invest Archives | Page 85 of 182

Sep

2023

The Effects of Deadweight Loss

By Matthew Zeitlin | invest, Investing, Terminology | Comments Off

Deadweight loss is the term used to describe societal or economic losses caused out of inefficiencies. It’s an economic term, and refers specifically to losses created as a result of a lack of equilibrium in supply and demand models — or, in other words, when resources are not being used as efficiently as possible.

This can have larger impacts on the overall economy, which can trickle down and have an effect on the markets and on investors, too. As such, investors would do well to understand the concept, and how it may impact their portfolios.

What Is Deadweight Loss?

As noted, deadweight loss refers to inefficiencies created by a misallocation or inefficient allocation of resources, and is an important economic concept. Deadweight loss is often due to government interventions such as price floors or ceilings, or inefficiencies within a tax system.

To understand more fully, it can be helpful to think about how government interventions can impact the equilibrium between supply and demand.

First: How to Calculate Surplus

In order to know how to calculate deadweight loss, we must first be able to calculate surplus.

Typically, a business will only sell something if they can do so at a price that’s greater than what they paid for it themselves, and a consumer will only buy something if it’s at or less than the price they want to pay for it — the same principle as generating a stock profit.

Scenario A — The Equilibrium: Let’s imagine a store selling comic books for $10 each. The store buys the comic books from the wholesaler for $5 and sells them for $10, pocketing $5 of “producer surplus.” Before the store opened, comic book readers would go over to the other town to buy comic books for $15, the price they were willing to pay, but now can buy them for $10. This $5 difference between the price they’re willing to pay is the “consumer surplus”.

In this case, let’s say the store is able to sell 1,000 comic books, that means the combined producer and consumer surplus is $10,000.

Breakdown:

• P₁ = Producer’s Cost of a Comic Book = $5

• P₂ = Producer’s Price to Sell a Comic Book = $10

• P₃ = Price A Consumer Pays = $10

• P₄ = Price A Consumer Is Willing to Pay = $15

• Units Sold = 1,000

• Producer Surplus = (P₂ – P₁) * Units Sold = ($10 – $5) * 1,000 = $5,000

• Consumer Surplus = (P₄ – P₃) * Units Sold = ($15 – $10) * 1,000 = $5,000

• Total Surplus₁ = Producer Surplus + Consumer Surplus = $5,000 + $5,000 = $10,000

Deadweight Loss Graph

Deadweight loss can be found on a supply and demand graph, or supply and demand curve. That graph generally shows the relationship between supply and demand with two lines that intersect at an equilibrium point, with a downward-sloping demand line and an upward-sloping supply line.

On such a graph, deadweight loss can be found to the left of the equilibrium point, comprising both the consumer surplus and consumer surplus.

Common Causes of Deadweight Loss

There can be several causes of deadweight loss, but some of the most common are government-mandated changes to markets. Examples include price floors, such as a minimum wage, which can create some inefficiencies in the labor market (there may be workers who would be willing to work for less than minimum wage). Price ceilings, also can create deadweight loss — an example could be rent control. Finally, taxes can create deadweight loss, too.

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How to Calculate Deadweight Loss

To properly calculate deadweight loss, you need to be able to represent the supply and demand of the goods being sold graphically in order to determine prices. According to the laws of supply and demand, the higher a price goes, the fewer of that item will get sold; and vice versa.

Example of Deadweight Loss

Scenario B — Imposed Tax: Let’s go back to our comic book example and imagine that the town’s government imposes a $2 tax on comic books.

What happens to the price of comic books and the surplus generated by the sales of comic books? If consumers had to buy comic books to live (and for some, it may feel that way) and there were no other way to buy them, then the comic book seller could simply bump up prices $2 and sell 1,000 comic books for $12 each, maintaining his $5 of producer surplus on each comic book sold with $2 going to the government and consumer surplus of $3.

In this case the combined consumer and producer surplus is lower — $5 × 1,000 + $3 × 1,000 = $8,000. So there’s a missing $2,000 of what economics call “gains from trade.” But, the government is collecting $2,000, so the money does not disappear from the economy.

The government can buy things, hire people, and literally send money to people, via economic stimulus, meaning the tax revenue does not disappear from the economy.

But, despite how fervently people want them, comic books are not a necessity in the same way food is and remember that comic book store in the neighboring town? If the demand for comic books can not literally be unchanged by its price, that means the comic book seller may think twice about passing on the tax fully on to his customers and that any price increase will result in some comic books going unsold.

If he were to increase the price to $12, thus passing on the tax to his customers, he may not be able to sell enough comic books to maintain the revenue he needs to keep his store open, so he lowers the price to $11, thus splitting the tax between himself and his buyers but still reducing the number of total comic books sold. In this case, let’s say he sells 600 comic books instead of 1,000.

The combined consumer and producer surplus is $4,800 ($4 × 600 + 600 × $4) with $1,200 of tax collected (600 × $2) meaning there’s a total of $6,000 of consumer surplus, producer surplus, and government revenue. In this case the deadweight loss is $4,000.

Breakdown:

• P₁ = Producer’s Cost of a Comic Book = $5

• P₂ = Producer’s Price to Sell a Comic Book = $9

• P₃ = Price A Consumer Pays = $11

• P₄ = Price A Consumer Is Willing to Pay = $15

• Units Sold = 600

• Tax = $2/Comic Book

• Producer Surplus = (P₂ – P₁) * Units Sold = ($9 – $5) * 600 = $2,400

• Consumer Surplus = (P₄ – P₃) * Units Sold = ($15 – $11) * 600 = $2,400

• Gains From Trade (Tax) = $2 * 600 = $1,200

• Total Surplus₂ = Producer Surplus + Consumer Surplus + Gains From Trade = $6,000

• Deadweight Loss = Total Surplus₁ – Total Surplus₂ = $10,000 – $6,000 = $4,000

The higher price, created through taxation, has impacted the equilibrium between supply and demand and created a deadweight loss — the surplus that evaporates due to fewer transactions happening between the comic book seller and the readers.

While this is a rather extreme example of what happens when taxes force up prices, it’s a good way of thinking about how deadweight losses are more than just items getting more expensive. Rather, the deadweight loss formula can illustrate the evaporation of mutually beneficial economic transactions due to different types of taxes.

Deadweight loss of taxation refers specifically to deadweight loss that occurs due to taxes, but a similar impact can occur when a government puts price floors or ceilings on items.

