InvestHL Archives | Page 14 of 52

May

2024

Private Credit vs. Private Equity: What’s the Difference?

By Rebecca Lake | Family Finances, invest, Investing | Comments Off

Private credit and private equity investments offer investors opportunities to build their portfolios in substantially different ways. With private credit, investors make loans to businesses and earn returns through interest. Private equity represents an ownership stake in a private company or a public company that is not traded on a stock exchange.

Each one serves a different purpose, which can be important for investors to understand.

Key Points

• Private credit and private equity are alternative investments that offer different ways to build portfolios.

• Private credit involves making loans to businesses and earning returns through interest, while private equity represents ownership stakes in private or delisted public companies.

• Private credit investors include institutional investors, high-net-worth individuals, and family offices, while private equity investments are often made by private banks or high-net-worth individuals.

• Private credit generates returns through interest, while private equity aims to generate returns through the sale of a company or going public.

• Private credit carries liquidity risk, while private equity investments can be affected by the company’s performance and potential bankruptcy.

What Does Private Credit and Private Equity Mean?

Private equity and private credit are two types of alternative investments to the stocks, bonds, and mutual funds that often make up investor portfolios. Alternative investments in general, and private equity or credit in particular, can be attractive to investors because they can offer higher return potential.

However, investors may also face more risk.

💡 Quick Tip: While investing directly in alternative assets often requires high minimum amounts, investing in alts through a mutual fund or ETF generally involves a low minimum requirement, making them accessible to retail investors.

Alternative investments,
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Start trading funds that include commodities, private credit, real estate, venture capital, and more.

Private Credit Definition

Private credit is an investment in businesses. Specifically, an investor or group of investors extends loans to private companies and delisted public companies that need capital. Investors collect interest on the loan as it’s repaid. Other terms used to describe private credit include direct lending, alternative lending, private debt, or non-bank lending.

Who invests in private credit? The list can include:

• Institutional investors

• High-net-worth individuals

• Family offices or private banks

Retail investors may pursue private credit opportunities but they tend to represent a fairly small segment of the market overall. Private credit investment is expected to exceed $3.5 trillion globally by 2028.

Private Equity Definition

Private equity is an investment in a private or delisted public company in exchange for an ownership share. This type of investment generates returns when the company is sold, or in the case of a private company, goes public.

Similar to private credit, private equity investments are often the domain of private banks, or high-net-worth individuals. Private equity firms can act as a bridge between investors and companies that are seeking capital. Minimum investments may be much higher than the typical mutual fund buy-in, with investors required to bring $1 million or more to the table.

Private equity is often a long-term investment as you wait for the company to reach a point where it makes sense financially to sell or go public. One difference to note between private equity and venture capital lies in the types of companies investors target. Private equity is usually focused on established businesses while venture capital more often funds startups.

What Are the Differences Between Private Credit and Private Equity?

Private credit and private equity both allow for investment in businesses, but they don’t work the same way. Here’s a closer look at how they compare.

Investment Returns

Private credit generates returns for investors via interest, whereas private equity’s goal is to generate returns for investors after selling a company (or stake in a company) after the company has grown and appreciated, though that’s not always the case.

With private credit, returns may be more predictable as investors may be able to make a rough calculation of their potential returns. Private equity returns are less predictable, as it may be difficult to gauge how much the company will eventually sell for. But there’s always room for private equity returns to outstrip private credit if the company’s performance exceeds expectations. However, it’s important to remember that higher returns are not guaranteed.

Risk

Investing in private credit carries liquidity risk, in that investors may be waiting several years to recover their original principal. That risk can compound for investors who tie up large amounts of capital in one or two sectors of the market. Likewise, changing economic conditions could diminish returns.

If the economy slows and a company isn’t able to maintain the same level of revenue, that could make it difficult for it to meet its financial obligations. In a worst-case scenario, the company could go bankrupt. Private credit investors would then have to wait for the bankruptcy proceedings to be completed to find out how much of their original investment they’ll recover. And of course, any future interest they were expecting would be out the window.

With private equity investments, perhaps the biggest risk to investors is also that the company closes shop or goes bankrupt before it can be sold but for a different reason. In a bankruptcy filing, the company’s creditors (including private credit investors) would have the first claim on assets. If nothing remains after creditors have been repaid, private equity investors may walk away with nothing.

The nature of the company itself can add to your risk if there’s a lack of transparency around operations or financials. Privately-owned companies aren’t subject to the same federal regulation or scrutiny as publicly-traded ones so it’s important to do thorough research on any business you’re thinking of backing.

Ownership

A private credit investment doesn’t offer any kind of ownership to investors. You’re not buying part of the company; you’re simply funding it with your own money.

Private equity, on the other hand, does extend ownership to investors. The size of your ownership stake can depend on the size of your investment.

Investor Considerations When Choosing Between Private Credit and Private Equity

If you’re interested in private equity or private credit, there are some things you may want to weigh before dividing in. Here are some of the most important considerations for adding either of these investments to your portfolio.

