What is an index fund? A low-cost, low-risk way to invest in the stock market

index funds1
Index funds suit investors with a long-term time horizon and a preference for a passive, buy-and-hold strategy.

  • Index funds are financial vehicles that pool investors’ money into a portfolio of securities that mirror a particular market index.
  • Because they are passively managed, index funds have low fees.
  • Diversified by design, index funds are relatively low-risk, but their gains tend to be slow as well.
  • Visit Insider’s Investing Reference library for more stories.

An index fund is a type of financial vehicle that pools investors’ money to purchase a portfolio of stocks, bonds, or other securities. This portfolio is designed to mimic a particular financial market index – a select group of securities.

An index fund can be structured as either a mutual fund or as an exchange-traded fund (ETF). The term “index fund” applies to either, but it’s often used synonymously with an ETF, since so many ETFs are index-tracking instruments.

Index funds differ from other funds on the basis of their investment strategy. This strategy is to follow its benchmark, or designated market index – generally, a broad-based one that tends to perform well over time.

There are many different indexes tracking different sectors of the market. Along with the well-known S&P 500, others include:

  • Dow Jones Industrial Average (DJIA), which is made up of 30 large-cap companies
  • Russell 2000 (RUT), which consists of 2,000 small-cap stocks
  • Bloomberg Barclays US Aggregate Bond Index, (LBUSTRUU), which consists of bonds
  • MSCI EAFE (MXEA), which is made up of foreign stocks
  • New York Stock Exchange Composite Index (NYA), which includes all common stocks listed on the NYSE

How index funds work

When you invest in an index fund, you’re buying shares in all the companies that make up the index. Most index funds are weighted by market capitalization – the total dollar market value of a company’s shares. That means that these funds usually purchase more of the largest companies in the index than of the smallest companies.

The composition of the benchmark index determines the trading decisions of an index fund. By design, true index funds must follow their index. That means there is no room for fund managers to make decisions about which trades to make. Rather than actively picking stocks, they are practicing passive management.

Index funds are also referred to as “passive funds” or “passively managed funds.”

Some funds, called “active index funds,” largely follow an index but also allow the fund manager to choose to buy certain other individual stocks or sell others.

These are not true index funds because they do not necessarily follow an index. Over time, the portfolio of these funds may differ significantly from the index the fund purportedly follows.

Benefits of index funds

Many investors, especially beginners, prefer index funds to invdividual stocks for plenty of reasons. The main benefits of index funds include:

1. Diversification means you’ll usually win.

Up to 90% of active fund managers underperform compared to their benchmark index (that is, the segment of the market they loosely follow).

And if a problem for the pros, imagine what it’s like for the amateur investor. “Trying to pick winners, for most, is a loser’s game,” says Robert R. Johnson, Professor of Finance at Creighton University. “The solution is to invest in diversified funds.”

An index fund provides you with a diversified portfolio of stocks that, as a group, usually do well over time. For example, the Vanguard 500 Index Fund (the one that started it all) has seen a 5-year average return of 11%.

2. They are cost-effective

Diversification can be expensive to pursue by yourself with individual investments. Index funds offer more bang for the buck – a single purchase into its pooled portfolio makes your diversification more cost-effective. Some funds have minimums as low as $1.

3. They are passively managed

Many casual investors aren’t interested in managing their investment; they just want to steadily grow their money. Index funds don’t require any decisions, so they’re great for hands-off investors.

4. They have the lowest costs and fees

Index fund managers don’t make many investment decisions, so they don’t need to hire researchers or analysts. Those cost savings are passed on to investors through lower management fees and costs. The average expense ratio of an index fund is around 0.49% and some are as low as 0.03%.

Disadvantages of index funds

Index funds also come with disadvantages and risks:

1. They’re not great for short-term gains

A diversification strategy limits how much you lose if a single stock tanks, but it also limits your opportunities to gain on well-performing stocks. That’s why index funds don’t see the big upswings that some investors are hoping for.

If you’re looking to speculate on a skyrocketing star, you’ll want another type of product (perhaps penny stocks).

2. They’re vulnerable to the market

By their nature, index funds are tied to their index. If the benchmark is dropping, so will the value of your index fund investment.

And management’s hands are tied. “Index portfolio managers typically can’t deviate from the index holdings-even to take advantage of trends or market mispricings,” says Tricia Rosen, Principal at Access Financial Planning. And they can’t exclude holdings that are over-valued, either.”

3. They may not be as diversified as they appear

Brian Berkenhoff of Birch Investment Management notes that “an investor who has $1,000,000 in an S&P 500 index fund would seem to be diversified by owning 500 stocks. However, because most index funds weight investment by market capitalization, $220,000 of that might be invested in just five companies.”

Case in point: The top five companies in the S&P 500 are Apple, Microsoft, Amazon, Facebook, and Alphabet – all players in the tech sector. So if that sector tanks….

Before you invest in index funds

Rosen suggests that anyone considering an index fund should read the fund’s prospectus to understand:

  • What index the fund follows. There are many different indexes and some funds use a blend of indexes.

  • How rigidly the fund follows the index. True index funds rigidly follow the index, but some allow portfolio managers to deviate from the index to try to increase returns.

  • The fund’s fees and expense ratio. Typically these are low. But they may be higher in funds where the portfolio manager is allowed to do more active trading.

The financial takeaway

Index funds are popular because they are a low-risk, low-maintenance, low-cost way to see steady returns over time. But no investment is one-size-fits-all. To see if they suit you, ask yourself:

  • Am I looking to invest for the future? Index funds are best suited for investors with a long-term horizon: While the market historically rises over time, you do need time to weather the bumps..
  • Am I the buy-and-hold type? Index funds are ideal for those who aren’t interested in picking stocks.
  • Am I comfortable with slow gains? Index funds typically perform better than actively managed funds over time, but gains are usually moderate. Actively managed funds can sometimes see higher returns in the short-term.

