock Market Crashes

Major stock exchanges like the New York Stock Exchange (NYSE) have instituted circuit breaker measures to protect against crashes. These measures halt trading after markets drop a certain percentage to curb panic selling and prevent the markets from going into a freefall.

The NYSE’s circuit breakers kick in when three different thresholds are met. A drop of 7% or 13% in the S&P 500 shuts down trading for 15 minutes when the drop occurs between 9 am and 3:25 pm. A market decline of 20% during the day will shut down trading for the rest of the day.

Suppose a crash does occur, and it threatens to weaken the economy. In that case, the federal government may step in to ease the situation through monetary and fiscal policy stimulus measures. Monetary policy stimulus is a set of tools the Federal Reserve can use to stimulate economic growth, such as lowering interest rates. Fiscal stimulus is generally infusions of cash through direct spending or tax policy.

Investment Tips During a Market Crash

A stock market crash can be alarming, especially when it comes to an investor’s portfolio. Here are some investment tips to consider for navigating a market downturn.

Don’t Panic and Focus on the Long-Term

It will help if you remain calm when the stock market is plummeting. That’s often easier said than done, especially when your portfolio’s value declines by more than 10% in a short period. It’s tempting to join the panic selling, to make sure stock losses are minimized.

But remember, investing is a long game. In general, making decisions based on something happening now when your investing time horizon might be 30 years, may not be the best choice. If you don’t need access to your money right away, it may be better to hold on to your investments and give them time to recover.

Diversify Your Portfolio

Stocks and the stock market get most of the media’s attention, especially when the stock market is crashing, but there are other potential ways to help you realize your financial goals. Other assets like bonds, commodities, or emerging market stocks may be attractive investment opportunities to consider during a crash.

Consider Buying The Dip

While it depends on an individual’s specific situation and risk tolerance, a stock market crash might present opportunities to purchase stocks at a lower, more attractive share price that some investors may want to consider.

The Takeaway

The stock market tends to recover following a stock market crash; it took the S&P 500 six months to recover the losses experienced during the coronavirus crash. So any rash moves investors make during a stock market crash may prevent them from seeing gains in the long term.

A stock market crash can be scary, causing you to panic and fret over your savings and investments. But often, with investing, the best advice is not to make rash decisions. Even during a stock market crash, there may still be some opportunities and strategies to help build wealth over time.

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

FAQ

When was the last market crash?

The last stock market crash was in 2020, at the onset of the coronavirus pandemic, when business shut down and the stock market plunged. The S&P 500 fell 30% in just one month. Within six months, however, the S&P 500 had recovered its losses.

What goes up when the stock market crashes?

Bonds generally tend to go up when the stock market crashes, although not always. Government bonds such as U.S. Treasuries typically do best during a market crash, though again, there are no guarantees.

Do stocks recover after a crash?

Historically, the stock market has recovered after a crash, although it’s impossible to say how long a recovery might take. Some stock market recoveries have taken a year or less, some have taken much longer.

Photo credit: iStock/Prostock-Studio

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.

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

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.
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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.

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

SOIN0124109

Nov

2024

How to Use the Risk-Reward Ratio in Investing

By Brian O'Connell | Growing Wealth, invest, Investing, Terminology | Comments Off

In the investment world, a reward-to-risk ratio indicates how much money an investor stands to gain, against how much they’ll have to risk. For example, a reward-to-risk ratio of 6:1 means that for every dollar an investor stands to lose, they have the potential to gain $6.

The risk-reward ratio is a valuable analytical tool available to investors. Since no investment is genuinely risk-free, the risk-reward ratio helps calculate the potential outcomes of any investment transaction — good or bad.

Key Points

• The risk-reward ratio is a crucial analytical tool for investors, illustrating potential gains against the risks involved in an investment transaction.

• Calculating the risk-reward ratio requires dividing net profits by the maximum risk of an investment, providing a straightforward evaluation of investment potential.

• Investors can be categorized into conservative, moderate, and aggressive types, each demonstrating different levels of risk tolerance and investment strategies.

• Utilizing the risk-reward ratio aids in informed decision-making, helping investors assess whether potential rewards justify the risks taken.

• Despite its utility, the risk-reward ratio has limitations, such as not accounting for market volatility or external factors that may impact investment outcomes.

What Is the Risk-Reward Ratio?

As noted, the reward-to-risk ratio indicates how much money an investor stands to gain levied against how much they’re risking in order to generate that potential gain. This can be particularly important for those with small portfolios, and it may be helpful to review tips on risk for new investors.