• Can you invest? As mentioned, private credit and equity are often limited to accredited investors. If you don’t meet the accredited investor standard, which is defined by income and net worth, these investments may not be open to you.

• How much can you invest? If you are an accredited investor, the next thing to consider is how much of your portfolio you’re comfortable allocating to private credit or equity.

• What’s your preferred holding period? When evaluating private credit and private equity, think about how long it will take you to realize returns and recover your initial investment.

• Is predictability or the potential for higher returns more important? As mentioned, private credit returns are typically easy to estimate if you know the interest rate you’re earning. However, returns may be lower than what you could get with private equity, assuming the company performs well.

Here’s one more question to ask: how can I invest in private equity?

These investments may not be available in a standard brokerage account. If you’re looking for private credit opportunities you may need to go to a private bank that offers them. When private equity is the preferred option, a private equity firm is usually the connecting piece for those investments.

When comparing either one, remember to consider the minimum initial investment required as well as any fees you might pay.

💡 Quick Tip: Did you know that opening a brokerage account 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.

The Takeaway

Private credit and private equity can diversify a portfolio and help you build wealth, though not in the same way. Comparing the pros and cons, assessing your personal tolerance for risk and ability to invest in either can help you decide if alternative investments might be right for you.

Ready to expand your portfolio's growth potential? Alternative investments, traditionally available to high-net-worth individuals, are accessible to everyday investors on SoFi's easy-to-use platform. Investments in commodities, real estate, venture capital, and more are now within reach. Alternative investments can be high risk, so it's important to consider your portfolio goals and risk tolerance to determine if they're right for you.

Invest in alts to take your portfolio beyond stocks and bonds.

FAQ

Why do investors like private credit?

Private credit can offer some unique advantages to investors, starting with predictable returns and steady income. The market for private credit continues to grow, meaning there are more opportunities for investors to add these types of investments to their portfolios. Compared to private equity, private credit carries a lower degree of risk.

How much money do you need for private equity?

The minimum investment required for private equity can vary, but it’s not uncommon for investors to need $100,000 or more to get started. In some instances, private equity investment minimums may surpass $1 million, $5 million, or even $10 million.

Can anyone invest in private credit or private equity?

Typically, no. Private credit and private equity investments most often involve accredited investors or legal entities, such as a family office. It’s possible to find private credit and private equity investments for retail investors, however, you may need to meet the SEC’s definition of accredited to be eligible.

Photo credit: iStock/shapecharge

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

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

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

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Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor's risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds.
Please note that Interval Funds are illiquid instruments, hence the ability to trade on your timeline may be restricted. Investors should review the fee schedule for Interval Funds via the prospectus.

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May

2024

Should I Use a Dividend Reinvestment Plan?

Dividend Reinvestment Plans: How DRIP Investing Works

By Laurel Tincher | Growing Wealth, Investing | No Comments

A dividend reinvestment plan, or DRIP, allows investors to reinvest the cash dividends they receive from their stocks into more shares of that stock. Hundreds of companies, funds, and brokerages offer DRIPs to shareholders. Reinvesting dividends through a DRIP may come with a discount on share prices or no commissions.

Of course, it’s possible to simply keep the cash dividends to spend or save, or use them to buy shares of a different stock. If you’re wondering, should I reinvest dividends?, it helps to know the pros and cons of dividend reinvestment programs and how they work.

Key Points

• Dividend reinvestment plans (DRIPs) allow investors to reinvest cash dividends into more shares of the same stock.

• DRIPs can be offered by companies or through brokerages, with potential discounts on share prices or no commissions.

• There are two types of DRIPs: company-operated DRIPs and DRIPs through brokerages.

• Reinvesting dividends through a DRIP may lead to greater long-term returns due to compounding.

• However, DRIPs have limitations, such as tying up cash, risk exposure, and limited flexibility in choosing where to reinvest funds.

What Is Dividend Reinvestment?

Dividend reinvestment typically means using the dividends you receive to purchase additional shares of stock in the same company rather than taking the dividend as a payout.

When you initially buy a share of dividend-paying stock, you typically have the option of choosing whether you’ll want to reinvest your dividends automatically.

Need a refresher on dividends? Check out what a dividend is and how they work.

What Is a Dividend Reinvestment Plan?

Depending on which stocks you invest in, you may have the option to enroll in a Dividend Reinvestment Plan or DRIP. This type of plan, offered by about 650 companies and 500 closed-end funds, allows you to automatically reinvest dividends as they’re paid out into additional shares of stock.

💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

Types of Dividend Reinvestment Plans

There are two main types of dividend reinvestment plans. They are:

Company DRIPs

With this type of plan, the company operates its own DRIP as a program that’s offered to shareholders. Investors who choose to participate simply purchase the shares directly from the company, and DRIP shares are often offered to them at a discounted price. Some companies allow investors to do full or partial reinvestment, or to purchase fractional shares.