Why Investors Should Care About Deadweight Loss

Deadweight loss can affect investors in a number of ways, and it’s important to consider it when looking at different types of investments. One of the most debated issues in economics is the effects that the tax system has on income, investment, and economic growth in the short and long run.

Some argue that income taxes, payroll taxes (the flat taxes on wages that fund Social Security and Medicare) and capital gains taxes work like the comic book tax described above, preventing otherwise beneficial transactions from happening and reducing the economic gains available to all sides. There’s evidence on all sides of this debate, and the effects of tax rates on overall economic growth are, at best, unclear.

As an investor, deadweight loss might matter when it comes to companies or sectors impacted by specific taxes, such as sales taxes or excise taxes on alcohol or cigarettes. Deadweight loss shows how taxes on specific items can not only reduce profitability by increasing a company’s tax bill, but also affect revenue by reducing overall sales or driving down prices that businesses can charge or receive from buyers. As an investor, this knowledge and insight can be useful when allocating capital between companies, sectors, or types of assets.

The Takeaway

Deadweight loss is the result of economic inefficiencies, and it can affect an investor’s portfolio if it results in slower sales and revenues for businesses. It’s a large economic concept, and may not have a day-to-day direct impact on the stock market. But it’s still good for investors to know the basics of deadweight loss and how it applies to them.

There are myriad economic concepts investors should pay attention to, and deadweight loss is merely one of them. Studying deadweight loss and related concepts can help investors plan for the future and work toward their financial goals.

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FAQ

Why does a monopoly cause a deadweight loss?

A monopoly can cause deadweight loss because competitive markets create competition and fairer prices. A monopoly distorts prices, leading to inefficiencies.

Can deadweight loss be a negative value?

No, deadweight loss cannot be a negative value, but it can be zero. Zero deadweight loss would mean that demand is perfectly elastic or supply is perfectly inelastic.

Is deadweight loss market failure?

Deadweight loss is not a market failure, but rather, the societal costs of inefficiencies within a market. Market failures can, however, create deadweight loss.

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Sep

2023

50 Investment Terms and Definitions

By Kaitlyn Farley | Growing Wealth, invest, Investing | Comments Off

Some investment terms and definitions may seem complex, but a little research can take the mystery out of most common investing terminology. That can help investors feel even more confident about starting their investing journey. It’s more or less the same as starting any new endeavor — from rock climbing to investing — at first, you need to get familiar with new words and phrases.

Given the girth of the investment space, the sheer amount of investment terminology investors need to know can be intimidating. But the more you read, invest, and envelope yourself in it, the easier it’ll become. If you’re just starting out, though, it may be helpful to get a big rundown of some of the more common investing terms.

Investment Terminology Every Beginner Investor Needs to Know

Here are a slew of common investing terms and definitions (in alphabetical order) that investors may benefit from committing to memory.

1. Alpha

Alpha is used to gauge the success of an investment strategy, portfolio, portfolio manager, or trader compared with a relevant benchmark. You may also hear alpha defined as “excess return” in that it refers to returns that can be attributed to active management, over and above market returns.

2. Assets

An asset is anything that holds value that can be converted to cash. Personal assets might include your home, a car, other valuables. Business assets might include machinery, patents. When it comes to investing, assets are typically the securities you invest in.

3. Asset Class

An asset class is a group of investments with similar characteristics that is likely to perform differently in the market than another asset class. Types of asset classes include stocks, bonds, real estate, currencies, and more. Given the same market conditions, stocks and bonds often move in opposite directions. Most financial advisors typically recommend you invest in multiple asset classes in order to have a well-diversified portfolio and minimize risk.

4. Asset Allocation Fund

An asset allocation fund is a diversified portfolio consisting of various asset classes. Most asset allocation funds have a mix of stocks, bonds, and cash equivalents. These types of funds can be popular as some advisors stress the importance of having diverse portfolios to minimize potential losses.

5. Beta

Beta refers to how risky or volatile a security or portfolio is compared with the market overall. Calculating the beta of the stocks in your portfolio can help you determine how your portfolio might respond to market volatility. You can also gauge the beta of a stock to help determine how much risk it might add to your portfolio.

6. Bear Market

A bear market occurs when the market declines, typically when broad market indexes fall 20% or more in two months or less. Bear markets can accompany a recession, but not always. They often signal that investors feel pessimistic about their investments’ ability to make money and the market’s ability to rebound.

7. Bull Market

A bull market is the opposite of a bear market, meaning prices are rising or are expected to rise for extended periods of time. Bull markets usually mean security prices are rising for months or even years at a time.

8. Blue Chip

Blue chip companies are generally thought to be well-established, financially sound, and therefore high-quality investments. Blue chip stocks are typically large companies, and many of them are household names. In some cases, blue chips may be more expensive to invest in since they can be considered relatively stable and likely to grow.

9. Bonds

When governments or corporations need to borrow money they issue bonds. Investors who buy the bonds are effectively loaning that entity cash, which will be repaid according to the terms of the bond (e.g. a 10-year bond with an interest rate of 3%). Bonds are often considered to be relatively stable, lower-risk investments compared with stocks.

10. Broker

An investment broker, whether a person or a firm, acts as a middleman to help investors buy and sell securities. Brokers may be necessary because some securities exchanges only allow members of that exchange to make an investment order. A broker’s primary function is to help clients place trades, although many brokers also help clients with market research and investment planning.

11. Diversification

You’ve probably heard that you should aim to have a diversified portfolio. That means investing in a range of asset classes that are likely to behave differently under different market conditions, in order to mitigate risk. A portfolio of only stocks, for instance, could be more vulnerable to market volatility than a portfolio that also included bonds, real estate, commodities, and so on.

12. Dividends

When a company shares their profits with investors, these are called dividends. Dividends are often paid in cash (although they can be paid in stocks). Some companies — e.g. many blue chip firms — pay dividends, but not all companies do. Ordinary dividends are taxed differently than qualified dividends, so you may want to consult a tax professional if you own dividend-paying stocks.

13. Dollar Based Investing

Also called fractional share investing, dollar based investing is a way for investors to buy partial shares of stocks. Instead of buying shares of a company, you instead invest a dollar amount. Dollar based investing is a great way for smaller investors to buy into popular companies that they may otherwise be priced out of.

14. EBITDA

EBITDA is a way to evaluate a company’s performance that is considered more precise than simply looking at net income. EBITDA stands for: earnings before interest, taxes, depreciation, and amortization. To calculate EBITDA, use the following formula: Net Income + Interest + Taxes + Depreciation + Amortization.