Typically, the more money one invests — such as in high-risk stocks — the more ample the reward if the investment turns out to be a winner. On that note, it may be beneficial to review a guide to high risk stocks, too. Conversely, the less risk you take with an investment, the less reward will likely be earned on the investment.

In addition, the investment itself directly impacts the risk-reward ratio. For example, if an individual parks his money in a savings account at a bank, the risk of losing that money is significantly low, as bank deposits are insured and there’s little chance the bank saver will lose any money on the deal.

In other words, using a savings account to accrue interest is a fairly safe investment.

Likewise, the potential reward for parking cash in a bank savings account is also low. Bank savings accounts offer routinely low interest rates earned on insured bank deposits, meaning the individual will likely earn little in interest on the deposit. If savings accounts were somewhere on an investment risk pyramid, they’d be among other relatively safe investments — low risk, but low potential returns.

Compare that scenario to a stock market investor, who has no guarantees that the money she steers into a stock transaction will be intact in the future. It’s even possible the stock market investor will lose all of her investment principal if the stock turns sour and loses significant value.

Correspondingly, this investor is presumably looking at a greater reward for the risk taken when buying a stock. If the stock climbs in value, the investor is rewarded for the risk she took with the investment, as she’ll likely earn significantly more money on the stock deal than the bank saver will make on the interest earned on his bank deposit.

💡 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).

How To Calculate Risk-Reward Ratio

The reward-to-risk ratio formula is a fairly straightforward calculation, and involves following a formula.

Risk-Reward Ratio Formula

To calculate risk-reward ratio, divide net profits (which represent the reward) by the cost of the investment’s maximum risk.

For instance, for a risk-reward ratio of 1:3, the investor risks $1 to hopefully gain $3 in profit. For a 1:4 risk-reward ratio, an investor is risking $1 to potentially make $4.

Example of a Risk-Reward Ratio Calculation

Let’s say an investor is weighing the purchase of a stock selling at $100 per share and the consensus analyst outlook has the stock price topping out at $115 per share with an expected downside bottom of $95 per share.

The investor makes the trade, hoping the stock will rise to 115, but hedges his investment by putting in a “stop-loss” order at $95, ensuring his investment will do no worse by automatically selling out at $95. The investor can also lock in a profit by instructing the broker to automatically sell the stock once it reaches its perceived apex of $115 per share.

As an aside: A stop loss order is a type of market order in which the order that is placed with a stockbroker to buy or sell a specific stock once that security reaches a predetermined price level. The mechanism is specifically designed to place a limit on an investor’s stock position.

In this scenario, the “risk” figure in the equation is $5 — the total amount of money that can be lost if the stock declines and is automatically sold out at $95 (i.e., $100 minus $95 = $5).

The “reward” figure is $15. That’s the amount of per-share money the investor will earn once the share price rises from buying the stock at $100 per share and selling it if and when the stock rises to $115 per share.

Thus, with an expected risk of 5 and an expected reward of 15, the actual risk reward ratio is 1:3 — the potential to lose $5 in order to gain $15.

Pros and Cons of the Risk-Reward Ratio

There are pros and cons to using the risk-reward ratio when investing.

As for the upsides, it’s a relatively simple formula and calculation that can help investors get a sense of whether their strategy makes sense. In that sense, it can be very useful with some basic risk management when tinkering with a portfolio.

On the other hand, it’s a relatively simple formula and calculation that may not be terribly accurate, and doesn’t necessarily deliver a whole lot of additional insight into a strategy. That’s something investors should take to heart, and why they may not want to only rely on risk-reward ratio to guide their overall strategy.

Recommended: Guide to Risk Neutral Probability

Three Risk-and-Reward Investor Types

Investors have their own comfort levels when assessing risk and reward ratios with their portfolios, with some proceeding cautiously, some taking a moderate dose of investment risk, and still others taking on more risk by investing aggressively on a regular basis.

The investment portfolios you build, either by yourself or with the help of a money management professional, reflect your personal risk tolerance.

Typically, there are three different types of investor when it comes to risk:

• Conservative investors. These investors focus on low-risk, low-reward investments like cash, bonds, bond funds, and large-company stocks or stock funds.

• Moderate investors. These investors look for a blend of risk and reward when constructing their investment portfolios, putting money into lower-risk investment vehicles like bonds, bond funds, and large-company stocks and funds with more broadly based categories like value and/or growth stocks and funds, international stocks, and funds, along with a small slice of alternative funds and investments like real estate, commodities, and stock options and futures.

• Aggressive investors. This type of investor may completely bypass conservative investments and elect to fill his investment portfolio with higher-risk stocks and funds (like overseas stocks or small company stocks), along with higher-risk assets like gold and oil (commodities), stock options and futures, and more.