DRIPs through a brokerage

Many brokerages also provide dividend reinvestment as well. Investors can set up their brokerage account to automatically reinvest in shares they own that pay dividends.

DRIP Example

Here’s a dividend reinvestment example that illustrates how a company-operated DRIP works. If you own 20 shares of a stock that has a current trading value of $100 per share, and the company announces that it will pay $10 in dividends per share of stock, then the company would pay you $200 in dividends that year.

If you choose to reinvest the dividends, you would own 22 shares of that stock ($200 in dividends/$100 of current trading value = 2 new shares of stock added to your original 20). If the stock price was $200, you’d be able to purchase a single share; if it was $50, you could theoretically reinvest and own an additional four shares.

If, instead, you want cash, then you’d receive $200 to spend or save, and you’d still have the initial 20 shares of the stock.

Pros and Cons of DRIPs

If you’re wondering, should I reinvest dividends?, it’s a good idea to weigh the advantages and disadvantages of DRIPs. But note, too, that some of the pros and cons may be specific to one of the two types of DRIPs: Those offered through a company, and those through a brokerage.

Pros of Dividend Reinvestment Plans

On the “pros” side, one reason to reinvest your dividends is that it may help to position you for potentially greater long-term returns, thanks to the power of compounding returns, which may hold true whether investing through a company-operated DRIP, or one through a brokerage.

Generally, if a company pays out the same level of dividends each year — whether that’s 2%, 3%, or another amount — and you take your dividends in cash, then you’ll keep getting the same amount in dividends each year (assuming you don’t buy any additional shares).

But if you take your dividends and reinvest them through a DRIP, then you’ll have more shares of stock next year, and then more the year after that — which means, ideally, that the dollar amount of the dividends (at least in our example where the payout percentage is the same each year) will keep rising. Over a period of time, the amount you would receive during subsequent payouts could increase.

An important caveat, however: Real-life situations aren’t often as straightforward as this example, of course. For one thing, stock prices aren’t likely to stay exactly the same for an extended period of time.

Plus, there’s no guarantee that dividends will be paid out each period; and even if they are, there is no way to know for sure how much they’ll be. The performance of the company and the general economy can have a significant impact on company profitability and, therefore, typically affect dividends given to shareholders.

There are more benefits associated with DRIPs:

• You may get a discount: Discounts on DRIP shares can be anywhere from 1% to 10%, depending on the type of DRIP (company-operated) and the specific company.

• Zero commission: Most company-operated DRIP programs may allow you to buy new shares without paying commission fees. However, many brokerages offer zero-commission trading outside of DRIPs these days, too.

• Fractional shares: DRIPs may allow you to reinvest into fractional shares, rather than whole shares that may be at a pricier level than you wish to purchase. This may be an option with either a company-operated or brokerage-operated DRIP.

• Dollar-cost averaging: This is a common strategy investors use to manage price volatility. You invest the same amount of money on a regular basis (every week, month, quarter) no matter what the price of the asset is.

Cons of Dividend Reinvestment Plans

Dividend reinvestment plans also come with some potential negatives.

• The cash is tied up. First, reinvesting dividends obviously puts that money out of reach if you need it, which may be particularly true for company-operated DRIP plans. That can be a downside if you want or need the money for, say, home improvements, a tuition bill, or an upcoming vacation.

• Risk exposure. You should also keep potential risk factors in mind. For example, you may have concerns about the stock market in general, or about the particular company where you’re a shareholder, and reinvesting your cash into more equities may seem unwise.

Or you may need to rebalance your portfolio. If you’ve been reinvesting your dividends, and the stock portion of your portfolio has grown, using a DRIP could inadvertently put your allocation further out of whack.

• Flexibility concerns. Another possible drawback to consider is that when your dividends are automatically reinvested through a DRIP, they will go right back into the company that issued the dividend. Though some company-operated DRIPs do give investors options (such as full or partial reinvestment), some investors may find that those DRIPs offer limited options as to where to reinvest their funds.

Perhaps you’d simply rather buy stock from another company – an option which may be available through a brokerage-operated DRIP. Note, though, that even brokerage-operated DRIPs may reinvest dividends as soon as they’re paid, so investors may not have a chance to redirect the investment.

• Less liquidity. Also, when you use a company-operated DRIP, and later wish to sell those shares, you must sell them back to the company in many cases. DRIP shares cannot be sold on exchanges. Again, this will depend on the specific company and DRIP, but is something investors should keep in mind.

💡 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.

Cash vs Reinvested Dividends

Should I reinvest dividends or take cash instead? How you approach this question can depend on several things, including:

• Your short-term financial goals

• Long-term financial goals

• Income needs

Accepting the cash value of your dividends can provide you with ongoing income. That may be important to you if you’re looking for a way to supplement your paychecks during your working years, or for other income sources if you’re already retired.