Any investment has some risk attached to it, of course. But index funds rank fairly low on the risk spectrum – and are certainly more cost-effective than trying to buy stocks on your own.

“Investors simply can’t afford to make oversized bets on individual securities,” says Johnson. “Investing in a broadly diversified basket of securities is a more prudent strategy.”

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Passive investing is a long-term wealth-building strategy all investors should know – here’s how it works

passive investing
Passive investors rarely trade, but prefer to buy and hold their investments with an eye towards long-term growth and faith that stocks ultimately go up.

  • Passive investing is a long-term strategy in which investors buy and hold a diversified mix of assets in an effort to match, not beat, the market.
  • The most common passive investing approach is to buy an index fund, whose holdings mirror a particular or representative segment of the financial market.
  • Passive investing is the opposite of active investing, a more vigorous strategy offering bigger short-term gains, but greater risk and volatility.
  • Visit Insider’s Investing Reference library for more stories.

If you can’t beat ’em, join ’em.

That, in a nutshell, is the mantra of passive investing. This popular investment strategy doesn’t try to outperform or “time” the stock market with a constant stream of trades, as other strategies do. Instead, passive investing believes the secret to boosting returns is by doing as little buying and selling as possible.

Passive investing, also known as passive management, may be laissez-faire – but it’s not lazy. Its thoughtful, time-honored philosophy holds that, while the stock market does experience drops and bumps, it inevitably rises over the long hauls.

So, rather than try to outsmart it, the best course is to mirror the market in your portfolio – usually with investments based on indexes of stocks – and then sit back and enjoy the ride.

Simple to understand and easy to execute, passive investing has become the go-to approach for many investors. Here’s how to join them.

What is passive investing?

The essence of passive investing is a buy-and-hold strategy, a long-term approach in which investors don’t trade much. Instead, they purchase and then hang onto a diversified portfolio of assets – usually based on a broad, market-weighted index, like the S&P 500 or the Dow Jones Industrial Average. The goal is to replicate the financial index performance overall – to match, not beat, the market.

Perhaps the most common passive investing approach is to buy an index fund tied to the market. These sorts of funds are often known as passively managed, or passive, funds. The underlying holdings in passive funds can be stocks, bonds, or other assets – whatever makes up the index being tracked.

If the index replaces some of the companies included in it, then the index fund automatically adjusts its holdings, selling the old stocks and purchasing the new ones. Thus, investors profit by staying the course and benefiting from the market increases that happen over time.

Typically, index funds specialize in such areas as equities, fixed income, commodities, currencies, or real estate. Choosing different types of funds depends on the investor’s desire for income or growth, risk tolerance, and needs to balance the portfolio.

Fixed-income bond funds generally act as a counterbalance to growth stocks’ volatility, for example, while foreign currency funds can help provide a hedge against the depreciation of the US dollar.

Key features of passive investing

The ultimate goal of passive investing is to build wealth gradually, as opposed to making a quick killing. Key characteristics of a passive strategy include:

  • Optimistic outlook. The core principle underlying passive investing strategies is that investors can count on the stock market going up over the long haul. By mirroring the market, a portfolio will appreciate along with it.
  • Low costs. Thanks to its slow and steady approach and lack of frequent trading, transaction costs (commissions, etc.) are low with a passive strategy. While management fees charged by funds are unavoidable, most ETFs – the passive investor’s vehicle of choice – keep charges well below 1%.
  • Diversified holdings. Passive strategies also inherently provide investors with an efficient, inexpensive route to diversification. That’s because index funds spread risk broadly by holding a wide array of securities from their target benchmarks.
  • Less risk. By its very nature, diversification almost always brings with it less risk. Based on the funds they choose, Investors can also diversify their holdings further, within sectors and asset classes, with more targeted index funds.

Passive vs. active investing

An active investing strategy is the opposite of passive investing.

As the name implies, it means investors that engage in frequent or regular buying and selling, the better to outperform the market and profit from short-term changes in prices. Often, active investors attempt what’s called “market timing”: anticipating the stock market’s moves, and trading accordingly.

Active investing, or active management, also characterizes many mutual funds and, increasingly, some ETFs. These funds are run by portfolio managers who generally focus on various specialized areas – say, individual categories of stocks or industries with growth potential. They constantly are evaluating, picking, and trading their portfolios.

Actively managed funds allow investors to benefit from the expertise of financial professionals with a considerably deeper understanding of the market and access to economic and financial analysis.

But actively managed funds are pricey. Thanks to all that buying and selling, they involve lots of transaction costs and fees. The average expense ratio for an actively managed equity fund is 1.4% compared to .6% for a passive fund, according to Thomson Reuters Lipper.

Also, there’s the matter of risk: When managers seeking high returns bet correctly, the upside is big. If they don’t, then they, and their investors, are out of luck.

In fact, actively managed funds, when fees are taken into account, tend to underperform their passive counterparts, especially in the US. One reason is that managers have to outperform the fund’s benchmark index by enough to pay its expenses and then some. And that’s hard to do. For example, in 2019, 71% of large-cap U.S. actively managed equity funds lagged the S&P 500, according to theS&P Dow Jones Indices’ SPIVA (S&P Indices Versus Active) Scorecard.

Downsides to passive investing

While passive investing has a great many benefits, it has its drawbacks too.