15. EBIT

EBIT is a simpler way to calculate a company’s profits than EBITDA, as it’s only one part of the EBITDA equation (literally!). It stands for “earnings before interest and taxes.” It’s calculated using this formula: Net Income + Interest + Taxes.

16. EPS

EPS stands for earnings per share, which is a common way investors measure how well a stock is performing. EPS is calculated by finding a company’s quarterly or annual net income and dividing it by the company’s outstanding shares of stock. Increases in EPS can be a sign that the company’s profit performance is on the upswing, whereas a decrease can be a red flag for investors.

17. ETF

Exchange-traded funds, or ETFs, are similar to mutual funds in that the fund’s portfolio can include dozens or even hundreds of different securities, and investors buy shares of the fund. Unlike mutual funds, ETF shares can be traded like stocks throughout the day (mutual fund shares are traded once a day). Most ETFs are considered lower-cost, passive investments because they track an index, although there are actively managed ETFs.

18. Expense Ratio

An expense ratio is an annual fee investors pay to cover the operating costs of mutual funds, index funds, ETFs and other types of funds. Fees are typically deducted from your investments automatically (you don’t pay a separate charge), and they can reduce your returns over time so it’s wise to shop around for lower fees. Expense ratios are calculated using this formula: Total Funds Costs / Total Fund Assets Under Management.

19. FCF

Free cash flow is the money a company has after it has paid its expenses. This number is important to investors because it can show them how likely it is that a company could have extra cash for dividends or share buybacks. A continuous decrease in free cash flow over a few years can also be a red flag to investors.

20. Growth Stock

Growth stocks are shares in a company that’s growing faster than its competitors, typically showing potential for higher revenue or sales. Growth stock companies may be considered leaders in their industry.

21. Hedge Fund

Hedge funds are usually managed by an LLC or limited partnership that invests in securities and other assets using money from multiple investors. Hedge funds tend to be more risky and expensive than mutual funds or ETFs, which often makes them accessible to more wealthy investors.

22. Index Fund

Index funds are a type of mutual fund that invest in securities that mirror a particular index, such as the S&P 500 Index or the MSCI World Index. Indexes track many different sectors, from smaller U.S. companies to big global companies to various kinds of bonds. Each index acts as a proxy for how that market sector is performing; the corresponding index funds reflect that performance.

23. Interest Rate

The interest rate is the amount a lender charges to borrow money — and it can also mean the amount your cash earns in a savings, money market or CD account. The baseline interest rate in the U.S. is set by the Federal Reserve. This rate in turn influences savings rates, mortgage rates, credit card rates, and more. Generally, when the Federal Reserve lowers interest rates, the stock market tends to rise.

24. Large Cap

A large-cap company has $10 billion or more in market capitalization. These companies are often considered industry leaders, and are relatively conservative, low-risk, and safe investments. A company’s stock may be considered large cap, mid cap, or small cap.

25. Market Cap

Market capitalization, or market cap, is the value of a company’s total outstanding shares. It’s often used to measure a company’s value and build a diversified portfolio. You can calculate market cap by multiplying the number of outstanding shares by the current price per share. Companies with lower market caps usually have more room to grow and usually are associated with newer companies, meaning they can also be riskier.

26. Mid Cap

Mid-cap companies are usually between $2 billion to $10 billion in market capitalization, putting them somewhere between small- and large-cap companies. Many mid-cap companies are in a growth phase, making them attractive to some investors who believe the company may grow into a large-cap over time, although this is not guaranteed to happen.

27. Mega Cap

Mega-cap companies are the largest companies you can invest in, with a market value of $1 trillion or more. Mega-cap stocks are typically industry leaders and household name brands.

28. Mutual Fund

Mutual funds may invest in stocks, bonds, and other securities — or a combination of these (e.g. a blended fund). Mutual funds can also be industry-specific (such as a mutual fund consisting only of energy stocks, green bonds, or tech companies, and so on).

29. Net Income

When talking about investing, net income usually refers to how much a company makes (or its total losses) after it has paid all its expenses. Net income is therefore usually calculated by subtracting a company’s expenses from its revenue. Investors may want to know a company’s net income because it can help determine how profitable the company is, although EBITDA (defined above) is another measure.

30. Over-the-Counter Stocks

Not all stocks are publicly traded. These “private” stocks, often called over-the-counter stocks, usually have to be traded through a broker. Companies may offer OTC stocks if they don’t meet the requirements to be traded publicly. Such companies are often startups or other small companies. So, while these companies may eventually grow to be able to trade publicly, investing in them also carries the risk that they may fold or even engage in fraudulent activity since the market is far less regulated than publicly traded markets are.

31. Price-to-Earnings Ratio

Investors commonly use P/E, or price-to-earnings ratios, to gain insight into how profitable a company is compared to its stock price. In other words, price-to-earnings ratios can help investors decide if the price of a stock is worth it when compared to how much a company is making.

32. Prime Interest Rate

Banks are likely to offer their best customers — those with the best credit histories and the lowest risk of defaulting — a prime interest rate for a loan. The prime interest rate is generally the lowest rate the bank will offer. A bank’s criteria for determining their prime interest rate may vary, but most banks consider the federal funds rate when setting any interest rate.

33. Portfolio Management

Portfolio management simply refers to how you select and manage the investments in your portfolio. There are many different management styles, such as active or passive, growth or value. Additionally, you can elect to manage your own portfolio or hire an individual or group to manage it for you.

34. Preferred Stock

A preferred stock means investors own shares in a company and get scheduled dividends, similar to how bond interest payments work. Preferred socks may not fluctuate in price like common stocks do, meaning they are often less volatile and risky.

35. Profit & Loss Statement

You probably know what profit and losses are, but do you know how to read a company’s P&L, or profit & loss statement? It can help you determine a company’s bottom line, as it can show you how well a company is doing compared to its peers in the same industry. If you’ve never read one before, this article about profit & loss statements could give you some tips on what to look for.

36. Prospectus

Companies that offer stocks, bonds, and mutual funds to investors are required to file a prospectus with the Securities and Exchange Commission that provides details about the investment they are offering (e.g. the expense ratio, the constituents of a fund, and more). Investors can use the prospectus to better understand a given security and how it might fit in their portfolio, or not.