As mentioned earlier, you could use that cash income to further a number of financial goals. For instance, you might use cash dividend payouts to pay off debt, fund home improvements or put your kids through college. Or you may use it to help pay for long-term care during your later years.

You might consider a cash option for dividends rather than reinvesting dividends if you’re already building sufficient wealth for retirement in your portfolio. That way, you can free up the cash now to enjoy it or address other current priorities.

Cash may also be more attractive if you’re comfortable with your current portfolio configuration and don’t want to purchase additional shares of the dividend stocks you already own.

On the other hand, reinvesting dividends automatically through a DRIP could help you to increase your savings for retirement. This assumes, of course, that your investments perform well and that the stocks you own don’t decrease or eliminate their dividend payout over time.

Tax Consequences of Dividends

For those wondering, do you have to pay taxes on reinvested dividends?, one thing to keep in mind is that dividends — whether you cash them out or reinvest them — are not free money. There may be tax consequences when you receive dividends because if the amount is significant enough, you might need to pay income taxes on what you’ve earned.

Each year, you’ll receive a tax form called a 1099-DIV for each investment that paid you dividends, and these forms will help you to determine how much you owe in taxes on those earnings.

Dividends are considered taxable whether you take them in cash or reinvest them — even though when you reinvest, the money isn’t currently available for you to spend.

The exception to that rule is for funds invested in retirement accounts, such as an online IRA, as the money invested in these accounts is tax-deferred. If you have received or believe you may receive dividends this year, it can make sense to get professional tax advice to see how you can minimize your tax liability.

Should You Reinvest Dividends?

Reinvesting dividends through a dividend reinvestment plan is partly a short-term decision, and mostly a long-term one.

If you need the cash from the dividend payouts in the near term, or have doubts about the market or the company you’d be reinvesting in (or you’d rather purchase another stock), you may not want to use a DRIP.

If on the other hand you don’t have an immediate need for the cash, and you can see the value of compounding the growth of your shares in the company over the long haul, reinvesting dividends could make sense.

The Takeaway

Reinvesting dividends and using a dividend reinvestment plan (DRIP) is an automatic feature investors can use to take their dividend payouts and use them to purchase more shares of the company’s stock. However, it’s important to consider all the scenarios before you decide to surrender your cash dividends to an automatic reinvestment plan.

While there is the potential for compound growth, and using a DRIP may allow you to purchase shares at a discount and with no transaction fees, these dividend reinvestment plans are limiting. You are locked into that company’s stock during a certain market period, and even if you decided to sell, you wouldn’t be able to sell DRIP shares on any exchange but back to the company. Whether you use a DRIP or not, you may want to consider having some dividend-paying stocks as part of a balanced portfolio in your investment account.

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

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

FAQ

How do you set up a dividend reinvestment plan?

There are two ways to set up a dividend reinvestment plan. First, you can set up an automatic dividend reinvestment plan with the company whose stock you own. Or you can set up automatic dividend reinvestment through a brokerage. Either way, all dividends paid for the stock will automatically be reinvested into more shares of stock.

Can you calculate dividend reinvestment rates?

There is a very complicated formula you can use to calculate dividend reinvestment rates, but it’s typically much easier to use an online dividend reinvestment calculator instead.

What is the difference between a stock dividend and a dividend reinvestment plan?

A stock dividend is a payment made from a company to its shareholders (people who own shares of their company’s stock). A dividend reinvestment plan allows investors to reinvest the cash dividends they receive from their stocks into more shares of that stock.

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

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

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

SoFi Invest®

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

May

2024

American Option vs European Options: Key Differences

American Option vs European Option: What is the Difference?

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

Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.

Two of the most popular types of options are American and European. American and European options have a lot in common, but there are some key differences that are important for investors to understand.

Key Points

• American options offer the flexibility to exercise the buy or sell right on any trading day before expiration.

• European options can only be exercised on the expiration date, limiting flexibility.

• American options are often traded on exchanges, while European options are typically traded over-the-counter.

• The pricing of American options usually includes higher premiums due to their increased flexibility.

• European options are generally less expensive and settle in cash, often related to indices rather than specific stocks.

Options Basics

One of the reasons investors like options trading is that it provides the right, but not the obligation to the buyer, to buy an asset. Making the choice to buy (call) or sell (put) is known as exercising the option.

Like all derivatives, the value of options reflects the value of an underlying asset. The value of an option changes as its expiration approaches and according to the price of the underlying asset. Investors using a naked option trading strategy may not have the cash or assets set aside in their portfolio to meet the obligations of the contract.

If the value of the contract or the underlying asset doesn’t increase, the investor would choose to let it expire and they lose only the premium they paid to enter into the contract. Both put and call options contracts include a predetermined price to which the buyer and seller agree, and the contract is valid for a specified period of time.

After the contract ends on the expiration date, so does the option holder’s ability to buy or sell. There are many different options trading strategies that investors can use.