  • Live by the benchmark, die by the benchmark. Index funds follow their benchmark index regardless of the state of the markets. Translation: They’ll rise when the index is performing well, and they’ll also drop when prices decline. And if the whole market goes into freefall…
  • Lack of flexibility. Even if index fund managers foresee a decrease in their benchmark’s performance, they typically can’t take such steps as cutting back on the number of shares they own, or take a defensive, counterbalancing position in other securities.
  • Fewer windfalls. Since passive funds are designed to mirror the market, investors are unlikely to experience the big coups that actively managed funds can sometimes provide. No catching that rising stock star, in other words. Even if a fund did, it might not benefit as much, since the returns would be mitigated by the other holdings in the portfolio.
  • Less pain but less gain. Buying and holding can be a winning tactic in the long run (at least a decade or two). You weather the market volatility. But evening out the risks also flattens out the rewards. In shorter time spans, active investing often provides better results and juicier gains.

A brief history of passive investing

Though buying and holding onto stocks is nothing new, passive investing as an official strategy first emerged in the 1970s with the creation of the first index fund for individual investors.

It was a new type of mutual fund, pioneered in 1976 by John C. Bogle, the then-CEO of investment company The Vanguard Group. Named the Vanguard 500 Index (VFINX), it allowed thousands of regular investors to buy shares in a fund that mirrored the S&P 500 – an index widely seen as a stand-in for the stock market overall. Priced cheaper than many mutual funds at the time, it enabled “the little guy” to have a stake in some of the market’s best companies, without the cost of buying them individually, and without much effort.

Other companies followed suit in offering index mutual funds. Then, in the 1990s came another innovation: exchange-traded funds (ETFs). They, too, were designed to track various indexes – and with even lower management fees than mutual funds. And also greater liquidity, since ETFs trade throughout the day on exchanges, like stocks themselves.

Cheap, diversified, and low-risk, they were tailor-made for a buy-and-hold strategy – and vice-versa. It was the advent of ETFs that really made passive investing part of the financial conversation, especially for retail investors.

The financial takeaway

Passive investing has become the strategy of choice for the average retail investor. It’s an easy, low-cost way to invest that removes the need to spend a lot of time researching stocks and watching the market.

The strategy’s core tenet is that, over the long haul, the market’s rise will reap financial benefits for those who wait. And that minimal trading yields maximum returns.

While the buy-and-hold approach has few downsides, it doesn’t suit everyone. Ultimately, passive investing is better tailored for investors with long-term objectives, such as saving for retirement, and who prefer being hands-off.

Conversely, investors who want more hands-on control over their portfolios, or haven’t got time for the waiting game, most likely aren’t a good fit for a passive strategy. If they want to try beating the market and are willing to pay bigger fees to do so, an active approach is the way for them to go.

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How to start investing in gold – and the major benefits and drawbacks to know about

gold bars
Gold is seen as a safe haven investment in uncertain times, a hedge against inflation and paper assets.

  • Individual investors can invest in gold in two ways: physical bullion (bars or coins), or securities (stocks, funds) that represent gold.
  • While bullion is a more direct, “pure” way to own gold, securities are easier to hold and can appreciate.
  • Analysts recommend investing 5 to 10% of your portfolio in gold, as a long-term inflation hedge and diversifier.
  • Visit Insider’s Investing Reference library for more stories.

Ah, gold. It’s rare, accepted everywhere, and governments can’t print it at will. These are the reasons that some folks – fondly known as “gold bugs” – have always invested heavily in the honey-hued metal. And in times of financial chaos, they’re not the only ones.

“History has shown that during economic slowdowns, from the Great Depression to the COVID-19 pandemic, gold appreciates in value,” says financial analyst James Jason of Mitrade, a commodities trading platform.

No matter what the state of the economy, gold offers a good way to diversify your assets. Many financial advisors recommend keeping anywhere from 5% to 10% of your portfolio in it – perhaps up to 15% in times of crisis.

Individuals have two main ways to invest in gold:

  • Physical gold, or bullion (the most obvious, but not necessarily the least expensive)
  • Gold securities such as stocks, funds, and futures (less of a pure play, but more convenient)

Let’s go digging into both.

How to invest in physical gold

Physical gold comes in many forms and sizes, each with its own characteristics and costs.

Gold bullion

Bullion often refers to gold in bulk form, usually bars or ingots. Typically, gold bars are poured and ingots are pressed (a cheaper production method). As a result, bars command a higher premium, or added cost, over the daily spot price of gold than ingots.

Ranging in size from quarter-oz. wafer to a 430-oz. brick, bars, and ingots are stamped with purity, origin, weight, and where the bullion was minted. Not all gold is equal, especially when it comes to purity and weight. Investment-grade gold is at least 99.5% pure.

Bullion bars and ingots are sold by banks and gold dealers. Banks often offer physical gold at a lower-markup than dealers but finding a branch that actually has it may be harder.

Gold coins

Minted coins are another common way to buy physical gold. Not to be confused with old rare coins that numismatists collect, these coins are new, minted by governments for investors. The prices they fetch are based on their gold content -aka their “melt value”- plus a 1%-5% premium.

Although several governments issue gold coins, for maximum liquidity, most buyers stick with the most widely circulated and recognized:

  • American Gold Eagle
  • Australian Gold Nugget
  • Canadian Maple Leaf
  • South African Krugerrand

Minted bullion coins are available from major banks, coin dealers, brokerage firms, and precious metal dealers.

Pros and cons of physical gold

For many people, the whole point of owning gold is to own the physical stuff. It’s the actual metal that has most of the inherent investment advantages.