37. Recession

A recession is a period of economic contraction. The National Bureau of Economic Research (NBER) defines a recession further as a decline in monthly employment, personal income, and industrial production. As an investor, a recession may indicate a drop in the value of your portfolio, although this may be temporary: When looking at the history of U.S. recessions, the stock market has always rebounded, sooner or later, after recessions.

38. REIT

Real estate investment trusts (REITs) are a way that investors can further diversify their portfolios. Instead of having the responsibility of managing an investment property yourself, you can invest in REITs, which are generally large-scale real estate projects that investors can help fund in exchange for partial ownership. Most REITs are publicly traded and pay dividends to investors.

39. Retained Earnings

When looking for a company’s net income statement, you may come across the term “retained earnings,” also sometimes called unappropriated profit, uncovered loss, member capital, earnings surplus, or accumulated earnings. In general, retained earnings is the amount of money a company keeps and potentially reinvests after it gives its investors a dividend payout.

As an investor, knowing whether a company had positive retained earnings can help you determine how much money it has to continue growing. If its retained earnings are negative, that could be a sign the company is in debt and may not be a good investment.

40. Return on Equity

Return on equity, sometimes called return on net worth, can help investors compare how well companies are managing their stockholders’ contributions. You can calculate it using this formula: Net income/Average shareholder equity. A higher return on equity can signal to investors that a company is managing its money efficiently.

41. ROI

Return on investment (ROI) is just that: the return you get after making an investment in a stock, bond, mutual fund, and so forth. Investors generally hope for a positive ROI, meaning that their investment has made a profit. While a good ROI will vary depending on the type of investments you’re making, some investors look to the historic return of the stock market (about 7% annually) as a barometer.

42. Small Cap

A small-cap company usually has a market cap of $250 million to $2 billion. Investors may be attracted to a small-cap company because they believe it has growth potential or may be undervalued.

43. SPAC

SPAC stands for special purpose acquisition company. SPACs are shell companies that list shares on an exchange to raise money so they can merge with a privately held company. Once the merger between the public SPAC and the private company is complete, that company is now in effect a public company — which is why a SPAC is sometimes called a backdoor IPO. Many companies may elect to use SPACs instead of traditional IPOs because they are often faster and less expensive.

44. Stocks

If you’ve made it this far, you probably know what a stock is. To review, a stock is a way to buy a piece of ownership into a company. You can buy and sell your stocks depending on whether you anticipate your stocks will decrease or increase in value.

45. Stock Exchange

A stock exchange is the place where you buy, sell, or trade stocks. Common U.S. stock exchanges are the New York Stock Exchange (NYSE) and the Nasdaq.

46. Stop-Loss Order

A stop-loss order can help investors have more control over their stocks. When a stock reaches a certain price that you choose, your broker will sell, buy, or trade that stock. Having a stop-loss order can help you limit how much money you make or lose in the stock market.

47. Target Date Fund

A target date fund is a type of mutual fund that includes a mix of asset classes to provide investors with a portfolio that adjusts over time to become more conservative as they age. Target date funds are often used to help investors plan their retirements. Target funds are typically constructed around various target retirement years (e.g. 2030, 2040, 2050) so investors can pick a date that corresponds with their hoped-for retirement.

48. Value Stock

A value stock is a stock that investors believe is undervalued and/or inexpensive compared to its past prices on the stock market or with its competitors. Investors may consider a stock’s price-to-earnings ratio to help them determine if something is a value stock.

49. Venture Capital

Venture capital is money a startup uses to grow its business. This money usually comes from private investors or venture capital firms. Investors may elect to invest venture capital into startups they believe have the potential to be profitable with time.

50. Yield

Yield is another way of referring to the return of an investment over a set period of time, expressed as a percentage. You may hear the term in relation to bonds (e.g. high-yield bonds), but yield is more accurately a measure of the cash flow an investor gets on the amount they invested in a security during that time period, and is different from total return.

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The Takeaway

Getting familiar with a few key investing words and phrases can go a long way in helping you gain confidence when you’re new to investing. Getting fluent with investing terminology is like any other pursuit — there’s a learning curve at first, but the terms will feel more natural as you move forward and start investing regularly.

Learning key investing terms and definitions is only the beginning, though. Putting your knowledge into practice is another thing entirely. Although, it is helpful to know the lingo before diving into investing.

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FAQ

What are the main investment types?

There are many types of investments, but perhaps the main investment types would include stocks, bonds, funds (mutual funds, index funds, exchange-traded funds), and options, though there are more.

What is the basic rule of investing?

There are many guidelines investors might want to follow, but the basic rule of investing is that you shouldn’t invest more than you’re comfortable losing – which is associated with an investor’s risk tolerance.

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Sep

2023

What Is Efficient Frontier?

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

The efficient frontier is a financial framework that investors can use to build an optimized asset portfolio that attempts to give them the greatest returns within their particular risk profile. In other words, it shows which investment portfolio will be “efficient” or provides a higher expected return for a lower amount of risk. It does not, however, eliminate risk for investors, which is important to keep in mind.

It’s visualized as a curved line on a graph according to an individual’s goals and risk tolerance. The framework is called the efficient frontier or the efficiency frontier because if one’s investments fall within the ideal range, they are working efficiently to achieve one’s goal.

How Does the Efficient Frontier Work?

The efficient frontier concept is a key facet of modern portfolio theory, which was created in 1952 by Harry Markowitz. Essentially, the efficient frontier is the optimal baseline for an investment portfolio. If an investor’s portfolio gives them lower returns because it contains riskier investments, then it may not be as well balanced as it could or should be. It’s also possible for a portfolio to provide returns that are greater than the frontier. As such, as long as a portfolio’s potential returns justify its associated risks, then the portfolio is well-allocated.

Every investor has a different risk tolerance, and their own corresponding goals for portfolio growth. Accordingly, every investor has a different frontier. By adjusting that frontier, the inventors can then see if their current portfolio measures up to the parameters set by the efficient frontier graph, and make changes to their asset allocation accordingly.

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How Is the Efficient Frontier Constructed?

Investors hoping to utilize the efficient frontier concept as a part of their strategy will create a corresponding graph, and apply it to their specific portfolio.

When constructing the graph, expected returns are on the y-axis and the standard deviation of returns, which are a measure of risk, are on the x-axis. Then, they would plot a curve that shows where the ideal or expected portfolio would land on the graph and the standard deviation of returns.

Once the graph is created, the investor can plot a portfolio or individual asset on the graph according to its expected returns and their standard deviation, and then compare it to the efficient frontier curve. The investor can also plot two or more portfolios on the graph to compare them.