Recommended: Call vs Put Option: The Differences

What Are American Options?

America options are the most popular, with both retail investors and institutional investors using them. One of the reasons for their popularity is their flexibility. Traders can exercise their right to buy or sell the asset on any trading day during the term of the agreement.

Most often, American stock options contracts have an expiration period between three and twelve months.

American Option Example

Say an investor purchases an American call in March with a one-year expiry date. The contract states that the investor has the option to purchase stock in Company X for $25 per share. In options terminology, $25 would be known as the option’s strike price. As the price of the underlying stock asset changes, the value of the option also changes.

After the investor purchases the American call options, the value of the stock increases. Within a few months the price was $50. The investor decides to exercise their option to buy, purchasing 100 shares of the stock at the agreed upon strike price of $25/share, paying a total of $2,500. The investor then sells the shares at the current market price of $50/share, making a profit of $2,500 because their value had doubled, not including the premium paid.

Investors can also buy put options, which give them the right to sell instead of the right to buy. With put options the scenario is reversed in that the investor would exercise their right to sell if the asset decreased in value.

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*Check out the
OCC Options Disclosure Document.

What Are European Options?

European options are similar to American options, but holders can only exercise them on the expiration date (not before), making them less flexible.

European Options Example

Let’s say an investor purchases a European call option for 100 shares of Company X with a strike price of $25 and an expiration date six months from the time of purchase. Three months after the contract starts, the price of the stock increases to $50/share. The investor can’t exercise the right to buy because the contract hasn’t reached the expiration date.

When the option holder is able to exercise three months later, the stock is down to $30/share. So the investor can still exercise the option and make a profit by purchasing 100 shares at $25 and selling them for $30. The investor would also need to subtract the upfront premium they made, so this scenario wouldn’t be nearly as profitable as the American option scenario.

This is why European options are not as valuable or popular as American options. Options pricing reflects this difference. The premium, or price to enter into a European option contract is lower. However, traders can sell their European options at any point during the contract period, so in the example above the trader could have sold the option for a profit when the stock price went up to $50/share.

American Style Options vs European Style

American and European options are similar in that they have a set strike price and expiration date. But there are several key differences between American and European options. These include how they’re traded, associated premiums, and more.

Trading

One main difference between American and European options is traders typically buy and sell European options over-the-counter (OTC) and American options on exchanges.

Recommended: What Is the Eurex Exchange?

Premiums

American options typically have higher premiums than European options since they offer more flexibility. If the investor doesn’t exercise their right to buy or sell before the contract expires, they lose the premium.

Settlement

European options tend to relate to indices, so they settle in cash. American options, on the other hand, typically relate to individual stocks or exchange-traded funds and can settle in stock or cash.

Settlement Prices

With American options, the settlement price is the last closing trade price, while with European options the settlement price is the opening price of index components.

Volume

American options typically have a much higher trading volume than European options.

Exercising Options

Traders can only exercise European options at the expiration date, while they can exercise American options at any point during the contract period. Traders can sell either type of option before its expiration date.

Pricing Models

A popular pricing model for options is called the Black-Scholes Model. The model is less accurate for American options because it can’t consider all possible trading dates prior to the expiration date.

Underlying Assets

The underlying assets of most American options are related to equities, European options are typically pegged to indices.

Risks of Americans and European Options

American options are riskier to an options seller because the holder can choose to exercise them at any time.

For buyers, it’s easier to create a hedging strategy with European options since the holder knows when they can exercise their right to buy or sell. Day traders and others who invest in options realize that there are risks involved with all investing strategies, along with potential reward.

The Takeaway

Options are one commonly traded type of investment, and many traders use them to execute a trading strategy. However, it’s possible to build a portfolio without trading options as well. If you have questions about how options may fit into your investment strategy, it may be a good idea to speak with a financial professional.

Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.

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

Photo credit: iStock/AleksandarNakic

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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May

2024

What Is 401(k) Auto Escalation?

By Austin Kilham | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off

One way to ensure you’re steadily working toward your retirement goals is to automate as much of the process as possible. Some employers streamline the retirement savings process for their employees with automatic enrollment, signing you up for a retirement plan unless you choose to opt out.

There are many ways to automate a 401(k) experience at every step of the way. You can have contributions taken directly from your paycheck before they ever hit your bank account and invest them right away. With automatic deductions, you’re more likely to save for your future rather than spending on immediate needs.

In some cases, you may also be able to automatically increase the amount you save. Some employers also offer a 401(k) auto escalation option that could increase your retirement savings amount as you get older. Here’s a closer look at how 401(k) auto escalation works and how it may help you on your way to your retirement goals.

Key Points

• 401(k) auto escalation automatically increases contributions at regular intervals until a preset maximum is reached.

• The SECURE Act allows auto escalation up to 15% of an employee’s salary.

• Auto escalation helps employees save more for retirement without needing to adjust contributions manually.