Advantages of physical gold

  • Inflation hedge. Advocates argue that, as a tangible asset, gold maintains an intrinsic value that always reflects the cost of living. There’s an old saying that an ounce of gold equals the cost of a quality business suit. That held in 1934 when men’s suits fetched $35, and it does today too, with gold close to $2,000 an ounce (of course, that suit better be a Boglioli).
  • Counterweight to stocks. Like other commodities, gold acts as a counterfoil to equities, usually moving in the opposite direction of the stock market. Case in point: When the subprime mortgage meltdown began in 2008, ushering in the Great Recession, gold-which for years had been trading in the $400-600 range-shot up to $1,000 per ounce and kept going for the next three years.
  • Safe haven. Gold’s seen as a safe haven in uncertain times or whenever there’s socio-political turmoil. After the 2016 Brexit vote, its price rose over 10% in one month, for example. “Owning gold,” says Dennis Notchick, a certified financial planner at Stratos Wealth Advisors, “appeals to individuals who are concerned about the collapse of global markets or other threats to a government’s ability to back its currency.”
  • Virtually indestructible. “Physical gold cannot be hacked or erased,” says Charles Stevens, COO of Bullion Box Subscriptions. (Remember, we’re thinking in catastrophic terms here.) “Gold cannot be destroyed by a natural disaster and it will not get worn down in time.”

Drawbacks of physical gold

  • Expensive to hold. Storing gold at home carries enormous risks of theft or loss. Keeping it in a commercial facility incurs storage costs, often based on the size and value of the holdings (anywhere from .5% to 2%). If you’re not using a professional storage facility, you’ll want to insure your gold, too – another ongoing charge.
  • Illiquid. Physical gold can’t be sold with a press of the button or a call to a broker. Even with dealers acting for you, a sale can get days or weeks to settle, plus you have to arrange for shipping.
  • Does not produce income or profit. A $1,000 investment in bullion buys $1,000 – period. Physical gold doesn’t generate interest or dividends. The only potential for appreciation is if there’s a jump in prices that lets you sell at a profit (and even that can be compromised by the time, effort, and various assessment costs that accompany selling).

How to invest in gold securities

Given the hassles and limits of bullion, gold securities – in the form of stocks, funds, or options – are often a better choice, especially for novice investors.

They may not be as pretty, but they’re infinitely more practical:

Gold stocks

Buying shares of companies in the mining, refining, or other aspects of the gold production business is one way to play. About 300 of these companies, aka “miners,” are listed on major stock exchanges. Their share prices generally reflect the movement of the metal itself. However, “the growth and return in the stock depend on the expected future earnings of the company, not just on the value of gold,” notes the World Gold Council, an industry trade group.

Gold ETFs and mutual funds

More conservative investors can buy shares in gold-oriented mutual funds or exchange-traded funds (ETFs). These funds have varying investment approaches: gold-backed ETFs tend to invest directly in physical gold, while mutual funds favor gold mining stocks. Some funds invest in both. But all offer a liquid, low-cost entry into the gold market that is more diversified, and so lower-risk, than buying equities outright.

Gold options

More seasoned investors might consider an option on a gold futures contract. Like any financial option, these represent the right – but not the obligation – to buy or sell an asset (gold in this case) at a specific price during a specified window of time. You can buy an option to bet on whether gold’s going up or going down, and if the market moves the opposite way, all you’ve lost is the small amount you’ve paid for the option.

Gold options trade on a division of the Chicago Mercantile Exchange (CME) known as COMEX. Gold options can be bought on gold bullion or on gold ETFs.

Pros and cons of gold securities

Like any financial asset, gold securities have both benefits and drawbacks.

Advantages of gold securities

Along with some of the general benefits of gold ownership, securities offer:

  • Liquidity. Trading as they do on major exchanges, gold securities are obviously easier to buy and sell than bullion. No storage costs, either – aside from any management or account fees your broker or fund manager might charge.
  • Compounded returns. While dividends offered by miners are typically average at best, they are greater than no dividends at all, which is what you get from physical gold. And there is also the possibility of appreciation in the share price.
  • Low initial investment. The most cost-efficient way to invest in general, mutual funds and ETFs let you in on the game at a far lower cost. With the spot price of an ounce of gold around $2,000, $180 for a share of the SPDR Gold Shares ETF (GLD) – equal to 1/10th of an ounce of gold – is, well, spot on.

Drawbacks of gold securities

  • Volatility. Just as with any company, a miner’s operating costs, reserves, and management all play a factor in its performance. As a result, shares prices tend to be more volatile: If bullion sinks 10%, gold stocks often plummet 15%. Miners definitely “have a higher speculative aspect to them,” says investment strategist Lyn Alden, who follows precious metals and currencies.
  • Systematic risks. A gold mining company’s share performance also reflects in political and economic conditions in its native country. Some of the biggest operations are in Africa, Russia, and Latin America – places that have known their share of turbulence and are often avoided by socially responsible and institutional investors.
  • You don’t own gold. Gold securities are less of a pure play. They represent physical gold but you don’t have the right to redeem them for the actual metal. So they don’t provide the protection against a paper currency or financial market meltdown that the metal itself does.

The financial takeaway

So, should you go for the gold? Though it usually becomes part of the conversation during times of economic crisis or political uncertainty, gold as part of your portfolio makes sense anytime – as a diversifier of your holdings, if nothing else.

But how much to invest, and what form to invest in, depends on your own tolerance for risk and desire for convenience.

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The Sherman Antitrust Act is the first in a line of federal laws protecting consumers from unfair prices

Photo of a judge with a gavel in the foreground with chart overlay.
The Sherman Antitrust Act underpins the government’s enforcement efforts against anticompetitive practices.

  • The Sherman Act was the first antitrust law, signed by President Harrison in 1890 and was meant to preserve competition in the market and avoid monopolization.
  • Antitrust laws preserve market competition and protect consumers from unfairly high prices.
  • The Sherman Act was deemed too vague and later amended by the Clayton Act.
  • Visit Insider’s Investing Reference library for more stories.

The US economy is based on a free enterprise system where the markets, not the government, determine prices. For this system to function properly, there must be competition.

“The fundamental purpose of our antitrust laws is to preserve competition and prevent markets from being monopolized,” says George A. Hay, Charles Frank Reavis Sr. Professor of Law and professor of economics at the Cornell Law School. “If we had widespread monopoly our economy would be much worse off.”