A portfolio that falls on the right side of the graph has a higher level of risk, while a portfolio that is low on the graph has lower returns. If an investor finds that their portfolio doesn’t fall on the graph where they would like it to, they can then make decisions about how to reallocate investments to move closer to the goal.

The curved line reflects the diminishing marginal return to risk. Adding more risk to a portfolio doesn’t result in an equal amount of increased return. Portfolios that lie below the curve on the graph are suboptimal because they don’t provide high enough returns to justify their amount of risk. Portfolios to the right of the curve are also suboptimal because they have a high level of risk for their particular level of return.

Again, the portfolios that display the lowest levels of risk are not inherently risk-free, which investors will need to keep in mind.

Efficient Frontier Example

Efficient frontier can be a somewhat difficult concept to visualize, so consider this: Your portfolio contains two assets. Each asset has its own respective expected annual return, and standard deviation — so multiple variables for each asset.

Data sets for each can be put together showing correlated expected returns and standard deviations, and plotted on a graph, as discussed. That graph will reveal the efficient frontier, and help investors determine which portfolio they’d prefer accordingly.

Again, it’s somewhat difficult to visualize, but practically speaking, a visual chart with different portfolios can be helpful in making portfolio decisions.

Benefits of the Efficient Frontier

The primary benefit of the efficient frontier is that it helps investors visualize and understand whether their investment portfolio is performing the way they would like it to. Every investment and portfolio comes with some risk, and oftentimes with more risk there is more reward. But it’s important to make sure that your returns are worth the risk, and to remember that there is no such thing as a risk-free investment or portfolio.

Investors can use the efficient frontier to analyze the current performance of a portfolio and figure out which assets to adjust, potentially liquidate, or reallocate. Investors can also see if a particular asset is giving them the same reward with less risk than other assets. In this case, they might want to sell the higher risk asset and put more funds into the lower risk asset.

How Do Investors Use the Efficient Frontier Model?

Using an efficient frontier model is one method of building a portfolio made of different types of investments that have the optimal balance of risk and return. No portfolio is without risk, and investors do need to reallocate investments on occasion to continue optimizing toward their goal. But the optimal portfolio would have a balance of high-risk, high-reward investments and more stable investments that still get decent returns.

There is often an assumption that investments with greater risk provide greater returns — as noted. Although this is sometimes true, the optimal portfolio holds both high risk and low risk assets, according to the efficient frontier.

If an investor has a higher tolerance to risk, they could choose to own a higher percentage of investments on the right end of the efficient frontier graph with higher risk and higher return. If an investor is more conservative, they could choose to hold lower-risk assets.

Proponents of efficient frontier claim that more diversified portfolios tend to be closer to the efficient frontier line than less diversified portfolios, and therefore have lower levels of risk, though they’re not risk-free.

Limits and Downsides of the Efficient Frontier

The main downside of using the efficient frontier tool is that it creates a curve with a normal distribution, which doesn’t necessarily always match reality. Real investments may vary within three standard variations of the mean curve. This “tail risk” means there are limits to the conclusions you can draw from the efficient frontier graph.

Another issue is that investors don’t always make rational decisions and avoid risk. Market decisions involve many complex factors that the efficient frontier does not factor into its calculations. Instead, the efficient frontier assumes that people always avoid risk and make investing decisions rationally.

Finally, the efficient frontier assumes that the number of investors in a market has no impact on market prices, and that all investors have the same access to borrow money with risk-free interest rates.

Investors using the efficient frontier should understand its limitations and might consider using it in conjunction with other tools for analyzing an investment strategy.

The Takeaway

The efficient frontier is one of many useful methods of analyzing portfolios and creating a long-term investing plan. It involves utilizing a financial framework to build an optimized asset portfolio with aims to maximize their potential gains within their particular risk profile. It also involves visuals to help investors get a better sense of where their portfolio stands. Investors should remember that it is not a tool that will help them completely remove risk from their investment portfolio or allocation.

It’s also a relatively high-level investing concept and tool that many investors may not feel comfortable using. There are plenty of strategies and tools that can be utilized in its stead, of course, and it may be worthwhile to consult with a financial professional if investors feel they’re in over their heads.

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 are common assumptions of the efficient frontier model?

Common assumptions of the efficient frontier model include that asset returns will follow a more or less common distribution, that investors will act rationally, and that riskier investments inherently lead to larger returns.

Can the efficient frontier be negative?

The efficient frontier model cannot be negative, as a negative figure would imply that an investor garnered losses from a given set of potential portfolios. That means that the investor was not actually investing.

What is the difference between efficient frontier and efficient portfolio?

The efficient frontier is a set of investment portfolios expected to provide the highest return for a specific risk level. Efficient portfolio, on the other hand, is a single portfolio that provides the highest return for a specific risk level.

Photo credit: iStock/undrey

SoFi Invest®

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

Sep

2023

10 Tips for Investing Long Term

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

While short-term investing can be highly risky, investing for the long term is a time-honored way to manage certain market risks so you can reach important financial goals, like saving for college tuition and retirement.

That’s because when it comes to building a nest egg for these bigger life expenses, saving alone won’t necessarily get you where you need to go. You need the boost of investment returns over time to help your savings grow. That’s where long-term investing, also called buy-and-hold, comes in.

The chief advantage of a long-term investing strategy is that “time in the market beats timing the market,” as the saying goes. In other words, by sticking to an investment plan for the long term, your portfolio is more likely to weather its ups and downs, and fluctuations in different securities.

That said, long-term investing isn’t a risk-free endeavor, and there are also tax implications for holding investments long term. Knowing the ins and outs can make all the difference to your portfolio over time.

10 Tips for Long-Term Investing

So how do you go about establishing a long-term investment plan? These tips should help.

1. Set Goals and a Time Horizon

Your financial goals will largely determine whether or not long-term investing is the right choice for you. Spend time outlining what you want to achieve and how much money you’ll need to achieve it, whether that’s paying for college, retirement, or another big goal.

Once you’ve done that, you can think about your time horizon — when you’ll need the cash — which can help you determine what types of investments are suited to your goals.

For example, if you are saving to buy a car in a couple of years — generally a shorter-term goal — you may consider setting aside money in a savings account, CDs, or money market accounts, which are stable and can provide relatively quick access to your cash.