Each of the above investors recognizes the realities of risk and the potential of reward and balances them in different ways. Even conservative investors will accept a little risk to gain some reward.

For example, a conservative investor may invest in a corporate bond or municipal bond, knowing that in return for a guaranteed profit (in the form of paid interest) and upside asset protection (the bond’s principal being repaid), she takes on the small risk that the bond will default, and the principal and interest on the bond disappears.

An aggressive investor understands that by placing money in a high-risk stock, he is potentially risking some or all of his investment if the stock goes under, or significantly underperforms. In return for that risk, the more aggressive investor may reap the financial rewards of a booming stock price and a resulting major return on his investment.

In either scenario, the investor gauges the risk reward ratio and acts accordingly, betting that the outcome will work out in their favor, and that the risk outweighs the reward.

By not acting at all, and taking both risk and reward out of the equation, the investor won’t see their investment portfolio appreciate in value, and risk losing ground as economic realities like inflation, taxes, and stagnation eat into their wealth.

💡 Quick Tip: Did you know that opening a brokerage account online typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

Investing With SoFi

The risk-reward ratio is helpful in allowing investors to get an idea of how much they stand to gain versus how much they stand to lose in a given investment situation. Any risk-reward engagement depends on the quality of the research undertaken by the investor and/or a professional money management specialist.

That research should set the proper expected parameters of the risk (i.e., the money the investor can lose) and the reward (i.e., the expected portfolio gain the investment can make.) Once the risk and reward boundaries are set, the investor can weigh the potential outcomes of the investment scenario and make the decision to go forward (or not) with the investment.

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 a good risk-reward ratio?

Generally speaking, a good risk-reward ratio is one that skews toward reward, rather than risk. If the ratio is calculated, a ratio below 1 is better, as it indicates that an investment has a bigger potential reward compared to risk.

What is a poor risk-reward ratio?

A poor risk-reward ratio would be one that is higher or greater than 1, as that would indicate that an investment involves more risk relative to the potential reward.

What are some things that the risk-reward ratio doesn’t take into account?

The risk-reward ratio doesn’t take several factors into account, and some of those include external and current events, market volatility, and liquidity in the markets.

SoFi Invest®

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

What Is Yield to Maturity (YTM)?

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How to Calculate Yield to Maturity

Yield to Maturity (YTM) Formula

Example of YTM Calculation

The Importance of Yield to Maturity

Yield to Maturity vs Yield to Call

Yield to Maturity vs Coupon Rate

Limitations of Yield to Maturity

Taxes

Presuppositions

The Takeaway

FAQ

What is a bond’s yield to maturity (YTM)?

What is the difference between a bond’s coupon rate and its YTM?

What is yield to maturity and how is it calculated?

Why is yield to maturity important?

Is a higher YTM better?

U.S. Stock Market Holidays

Is the Market Closed the Following Monday After a Holiday?

Other Times the Stock Market Closes or Is Halted

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Stock Market Operating Hours

Why Does the Stock Market Close Each Day?

When Does the Market Open for Premarket Trading?

After-Hours Trading

The Takeaway

FAQ

Is the stock market closed on holidays?

When is the stock market closed and opened?

Is the stock market open for extended hours?

What Is Spoofing?

What’s the Point of Spoofing?

Is Spoofing Illegal?

Example of Spoofing

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Consequences of Spoofing

How to Protect Against Spoofing

The Takeaway

You may also be interested in:

What Happens When the Stock Market Crashes?

What Causes the Market to Crash?

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Examples of Past Stock Market Crashes

Stock Market Crash of 1929

Black Monday Crash of 1987

Dotcom Crash of 2000

Financial Crisis of 2008

Coronavirus Crash of 2020

What Are the Effects of a Crash?

Preventing Stock Market Crashes

Investment Tips During a Market Crash

Don’t Panic and Focus on the Long-Term

Diversify Your Portfolio

Consider Buying The Dip

The Takeaway

FAQ

When was the last market crash?

What goes up when the stock market crashes?

Do stocks recover after a crash?

What Is the Risk-Reward Ratio?

Get up to $1,000 in stock when you fund a new Active Invest account.*

Access stock trading, options, alternative investments, IRAs, and more. Get started in just a few minutes.

How To Calculate Risk-Reward Ratio

Risk-Reward Ratio Formula

Example of a Risk-Reward Ratio Calculation

Pros and Cons of the Risk-Reward Ratio

Three Risk-and-Reward Investor Types

Investing With SoFi

FAQ

What is a good risk-reward ratio?

What is a poor risk-reward ratio?

What are some things that the risk-reward ratio doesn’t take into account?

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