The first of those antitrust laws is the Sherman Antitrust Act, enacted in 1890.

What is the Sherman Antitrust Act?

The Sherman Antitrust Act was intended to “preserve free and unfettered competition as the rule of trade” for the benefit of consumers. It made monopolization and other contracts that unreasonably restrain trade illegal. It is one of three core federal antitrust laws, along with the Clayton Antitrust Act and the Federal Trade Commission Act.

The Sherman Act was named for Sen. John Sherman of Ohio, who was considered an expert on regulating commerce. It was signed into law by President Benjamin Harrison on July 2, 1890.

Some states had already passed similar laws, but their scope was limited to intrastate business, whereas the Sherman Antitrust Act was applied across the nation.

There are three main parts of the Sherman Act:

  • The first defines and bans various forms of anticompetitive conduct. It makes forming a trust or contract that restrains trade or conspiring to restrain trade among US states and with foreign nations illegal.
  • The second makes monopolizing, attempting to monopolize, or conspiring to monopolize trade or commerce a felony.
  • The third extends these provisions to include the District of Columbia and all US territories.

“The most important application of section one is to make price-fixing agreements between or among competing sellers unlawful,” Hay says. “While price fixing does not create monopoly – literally a single seller – it results in prices that a monopolist would charge, prices much higher than would prevail under competition.”

The second section makes it unlawful to monopolize a part of commerce. “Basically it covers situations where large firms try to drive smaller competitors out of the market by various anticompetitive tactics, such as pricing below cost,” Hay says.

There are other practices some people may think are innocent that actually violate the Sherman Act, says Mark Grady, a UCLA law professor. These include, “protests against low wages by people who are ineligible for union membership.”

The Federal Trade Commission (FTC) enforces the Sherman Act and other antitrust laws. It monitors businesses and challenges them when they’re suspected of antitrust activities. The FTC reviews all major mergers and agreements, analyzing their potential effects on consumers and competition.

While great in theory, the Sherman Act proved too vague in practice. For instance, it didn’t clearly define key terms such as “monopoly” and “trust,” and left up for interpretation what constitutes “unreasonable” restraint of trade. This left loopholes through which corporations could argue their defense. As a result, Congress passed the Clayton Antitrust Act in 1914 to amend the Sherman Act.

The Sherman Antitrust Act vs. Clayton Antitrust Act

The Clayton Act strengthens the Sherman Act by clarifying key points in and prohibiting other harmful practices that the Sherman Act does not address, such as mergers and interlocking directorates when one person makes business decisions for competing companies.

Hay says the most significant provision that supplements the Sherman Act deals with mergers, primarily between competitors. “The Act says a merger is unlawful if the effect may be substantially to lessen competition,” he says. “It is mostly forward-looking in that it allows the government to block a merger that has not happened yet if the predicted effect is that competition may be harmed.”

The Clayton Act also created new ways of suing under the Sherman Act, UCLA’s Grady notes. It allowed private parties to sue for triple damages if they have been harmed by conduct in violation of either the Clayton Act or the Sherman Act.

Later, amendments further strengthened the Clayton Act, such as the Robinson-Patman Act amendment of 1936, making it illegal for merchants to use certain discriminatory pricing in their dealings with each other.

In 1950, the Celler-Kefauver Act extended the breadth of antitrust laws to include all forms of mergers that substantially reduced competition through monopolization. It also prevented one firm from gaining stock or physical assets in another firm if doing so would inhibit competition.

Then in 1976, the Hart-Scott-Rodino Antitrust Improvements amendment required companies to notify the government before engaging in a large mergers or acquisitions.

Sherman Antitrust Act Clayton Antitrust Act
  • Defines and bans various forms of anticompetitive conduct
  • Makes monopolizing, attempting to monopolize, or conspiring to monopolize trade or commerce is a felony
  • Used vague language that left loopholes for defendants
  • Amended by Clayton Antitrust Act
  • Strengthens Sherman Act by expanding definition of anticompetitive conduct
  • Gives private parties the right to sue for triple damages
  • Amended by Robinson-Patman Act of 1936, the Celler-Kefauver of 1950, and the Hart-Scott-Rodino Antitrust Improvements Act of 1976

Understanding antitrust laws

These US antitrust laws are designed to preserve competition in the marketplace. Consumers benefit from competition as it keeps prices low and leads to more and higher-quality options. Without the antitrust laws, businesses could form monopolies allowing them to have outsized control over market prices and the availability of goods.

“Our system of enforcing the antitrust laws is complex,” Hay says. “There are two federal agencies charged with maintaining competition: the Antitrust Division of the US Department of Justice and the Federal Trade Commission. But in addition, each of the 50 states has laws resembling the federal laws. And on top of that, individuals or companies injured as the result of other entities violating the laws can bring a private action to recover damages.”

The financial takeaway

The Sherman Act was the first antitrust law passed by Congress in an attempt to preserve competition in the open market. It was later deemed too vague and amended by the Clayton Act, which gives individuals the right to sue for triple damages if they have been harmed by actions that violate either the Sherman Act or Clayton Act.

“The most significant takeaway for the average consumer is that the antitrust laws serve to maintain prices at competitive levels,” says Hay. “Not only are consumers better off, but since consumers buy more when prices are lower, workers and suppliers of inputs also benefit.”

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Day trading is for experienced investors who can make quick decisions about fast-moving securities

A man with his hand on his chin while looking at investing charts on his computer screen.
Day trading is all about taking advantage of quick movements in the market and profiting off of buying and selling securities.

  • Day trading is the practice of making several trades of a security within a single day.
  • Day traders hope to use market volatility to make money on small gains by trading stocks.
  • While there’s significant money to be made with day trading, there’s also significant risk.
  • Visit Insider’s Investing Reference library for more stories.