• Employers benefit from auto escalation by attracting and retaining talent and possibly reducing payroll taxes.

• Employees should assess if auto escalation aligns with their financial capabilities and retirement goals.

401(k) Recap

A 401(k) is a defined contribution plan offered through your employer. It allows employees to contribute some of their wages directly from their paycheck. Contributions are made with pre-tax money, which may reduce taxable income in the year they are made, providing an immediate tax benefit.

In 2024, employees can contribute up to $23,000 a year to their 401(k), up from $22,500 in 2023. Those aged 50 and older can contribute an extra $7,500, bringing their potential contribution total to $30,500 in 2024 and $30,000 in 2023.

For many individuals, the goal is to eventually max out a 401(k) up to the contribution limit. Employers may offer matching funds to help encourage employees to save. Individuals should aim to contribute at least enough to meet their employer’s match, in order to get that “free money” from their employer to invest in their future.

💡 Quick Tip: Did you know that you must choose the investments in your IRA? Once you open an IRA account and start saving, you get to decide which mutual funds, ETFs, or other investments you want — it’s totally up to you.

How 401(k) Auto Escalation Works

An auto escalation is a 401(k) feature that automatically increases your contribution at regular intervals by a set amount until a preset maximum is achieved. The SECURE Act, signed into law in 2019, allows auto escalation programs to raise contributions up to 15%. Before then, the cap on default contributions was 10% for auto escalation programs.

For example, you may choose to set your auto escalation rate to raise your contributions by 1% each year. Once you hit that 15% ceiling, auto escalation will cease. However, you can still choose to increase the amount you are saving on your own beyond that point.

Advantages of 401(k) Auto Escalation

When it comes to auto escalation programs, there are important factors to consider — for employees as well as for employers who sponsor the 401(k) plan.

Advantages for Employees

• Auto escalation is one more way to automate savings for retirement, so that it is always prioritized.

• Auto escalation may increase the amount employees save for retirement more than they would on their own.

• Employees don’t have to remember to make or increase contributions themselves until they reach the auto escalation cap.

• Increasing tax-deferred contributions may help reduce an employee’s tax burden.

Advantages for Sponsors

Employers who offer auto escalation may find it helps with both employee quality and retention as well as with reducing taxes.

• Auto escalation provides a benefit that may help attract top talent.

• It helps put employees on track to automatically save, which may increase retention and contribute to their sense of financial well-being.

• It reduces employer payroll taxes, because escalated funds are contributed pre-tax by employees.

• It may generate tax credits or deductions for employers. For example, matching contributions may be tax deductible.

• As assets under management increase, 401(k) companies may offer lower administration fees or even the ability to offer additional services to participants.

Disadvantages of 401(k) Auto Escalation

While there are undoubtedly benefits to 401(k) auto escalation, there are also some potential downsides to consider.

Disadvantages for Employees

Even on autopilot, it can be important to review contributions so as to avoid these disadvantages.

• Auto escalation may lull employees into a false sense of security. Even if they’re increasing their savings each year, if their default rate was too low to begin with, they may not be saving enough to meet their retirement goals.

• If an employee experiences a pay freeze or hasn’t received a raise in a number of years, auto escalation will mean 401(k) contributions represent an increasingly larger proportion of take-home pay.

Disadvantages for Sponsors

Employers may want to consider these potential downsides before offering 401(k) auto escalation.

• Auto escalation requires proper administrative oversight to ensure that each employee’s escalation amounts are correct — and it may be time-consuming and costly to fix mistakes.

• This option may increase the need to communicate with 401(k) record keepers.

• Auto escalation may cause employer contribution amounts to rise.

Is 401(k) Auto Escalation Right for You?

If your employer offers auto escalation, first determine your goals for retirement. Consider whether or not your current savings rate will help you achieve those goals and whether escalation could increase the likelihood that you will.

Also decide whether you can afford to increase your contributions. Perhaps your default rate is already set high enough that you are maxing out your retirement savings budget. In this case, auto escalation might land you in a financial bind.

However, if you have room in your budget, or you expect your income to grow each year, auto escalation may help ensure that your retirement savings continue to grow as well.

If your employer does not offer auto escalation, or you choose to opt out, consider using pay raises as an opportunity to change your 401(k) contributions yourself.

The Takeaway

A 401(k) is one of many tools available to help you save for retirement — and auto escalation can help you increase your contributions regularly without any additional thought or effort on your part.

If you’ve maxed out your 401(k) or you’re looking for a retirement account with more flexible options, you might want to consider a traditional or Roth IRA. Both types of IRA offer tax-advantaged retirement savings, and in 2024, individuals can contribute $7,000 per year across IRA accounts, with an extra $1,000 catch-up contribution available to those aged 50 and older. In 2023, individuals can contribute $6,500 per year across IRA accounts, with an extra $1,000 catch-up contribution available to those aged 50 and older.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Help grow your nest egg with a SoFi IRA.

FAQ

Is 401(k) auto enrollment legal?