Stock market investing can be more appropriate for big goals in the distant future, such as saving for a child’s education or your own retirement, which could be 20 or 30 years down the line. This relatively long time horizon not only gives your investments a chance to grow, but it means that you also have the time to ride out market downturns that may occur along the way — which may translate to a better ROI (i.e. a higher return on investment), although there are no guarantees.

2. Determine Your Risk Tolerance

Your risk tolerance is essentially a measure of your ability to stomach volatile markets. It can help you determine the mix of investments that you will hold in your investment accounts — but your risk tolerance also depends on (or interacts with) your goals and time horizon.

Longer time horizons may allow you to take on more risk in some cases, because you’re not focused on quick gains. Which in turn means you might be more inclined to hold a greater proportion of stocks inside your portfolio.

How long should you hold stocks? Generally, holding stocks longer can be beneficial from a tax perspective, and from a risk perspective. The longer you stay invested, the longer you have to recover should markets take a dive.

Setting your risk tolerance also means knowing yourself. If you’re somebody who will be kept up at night when the market takes a downward turn, even if your goal is still 20 years away, then you may not want a portfolio that’s aggressively allocated to stocks. While there are no safe investments per se, it’s possible to have a more conservative allocation.

On the other hand, if short-term market volatility doesn’t bother you, an aggressive allocation may be the best fit to help you achieve your long-term goals.

3. Set an Appropriate Asset Allocation

Understanding your goals, time horizon, and risk tolerance can help give you an idea of the mix of assets — generally stocks, bonds, and cash equivalents — you may want to hold in your portfolio. For example, a portfolio might hold 70% stocks, 30% bonds, and no cash equivalents, depending on the investment opportunities you want to explore.

As a general rule of thumb, the longer your time horizon, the more stocks you may want to hold. That’s because stocks tend to be drivers of long-term growth (although they also come with higher levels of risk).

As you approach your goal, you’ll likely begin to shift some of your assets into fixed-income investments like bonds. The reason for this shift? As you approach your goal — the time when you’ll need your money — you’ll be more vulnerable to market downturns, and you won’t want to risk losing any of your cash.

For example, if the market experiences a big drop, you may be left without enough money to meet your goal. By gradually shifting your money to bonds, cash, or cash equivalents, you can help protect it from stock market swings, so by the time you need your cash, you have a more stable source of income to draw upon.

4. Diversifying Your Investment Portfolio

A key factor of any investing is that portfolio diversification matters. The idea is that holding many different types of assets reduces risk inside your portfolio in the long and short term. Imagine briefly that your portfolio consists of stock from only one company.

If that stock drops, your whole portfolio drops. However, if your portfolio contains stocks from 100 different companies, if one company does poorly, the effect on the rest of your portfolio will be relatively small.

A diverse portfolio contains many different asset classes, such as stocks, bonds, and cash equivalents as mentioned above. And within those asset classes a diverse portfolio holds many different types of assets across size, geographies and sectors, for example.

Different types of stocks

The basic principle behind diversification is that assets in a diverse portfolio are not perfectly correlated. In other words, they react differently to different market conditions.

Domestic stocks for example, might react differently than European stocks should U.S. markets start to struggle. Or investing in energy stocks will be different than tech-stock investing. So, if oil prices drop, energy sector stocks might take a hit, while tech might be less affected.

Many investors may choose to add diversification to their portfolios by using mutual funds, index funds, and exchange-traded funds, which themselves hold diverse baskets of assets.

Recommended: What Is an ETF?

5. Starting Investing Early

This tip may seem like a no-brainer, but increasing your time horizon gives you the opportunity to invest in riskier investments, like stocks, for longer. Though risky, stocks typically offer higher earning potential than other types of investments, such as bonds. Consider that the average stock market return annually is about 10%.

Second, the sooner you start investing, the sooner you are able to take advantage of compound growth, one of the most powerful tools in your investing toolkit. The idea here is that as your money grows, and you reinvest your returns, you steadily keep increasing the amount of money on which you earn returns.

As a result, your returns keep getting bigger and your investments can start to grow exponentially. This phenomenon can also help mitigate inevitable losses.

💡 Quick Tip: If you’re opening a brokerage account for the first time, consider starting with an amount of money you’re prepared to lose. Investing always includes the risk of loss, and until you’ve gained some experience, it’s probably wise to start small.

6. Leaving Emotions Out of It

Investing is just numbers and math, so it’s totally rational, right? Well…not exactly. Humans are emotional creatures and sometimes those emotions can get the better of us, leading us to make decisions that aren’t always in our best interest. Letting emotions dictate our investing behavior can result in costly mistakes, as behavioral finance studies have shown.

For example, if you’re investing in a recession and the stock market starts to drop, you may panic and be tempted to sell your stocks. However, doing so can actually lock in your losses and means that you miss the subsequent rally.

On the other end of the spectrum, when the stock market is roaring, you may be tempted to jump on the bandwagon and overbuy stocks. Yet, doing so opens you up to the risk that you are jumping on a bubble that may soon burst.

There are a number of strategies that can help these mistakes be avoided. First, fight the urge to check how your investments are doing all the time. There are natural cycles of ups and downs that can happen even on a daily basis. These can cause anxiety if you pay attention too closely. You might want to avoid constant checking in and instead keep your eye on the big picture — achieving your long-term goals.

Trust your asset allocation. Remember that your asset mix has already taken your goals, time horizon, and your risk tolerance into consideration. Tinkering with it based on spur-of-the-moment decisions can throw off your allocation and make it difficult to achieve your goals.

7. Reducing Fees and Taxes

Be wary of taxes and fees as these can take a hefty bite out of your potential earnings over time. Also, many investment fees are expressed as a small percentage (e.g. less than 1% of the money you have invested) that may seem negligible — but it’s not.

Also, many investment costs can be hard to find, and thus hard to track. Meanwhile, various expenses can add up over time, reducing your overall gains.

Expense ratios

To cover the cost of management, mutual funds and exchange-traded funds charge an expense ratio — a percentage of the total assets invested in the fund each year. An actively managed mutual fund might charge 1.0% or more. A passively managed ETF or index fund may charge 0.50% or less. So you may want to choose mutual funds with the lowest expense ratios, or you may consider passive ETFs or index funds that charge very low fees.

The expense ratio is deducted directly from your returns. You may also encounter annual fees, custodian fees, and other expenses.

Advisory fees

You can also be charged fees for buying and selling assets as well as commissions that are paid to brokers and/or financial advisors for their services. It’s important to manage these costs as well. One of the best lines of defense is doing your research to understand what fees you will be charged and what your alternatives are.