There’s more than one way to make money with securities – and day trading is one such way. With increased access to investment tools and apps, reduced fees for trades, and data relating to securities, many people are becoming more interested in how small moves in the market can deliver profits.

But day trading isn’t for the inexperienced investor. To be successful, you need the right mix of education, experience, and capital – not to mention the discipline to execute a cultivated strategy. Here’s a closer look at what day trading is and what you need to know before taking the leap into these often perilous waters.

What is day trading?

Day trading is when you buy and sell the same security multiple times within the same day. The hope is that in making these trades, you can capitalize on any increases the securities might have gained during the day. Technically, anyone can day trade, though you’ll find this type of investing done by financial services companies as well as individuals.

There’s a lot of risk with day trading, which is why it’s not for everyone. Profit margins are often razor-thin, and you can lose a significant amount of money in a short period of time. You also can expect to devote a significant amount of time researching, planning, and making trades.

“Day trading is a full-time job,” says Vinny Yu, co-founder of JAVLIN Invest. “So if you’re thinking it’s quick and easy money, think again. Day trading requires discipline, patience, and emotional stability.”

Like most kinds of investing, day trading is subject to regulatory oversight by the Financial Industry Regulatory Authority (FINRA) and the Securities Exchange Commission. This is because day trading involves the purchase and sale of securities. More specific rules apply to day trading when investors buy on margin and make at least four day trades within the span of five days. Those who engage in this kind of activity are known as pattern-day traders.

How does day trading work?

Much of a day trader’s day is spent researching and watching the markets. The goal is to find opportunities to buy securities at a low price and then sell them at a profit – and repeat that to hopefully turn a profit within a single day. This is where a strong education in finance and investment – as well as experience working within the market – is an asset.

“Investors can access equity markets more cheaply and easily than ever before,” says David Keller, chief market strategist at StockCharts.com. “But that easier access also comes with increased risk. Investors should educate themselves on the concepts of risk versus reward, particularly how to manage risk on individual stocks as well as at the portfolio level through asset allocation. By learning about market history using charts and technical analysis, day traders can better appreciate how repeatable patterns in price action can be identified and quantified.”

Because day trading can be so risky, investors who day trade have a lot to consider. “In addition to reading charts and monitoring news, a good day trader can also recognize opportunities from reading the tape,” says Yu. “The goal of a day trader is obviously to make money, but equally as important is to hang on to that money and not lose it.”

Day traders employ a variety of strategies to accomplish their mission:

  • Breakout trading: Many traders believe stocks trade within a range of values. When a value goes above or below that range, a day trader may decide to buy or sell.
  • Pullback trading: This strategy looks for opportunities within a long-term trend to capitalize on declines in price. Since most stocks trend upward in value, dips in the market can offer the opportunity to buy shares at a decreased price and then sell when the value goes up again.
  • Scalping: Scalping is when you make several trades in a day that result in small profits. Day traders hold onto these securities for seconds-to-minutes since trading happens so quickly with this strategy. Trading in large volumes is key for success with this method.
  • Range trading: This strategy is much like breakout trading. Instead of waiting for stocks to go above or below the estimated range, day traders will buy and sell when prices come near the limits of the range.
  • News-based trading: Day traders follow the news to look for conditions that could impact the price of stocks. They have to continually monitor news outlets to look for information they can use to make predictions about how stocks will fare, and then base buying and selling actions on that information.
  • High-frequency trading: This strategy uses automated algorithms to trade securities in large amounts as fast as possible. Special computer systems are needed for this kind of day trading, which is why it’s usually done by institutional investors.

What are the rules of day trading?

A lot of the rules day traders work by have to do with trading discipline and commitment, as well as having the emotional wherewithal to deal with constant market volatility. It takes time to learn what works and what doesn’t with day trading and to develop a methodology that results in the kind of profits you’re looking to achieve.

“In my experience, the most successful traders exercise good discipline in their decision-making by focusing on the weight of the evidence,” says Keller. “It’s good to consider different perspectives, but at the end of the day, your decision process is up to you. Develop a well-articulated checklist for entering and exiting positions, apply that checklist consistently, and find success.”

If you’re a pattern day trader who uses a margin account, you will have additional rules from FINRA to follow. These include:

  • You must keep a minimum of $25,000 of equity in each account used for day trading at all times.
  • If the balance falls below that amount on a day you want to trade, you won’t be allowed to make the transaction.
  • You’re also only allowed to trade up to four times the amount above the $25,000 minimum in your account from the previous trading day.
  • Cross-guarantees are not allowed to count toward the $25,000 minimum.
  • Any funds used to meet the $25,000 minimum have to remain in the account for two business days after any day they are required for trading.

Pros and cons of day trading

There are many risks to day trading, and many who step into this area of investing are unsuccessful. Because you’re counting on market volatility to increase the value of stock buys with day trading, you always run the risk of losing money. The best you can do is make educated guesses about what will happen in the market, and that can always lead to losses instead of gains.

Robert Johnson, professor of finance with Heider College of Business at Creighton University, describes day trading as the practice of placing “numerous bets on short-term price moves in securities. [Day traders] are properly classified as speculators and not investors.”

“The deck is stacked against the day trader and is stacked in favor of the long-term investor,” says Johnson. “Over the long-term, investing in the stock market is a positive-sum game. That is, over the long run the value of stocks, both individually and collectively, generally rises. On the other hand, over the short-term, investing in any asset class is a zero-sum game.”

Yu says that loss management is important for being successful with day trading. He says preserving capital is paramount in not letting small losses turn into large ones.

“If successful, day traders can make a lot of money in a relatively quick amount of time,” Yu adds. “You can also work as much or as little as you want. Some traders can make money by just trading the open and then [taking] the rest of the day off.”