Yes, automatic enrollment allows employers to automatically deduct 401(k) contributions from an employee’s paycheck unless they have expressly communicated that they wish to opt out of the retirement plan.

What is automatic deferral increase?

Automatic deferral increase is essentially the same as auto escalation. It automatically increases the amount that you are saving by a set amount at regular intervals.

Can a company move your 401(k) without your permission?

Your 401(k) can be moved without your permission by a former employer if the 401(k) has a balance of $5,000 or less.

Photo credit: iStock/Halfpoint

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

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May

2024

What Is a Stock Split? How Does It Affect Investors?

By Michael Flannelly | Growing Wealth, invest, Investing | No Comments

Table of Contents

What is a Stock Split?
Types of Stock Splits
Why Do Companies Conduct Stock Splits?
Pros and Cons of Stock Splits
Examples of Stock Splits Throughout History
What Happens When A Stock You Own Splits?

A skyrocketing share price is usually a good thing for a company; investors expect the company to continue growing in the future. However, a stock trading with a hefty price tag may frighten away smaller investors, who may perceive the stock as too rich for their blood. That means many investors might pass over the company’s stock for other stocks with a lower per share price tag.

To combat this, a company may conduct a stock split. This action brings down the price of the company’s stock so that shares look more attractive to more investors, even though the company’s value remains the same. The idea is that investors can invest, and the company gets more marketability and liquidity on the stock market.

Learn more about a stock split and how it works.

Key Points

• A stock split is when a company increases the number of its outstanding shares on the stock market, lowering the price per share.

• Stock splits can make shares more affordable to retail investors and increase liquidity in the market.

• There are different types of stock splits, including forward stock splits and reverse stock splits.

• Companies conduct stock splits to make their stock more accessible and increase marketability.

• Stock splits can have pros such as increased accessibility and liquidity, but also cons such as potential expenses and dilution of ownership.

What Is a Stock Split?

A stock split is when a company increases the number of its outstanding shares on the stock market, which lowers the price of its shares, but its market capitalization (sometimes referred to as market cap) stays the same. This is also known as a forward stock split.

For example, if an investor owns 10 shares of a company with a stock price of $100 and the company announces a 5-to-1 stock split, the investor will then own 50 shares of the stock trading at $20 per share after the stock split. Despite the split, the shareholder still owns $1,000 worth of stock.

A stock split may also be referred to as a one-time stock dividend, since the company is giving out additional shares to stockholders.

What Is a Reverse Stock Split?

In a reverse stock split, a company swaps each outstanding share of the company’s stock for a fraction of a share. A company often conducts a reverse stock split when the share price is low and the company is looking to increase the share price.

For example, in late July 2021, General Electric (GE) completed a 1-for-8 reverse split of its shares to boost the stock’s share price. The reverse split increased its share price from less than $13 pre-split to more than $100 post-split; the company replaced every eight shares held by an investor with one share.

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Types of Stock Splits

A number of different ratios can be used to split a stock. When the bigger number comes first in the ratio (such as 2 for 1) it means that the number of outstanding shares will increase—this is a forward stock split. In other words, the stock split ratio can reveal the number of new shares that will be created.

Here are some common stock split types and what they mean.

5 for 1 (5:1)

With a 5 for 1 stock split, for every one share of stock that currently exists, four new shares will be created, for a total of five shares. The share price will adjust downward accordingly, but the company’s market capitalization will stay the same.

2 for 1 (2:1)

In a 2 for 1 stock split, one new share of stock is created for every share that already exists, for a total of two shares. Again, the price for each share will adjust accordingly. A 2 for 1 stock split is one of the most common stock splits.

3 for 1 (3:1)

With a 3 for 1 split, for every share of existing stock, two more shares of stock are created, for a total of 3 shares.

3 for 2 (3:2)

Another fairly common stock split is the 3 for 2 split. In this case, one new share of stock is created for two already-existing shares, for a total of three shares.

Why Do Companies Conduct Stock Splits?

Companies will often split their stock when the share price gets too high. By splitting the stock, a company lowers its share price and makes it more affordable to retail investors, even though the company’s value stays the same.

For example, retail investors may be more likely to buy a chunk of shares of a stock trading at $20 rather than shares trading at $100 or more. This move to reduce the individual share price helps increase the stock’s liquidity in the market.

Pros and Cons of Stock Splits

There are several potential benefits of stock splits, but there are some possible disadvantages of the practice as well.

Pros

Some advantages of a stock split include:

The stock may become more accessible to more investors.

If a stock’s price is very high, smaller investors may be less likely to buy it. Splitting the stock and making it more affordable can result in more investors purchasing the stock.

The stock may have greater liquidity.

Creating more outstanding shares of the stock can make it easier to buy and sell it. For many investors, greater liquidity means they can more readily access their money by selling the stock if they need the funds. Liquidity is typically an important consideration when building a portfolio.