8. Taking Advantage of Tax-Advantaged Accounts

There are a few long-term goals that the government wants you to save for, including higher education and retirement. As a result, the government offers special tax-advantaged accounts to help you achieve these goals.

Saving for Education

A 529 savings plan can help you save for your child’s — or anyone’s — college or grad school tuition. Contributions can be made to these accounts with after-tax dollars. This money can be invested inside the account where it grows tax-free. You can then make tax-free withdrawals to cover your child’s qualified education expenses.

Saving for Retirement

Your employer may offer you a 401(k) retirement account through your job. These accounts allow pre-tax dollars to be contributed, which lower your taxable income and can grow tax-deferred inside the account. If your employer offers matching funds, you could try to contribute enough to receive the maximum match. When you withdraw money from your 401(k) at age 59 ½, it is subject to income tax.

You may also take advantage of traditional IRAs and Roth IRAs. Traditional IRAs use pre-tax dollars and allow tax-deferred growth inside your account. Withdrawals at age 59 ½ are subject to income tax.

You fund Roth IRAs, on the other hand, with after-tax dollars, so money in your account grows tax-free, and withdrawals are not subject to income tax.

There are other tax-advantaged accounts that can work favorably for long-term investors, including SEP IRAs for self-employed people, and health savings accounts (or HSAs), in addition to other options.

9. Making Saving Automatic

One way to continually add to your investments is by making saving a regular activity. One easy way to do this is through automation. If you have a workplace retirement account, you can usually automate contributions through your employer.

Or if you’re saving in a brokerage account you can arrange with your broker for a fixed amount of money to be transferred to your brokerage account each month and invested according to your predetermined allocation.

Automation can take the burden off of you to remember to invest. And with the money automatically flowing from your bank account to your investments accounts, you probably won’t be as tempted to spend it on other things.

10. Checking In on Your Investments

You may want to periodically check in on your portfolio to make sure your asset allocation is still on track. If it’s not, it may be time to rebalance your portfolio. You may want to rebalance when the proportion of any particular asset shifts by 5% or more.

This could occur, for example, if the stock market does really well over a given period, upping the portion of your portfolio taken up by stocks.

If this is the case, you might consider selling some stocks and purchasing bonds to bring your portfolio back in line with your goals. Periodic check-ins can also provide opportunities to examine fees and other costs (like taxes) and their impact on your portfolio.

What Is Long-Term Investing?

A long-term investment is an asset that’s expected to generate income or appreciate in value over a longer time period, typically five years or more. Long-term investments often gain value slowly, weathering short- to medium-term fluctuations in the market, and (ideally) coming out ahead over time.

Short-term investments are those that can be converted to cash in a few weeks or months — but they’re generally held for less than five years. Many investors trade these assets in short periods, like days, weeks, and months, to profit from short-term price movements.

However, a short-term investing strategy can be risky and volatile, resulting in losses in a short period.

💡 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.

Long-term Investments and Taxes

It’s also worth noting that for tax purposes the Internal Revenue Service (IRS) considers long-term investments to be investments held for more than a year. This is another important consideration when developing a longer-term strategy.

Investments sold after more than a year are subject to the long-term capital gains rate, which is equal to 0%, 15%, or 20%, depending on an investor’s income and the type of investment. The long-term capital gains rate is typically much lower than their income tax rate, which can help incentivize investors to hang on to their investments over the long run.

Why Is Long-Term Investing Important?

Long-term investing can be beneficial for the three reasons noted above:

• Holding investments long term can allow certain securities to weather market fluctuations and, ideally, still see some gains over time. While there are no guarantees, and being a long-term investor doesn’t mean you’re immune to all risks, this strategy may help your portfolio recover from periods of volatility and continue to gain value.

• In the case of bigger financial goals, e.g. saving for retirement or for college tuition, embracing a long-term investment plan may help your savings to grow and better enable you to reach those larger goals.

• Last, there may be tax benefits to holding onto your investments for a longer period of time.

Recommended: Short- vs. Long-Term Investments

Investing With SoFi

The most important tips for long-term investing involve setting financial goals; understanding your time horizon and risk tolerance; diversifying your holdings; minimizing taxes and fees; and starting early so your portfolio can benefit from compounding; and understanding how tax-advantaged accounts can be part of a long-term plan.

When you’re ready to invest, whether through retirement accounts, brokerage accounts, by yourself, or with help, these strategies can help you build an investment plan to match your financial situation.

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

FAQ

What is a realistic long-term investment return?

The average historical return of the U.S. stock market is about 10%, but that’s an average over about a century. Different years had higher or lower returns. So asking what a realistic long-term investment return is hard to gauge, and it will ultimately depend on the investments you choose, how long you hold them, as well as the fees and taxes you pay.

Where is the safest place to invest long-term?

All investments come with some degree of risk, but a more secure way to invest for the long term might be with fixed-income securities like bonds, which pay a set return over a period of time. Money market accounts and certificates of deposit (CDs) generally also have fixed rates. But remember that the lower the risk, the lower the return.

What is the biggest threat to long-term investments

Long-term investments, like all investments, are vulnerable to market changes. Even when investing for the long haul, it’s possible to lose money. Another threat is the risk of inflation. As inflation rises, your money doesn’t go as far. So even if you save and invest for decades, inflation is also rising at the same time, and your money may have less purchasing power than you expected.

Photo credit: iStock/Pekic

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.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
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.

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

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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Sep

2023

What Are Separately Managed Accounts? How Do They Work?

What Is a Separately Managed Account (SMA)?

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

A separately managed account (SMA), also referred to as a managed account, is an investment account that is like a customized portfolio of individual securities. An individual investor owns those securities — which may include stocks, bonds, and other investments — but a professional money manager oversees the account.

High net-worth investors who want to build customized portfolios often use separately managed accounts (or SMAs), which allow them to keep their assets separate, versus pooling funds alongside other investors through a mutual fund or exchange-traded fund (ETF).

Understanding what an SMA is, as well as the differences between these accounts and mutual funds and other types of pooled investments can help you decide if an SMA is the right approach for you.

How SMAs Work

Investors pay a financial professional to manage the separately managed accounts they own. The portfolio manager handles day-to-day decision making, but the investor retains control over the overall SMA investment strategy. That includes making initial decisions about which securities to hold inside a separately managed account.