Is day trading right for me?

Only you can determine if day trading is right for you. Certainly, you’ll want to gather as much information and tools as possible that can help you be successful. These may include:

  • A thorough education in finance, investing, and world markets
  • Access to real-time market news, data, and the Electronic Communication Network (ECN), which provides the best-available stock quotes at any given time
  • Securities price charts, analyses, and other technical data that can help you make informed decisions
  • A brokerage account that will allow you to make the volume of trades you need to achieve goals
  • Enough capital to make the kind of trades needed to turn a profit

You can get started day trading with a few hundred dollars, but the returns on trades of that size would be small. Making larger trades can result in larger gains and more in profit.

Some other considerations include:

  • How much time can you commit to day trading? As Yu stated, the research, monitoring, and trading activity can be a full-time job. However, you may be able to get to a position where you can hit your goals within a few hours. It all depends on your situation and the market.
  • What kind of risks are you comfortable taking? If you’re a conservative investor, day trading is most definitely not for you. A long-term strategy would work best for your goals. If you are comfortable with potential losses and feel that risk is worth what you could make in profits, then day trading might be something to look into. Again, it all depends on you.

The financial takeaway

Day trading is all about taking advantage of quick movements in the market and profiting off of buying and selling securities. It can take a lot of time and money to be successful in this endeavor, and anyone considering getting into day trading should do so with caution. This is an area of investment that is subject to extreme wins and losses.

If you do want to try your hand at day trading, make sure you thoroughly understand the risks you could be taking and the markets you will be navigating, as well as have a plan to manage your capital through both good times and bad. Seeking out as much information as possible about day trading is also always a good idea.

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Liquid assets are an important part of a portfolio because they can be quickly converted into cash

Water faucet with coins coming out, above a hand holding coins 2x1
Generally, you should keep a portion of your overall assets as liquid assets, in case you need to get your hands on some cash.

You’ve probably heard the term “liquidity” thrown around when it comes to your portfolio and assets. It refers to how quickly an asset can be converted into cash. As such, liquid assets are those that can easily be sold or traded.

Liquidity is really a gauge of how much access an individual or business has to cash. The easier an asset – be it an investment, a collectible, or even a precious metal stored in a safe somewhere – can be “liquefied” for its cash value, the higher its liquidity.

“A liquid asset is something you can pay rent with next month,” says Jedidiah Collins, a certified financial planner and financial educator who runs Money Vehicle, a financial literacy program. “It’s something I can change into cash fast, to put it more simply.”

Each type of asset has a differing level of liquidity. But liquid assets tend to include things like money in bank accounts, certificates of deposit (CDs), and even certain types of bonds such as US Treasuries.

How liquid assets work

For an asset to be considered truly liquid, there are several boxes to tick:

  • A liquid asset must exist or be traded in an existing, established market. That means that there are buyers and sellers and the asset is always (or nearly always) in demand at some price. When there’s always a buyer, the asset is easy to sell or trade, making it more liquid.
  • A liquid asset can be converted to cash quickly. The more difficult or time consuming it is to sell an asset, the less liquid the asset is – otherwise known as illiquid. Collins says an illiquid asset is something that requires at least some leg work to exchange for cash: “An illiquid asset would be anything I need to find a buyer for. Something that there’s not a buyer readily available for.”
  • The process of selling or trading the asset also needs to be both secure and simple for it to be truly liquid. Think about the cash you may have in a bank account, for example. The cash in it is considered a liquid asset because the process of getting it out is as easy as a trip to the ATM. And because banks are liable for the the safely securing your funds, they’re also protected. The same goes for other assets like stocks or exchange-traded funds: Stocks can be easily traded or sold for cash since there’s always an interested buyer.

Finally, the vast majority of liquid assets also are the type most commonly owned by investors. That is, they’re things like stocks, or other easily-sold securities such as US Treasury bonds. Cash, of course, also fits the bill, as it can be used by anyone at any time.

Liquid assets examples

Assets come in a variety of types, and are spread across a spectrum of liquidity. Even among certain asset types, liquidity can vary – some real estate assets may be more liquid than others, for example.

Finalassesttable 02

Here are some of the types of liquid assets:

  • Cash, and cash equivalents: It doesn’t get much more liquid than cash. It can be used to purchase just about anything, and doesn’t require a transaction to “liquify.” Cash equivalents, such as CDs, are in the same bucket, although there may be a fee to pay when liquify ing this type of asset.
  • US Treasury bills and bonds: Treasuries are bonds issued by the US government. They are among the most liquid types of bonds, as there are always buyers in the market.
  • Stocks: As we mentioned before, stocks are liquid in that they can easily and almost always be purchased or sold for cash at a moment’s notice. It may take some time for cash to hit your account, of course, and you may take a loss on the sale. But the speed and ease with which stocks can be liquidated is what earns them a spot on the list.
  • Bonds: Much like stocks and other securities, bonds can be sold at any time for cash so long as the markets are open.
  • Mutual funds: While not quite as liquid as other securities as they only trade at the market close, mutual funds can be liquidated for cash rather fast and easily.
  • ETFs: Perhaps best described as baskets of investments – like a bundle of stocks – ETFs trade on exchanges like other securities. Since they trade easily, they are likewise fairly liquid.
  • Foreign currency: Foreign currencies are cash, and as such, are highly liquid. You would need to exchange a foreign currency for US dollars, which may require an extra step, but in terms of liquidity, foreign currencies are among the most liquid assets you can own.
  • Precious metals: Gold, silver, platinum – precious metals are fairly liquid, as they’re easy to sell for cash. It might require a trip to a local coin shop to access the “market,” but in terms of liquidity, precious metals tend to tick the boxes.