The stock’s price may rise.

Companies that undergo a stock split often do so because their stock price is rising, signaling investor confidence in the company. So, the announcement of a stock split is an indication that the company is doing well. Investors may want to put money into the company, pushing the share price up even before the stock split.

Following the stock split, the stock’s share price may go up because the lower price makes it more affordable to smaller retail investors that may not be able to purchase shares at, say, a $1,000 price. There becomes an increased demand for the lower share price.

Cons

Stock splits can also have drawbacks, such as:

Expensive and complicated.

In order to conduct a stock split, a company must get legal oversight of the process and meet regulatory requirements, which can be costly. A stock split does not change the company’s market cap, so the company must determine whether a split is worth the expense involved.

May attract too many investors.

A company may prefer to keep ownership of its shares exclusive. However, with a stock split, many more investors may be able to afford to buy the stock, meaning the shares would lose their exclusive equity ownership.

Potential for the share price to drop in the future.

It’s possible that once a stock is split and its share price is reduced, the price might drop even lower in the future, which lowers the value of the stock. For instance, if a company’s performance suffers, the face value of the stock might drop more in response.

Examples of Stock Splits Throughout History

Here are some notable stock splits from the last couple of decades:

• Apple (AAPL): The computer giant split its stock by a 4-to-1 ratio in August 2020. Prior to the split, the stock was trading at around $500. After the split, the stock traded at about $124.

• Netflix (NFLX): The entertainment company announced a 7-to-1 stock split in July 2015. Before the split, the stock was trading at nearly $800 per share. After the split, the stock traded at about $114.

• Nike (NKE): The sports apparel company split its stock by a 2-to-1 ratio in December 2015. Prior to the split, the stock was trading at around $128 per share. After the split the stock traded at about $64 per share.

• Nvidia (NVDA): The technology company engaged in a 4-to-1 stock split in July 2021. Before the split, Apple’s stock was trading at around $750, and after the split, the shares were priced near $187.

• Tesla (TSLA): The electric car manufacturer split its stock by a 5-to-1 ratio in August 2020. Before the split, the stock was trading at around $2,200. After the split, the stock traded at around $440. Tesla’s shares rallied during the next two years, so the company declared a 3-to-1 stock split in August 2022, bringing the stock price down to around $300 from nearly $900 per share.

💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.

What Happens When a Stock You Own Splits?

If an investor owns stock in a company that announces a split, it will not materially affect the investment. As mentioned above, if an investor owns $1,000 worth of stock and a company splits its stock, an investor will still own $1,000 worth of stock after the split.

The additional shares at the lower share price will be automatically added to an investor’s account by the broker.

A stock split does not dilute the ownership of existing shareholders like a new stock issue may do. After a stock split, an investor still owns the same percentage of the company.

Recommended: Understanding Stock Dilution

The Takeaway

When a company announces a stock split, it can be tempting for investors to buy the stock because it will be more affordable on a per share basis. However, investors should be wary of making rash decisions simply because a stock may look more affordable and attractive. After all, the value of the company is still the same.

For most investors, it’s wise to make financial decisions that line up with their long-term investment and wealth-building goals, regardless of a stock’s price tag.

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FAQ

Are stock splits a good thing?

Generally, a stock split is considered to be a good thing. It typically happens when the price of a company’s stock is high. The high price and value of the stock tends to be a positive sign reflecting that the company is doing well. Splitting the stock may encourage more investment in it, which could then drive up the price of the stock and be beneficial.

Do stocks do better after a split?

It is possible that a stock might do better after a split, but this isn’t always the case. The stock may be bought by more investors, which could drive up its share price. But even after a stock split, the company’s market capitalization doesn’t change. And it’s possible that a stock could drop in price after a split.

Is a stock split bullish or bearish?

A forward stock split, in which more shares of stock are created, is generally considered bullish, since it typically indicates that the company is performing well. However, a reverse stock split, which reduces the total number of shares of a stock, is usually considered bearish, since it may indicate that a company has underperformed.

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.

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

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Private Credit vs. Private Equity: What’s the Difference?

What Does Private Credit and Private Equity Mean?

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Dividend Reinvestment Plans: How DRIP Investing Works

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Cash vs Reinvested Dividends

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Should You Reinvest Dividends?

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American Option vs European Option: What is the Difference?

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What Is 401(k) Auto Escalation?

401(k) Recap

How 401(k) Auto Escalation Works

Advantages of 401(k) Auto Escalation

Advantages for Employees

Advantages for Sponsors

Disadvantages of 401(k) Auto Escalation

Disadvantages for Employees

Disadvantages for Sponsors

Is 401(k) Auto Escalation Right for You?

The Takeaway

FAQ

Is 401(k) auto enrollment legal?

What is automatic deferral increase?

Can a company move your 401(k) without your permission?

What Is a Stock Split? How Does It Affect Investors?

What Is a Stock Split?

What Is a Reverse Stock Split?

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