A wealth management firm may give SMA investors several portfolio options to choose from. These portfolios can include a mix of different securities that reflect a specific investment strategy or goal. For example, SMA investing may focus on:

• Increasing tax efficiency

• Generating current income

• Managing interest rate risk

• Delivering above-average returns through trend trading

• Promoting ESG (environmental, social and governance) principles

Within the portfolio there may be stocks, bonds, cash or cash equivalents, or other assets. Stock investments may include small-cap stocks, as well as mid-cap, or large-cap companies. It would be up to the investor to choose which strategy to follow, based on their individual needs, risk tolerance, and objectives.

Recommended: What Is Market Capitalization?

The fees for separately managed accounts are typically based on a percentage of the assets under management, or AUM. Often, the management firm uses a tiered structure in which the fee decreases as the account balance climbs. So, in some cases, the more you invest in a separately managed account, the less you’ll pay as a percentage of assets for professional management.

Wealth managers may also charge fees based on the type of investment strategy. For instance, you may pay one management fee for an equities-based strategy but a different fee if you focus on fixed income. Generally, separately managed accounts do not carry trading or transaction fees the way there would be in a traditional brokerage account.

How Can SMAs Benefit an Investor?

Separately managed accounts can yield some benefits to investors who can afford them. Generally, SMA investing may be a good fit for higher net worth investors who want to take advantage of professional asset management while still being able to decide what happens with their portfolios.

SMAs sit at the opposite end of the spectrum from robo-advisor accounts. Robo advisors, or automated platforms, typically offer an investing strategy that’s driven by an sophisticated algorithm on the back end. While robo services can vary from company to company, generally the algorithm creates pre-set portfolio options that investors can choose from, based on individual preferences.

Here are some of the key benefits associated with separately managed accounts.

Control, Transparency, and Customization

While an asset manager may make investment decisions on an investor’s behalf, the investor still has the final say on what happens with their portfolio inside a separately managed account.

For instance, if you’re offered a prebuilt portfolio you may be able to exclude certain securities or request that others be added to align with your investment goals. Or you may be able to work with your advisor to hand-pick all the securities that are held inside an SMA, or to change the direction of the strategy in the case of a recession or other market event.

Either way, you always directly own the securities held inside your account.

Tax Benefits

Managing tax liability in an investment portfolio matters. The more tax efficient your portfolio is, the more of your returns you get to keep. With separately managed accounts, a financial advisor or wealth manager can implement tax-loss harvesting strategies to help you get the most from your investment dollars.

Cost

As mentioned, with separately managed accounts, fees are typically asset-based. That means you typically won’t pay commission fees, and since you’re investing in individual securities versus pooled investments (like mutual funds or ETFs), you don’t have to pay fund expense ratios either.

Compared to the fees associated with investing in mutual funds or trading in taxable brokerage accounts, SMAs can be more cost-friendly for investors.

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

What Are the Drawbacks of SMAs?

While separately managed accounts may work well for some types of investors, they aren’t necessarily a good fit for everyone. Here are some of the downsides of SMAs to keep in mind.

Investment Minimums

Separately managed accounts typically have higher minimum investment requirements, which may be a barrier to entry for some investors. You may need $50,000 to $100,000 or more to open a separately managed account. The reason being that SMAs provide a highly customized investment portfolio for the investor: hands-on investment management.

By contrast, the investment minimums required to open a traditional self-directed brokerage account can be quite low, depending on the type of account and the institution. Again, this is because a professional manager is not involved.

So if you’re just getting started with investing, you may not qualify for a separately managed account.

Less Diversification

Since separately managed accounts hold individual securities, it’s harder for them to offer the same level of broad-based diversification as a mutual fund or exchange-traded fund (ETF), which could hold hundreds or thousands of different stocks.

SMAs vs Pooled Investment Funds

The main similarity between separately managed accounts and pooled investment funds, e.g. mutual funds and exchange-traded funds, is that SMAs are portfolios of many securities, and the portfolio of a mutual fund or ETF also includes many securities. But SMAs are customized based on the individual investor’s wishes, and managed by a professional investment manager who adheres to the investor’s strategy.

Comparing SMAs and Mutual Funds

With an SMA, your portfolio includes individual securities that you own. A mutual fund, on the other hand, is a pooled investment that includes money from multiple investors.

When you invest in a mutual fund, you don’t get to choose what the fund holds. That’s the job of a fund manager, who decides what to buy or sell, based on the fund’s objectives. So a fund may hold a mix of stocks, bonds, cash or other securities. You, along with the other investors who have pooled their money in the mutual fund, share in the fund’s returns or its losses.

Compared to separately managed accounts, mutual funds can have a much lower initial investment to get started: a hundred dollars versus tens of thousands of dollars (depending on the fund).

And instead of paying an asset-based management fee, mutual funds charge expense ratios. This expense ratio reflects the annual cost of owning the fund.

The Difference Between SMAs and ETFs

The difference between separately managed accounts and exchange-traded funds (ETFs) is similar to the difference between SMAs and mutual funds. Instead of building a portfolio that’s composed of individual securities and managed by a financial professional, you’re pooling money into a fund along with other investors.

This fund can hold hundreds of securities and have specific goals. For example, there are ETFs that invest in gold, in commodities, in biotech, and more.

Many investors begin by putting their money into exchange-traded funds or mutual funds, and then move some of their portfolio into a separately managed account once it grows larger.

The Takeaway

Separately managed funds are a popular way for high net worth investors to have some control over their professionally managed funds when building an investment portfolio. However, if you can’t meet the high minimum investment requirements for a separately managed account, you may want to consider investing in ETFs or mutual funds instead.

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

FAQ

How are SMAs customized?

With an SMA, you can work with your financial advisor and/or investment manager to pick all the securities that are held inside an SMA. You can choose to exclude certain securities or ask that others be added to align with your investment goals. You can also request to change the direction of the strategy in the case of a market event like a recession.

What type of due diligence do you need to do before investing in SMAs?

An investor should do thorough due diligence on the money manager they’re considering working with before setting up an SMA. Investigate the manager’s investment philosophy, approach, and process, inquire about their compliance history, and ask to see performance data, including quarterly returns. Inquire about all the fees involved, including transaction expenses. And finally, find out how the investment manager is compensated and what their incentives are.

What is the difference between a separate account and a separately managed account?

A separate account and a separately managed account are the same thing: an investment vehicle that holds securities and is owned by an investor and managed by a professional financial advisor or money manager. These accounts are sometimes referred to by either name.

Photo credit: iStock/adamkaz

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.

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

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
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.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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