Example of illiquid assets

Conversely, illiquid assets are those that cannot be easily converted to cash. They may take a while to sell, or lack a bustling market full of potential buyers. The point is, it’ll be tough to turn these types of assets into fast cash:

  • Real estate: Real estate may hold a lot of value, but it is neither fast nor easy to sell. On average, it takes around two months to sell a house in the US, making real estate an illiquid asset.
  • Collectibles: Collectibles can be almost anything, from baseball cards to paintings. While these assets may hold value, it can be difficult to find buyers, depending on the specific market, and their values may be hard to assess. For that reason, collectibles are considered illiquid.
  • Stock options: Like other items on this list, stock options may be valuable, but aren’t easy to transfer or squeeze cash out of.
  • Private equity: Do you own a share of a business or organization? This is also called “equity,” and while it may be of some value, that value isn’t easy to tap into.
  • Intangible assets: It’s hard to define intangible assets since they’re, well, intangible. But they may include things like intellectual property. These would be illiquid, given their specific nature, and a lack of an immediate marketplace where they can be exchanged for cash.

The financial takeaway

Liquid assets give their owners quick and easy access to cash. They can quickly be sold, granting access to their cash value, in contrast to illiquid assets, which may take more time and effort to sell or trade. Generally, you should keep a portion of your overall assets as liquid assets, in case you need to get your hands on some cash.

A good goal? Think about how long you’d be able to maintain your lifestyle, and tackle all of your financial obligations, if you sold your liquid assets – and aim for three years’ worth of available cash. “It’s not a percentage of your portfolio that matters,” says Collins. “It’s about the protection of your lifestyle.”

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Understanding fiscal policy: The use of government spending and taxation to manage the economy

Two women in suits talking and walking through the US capitol building.
The Federal Reserve is not involved in determining fiscal policy decisions – that’s done by Congress and the Administration.

  • Fiscal policy describes how a government uses taxation and spending to influence the economy.
  • Fiscal policies can be neutral, expansionary, or contractionary depending on the goal.
  • Changing fiscal policy could affect interest rates, inflation, employment, and your investments.
  • Visit Insider’s Investing Reference library for more stories.

Fiscal policy is how a government manages spending and taxation levels in ways intended to influence the economy. If US officials want to stimulate growth, they might increase spending or cut tax rates. Conversely, they might want to slow down an overheating economy with lower spending and higher taxes. In turn, these changes can have an impact on interest rates, employment, trade deficits, and inflation.

Current US fiscal policy has its roots in Keynesian economics – which makes a case for the proactive government response to crises and up-and-down business cycles. Fiscal policy may be intertwined with, but is separate from, monetary policy.

How does fiscal policy work?

Fiscal policies are always present, but changes in them may be driven by a specific situation or a broad agenda.

“You can have specialized fiscal policy, such as the response to COVID, where the federal government gets together and provides relief,” says Kevin Flanagan, head of fixed income strategy at WisdomTree.

In responding to COVID, the government’s emphasis was on increasing spending through relief programs, including direct stimulus payments and Paycheck Protection Program (PPP) loans. Specialized fiscal policy responses also occurred during the Great Recession, such as the Troubled Asset Relief Program (TARP). The government’s increased spending was driven, in part, by a desire to end the recession.

Not all fiscal policy changes are made in response to a crisis. For example, the 2017 Tax Cuts and Jobs Act (TCJA) is an example of an agenda-driven fiscal policy. “One is reactive, and one is more in line with everyday government,” explains Flanagan. “They’re trying to determine policy going forward.”

Officials may take a neutral approach if there’s a stable economy that they want to maintain. However, changing business cycles or a crisis may quickly lead to expansionary or contractionary policies.

Who determines fiscal policy in the US?

In the US, the executive and legislative branches have the most direct impact on fiscal policy.

“While the president requests a budget that outlines [their] priorities, Congress ultimately controls the government’s purse strings and sets fiscal policy,” explains Jason Blackwell, chief investment strategist at The Colony Group.

The judicial branch could also have an influence on fiscal policy if it finds spending or tax proposals are unconstitutional.

Fiscal policy vs. monetary policy

In the US, the Federal Reserve, or Fed, is an independent federal agency that sets the country’s monetary policy.

Monetary policy explainer

While fiscal policy tends to be targeted, Blackwell says monetary policy is often a blunt tool that can influence consumers’ and business’ interest rates and borrowing. And while they’re different and separate from each other, fiscal and monetary policy work in tandem at times.

“For example, in the last two recessions, the Federal Reserve lowered the lending cost for banks to incentivize them to make more loans to businesses, while Congress authorized cash infusions more directly to consumers and businesses,” says Blackwell.

However, at other times, the government’s fiscal and monetary policies may counteract each other. “If fiscal policy is being viewed as restrictive, perhaps the Fed would want to counter or offset that,” says Flanagan.

How can fiscal policy affect investments

Fiscal policies may have direct and indirect impacts on your investments.

Consider, for example, a new tax rate that could leave you with more or less money to invest. And new rules about tax-advantaged accounts could require you to adjust your investment strategy.

For investors, the impact fiscal policy can have on the overall economy, interest rates, specific industries, and individual companies can be quite significant, says Blackwell.

Fiscal policy can also impact the overall economy, interest rates, specific industries, and individual companies. “For investors, the impact can be significant,” says Blackwell.

He shares a hypothetical example related to the clean-energy industry to explain: “If the government allocates tax credits and prioritizes spending within the space, it can create risks for traditional energy companies and opportunities for new entrants.”

Predicting fiscal policy might not be possible. But being aware of changes and their potential consequences is important.

The financial takeaway

Fiscal policy is the government’s approach to spending and taxation. Both reactive and agenda-driven policies could affect your household’s financial situation, as well as the overall economy.

“We tend to focus on fiscal policy during times of crisis,” says Blackwell. “For example, the automaker bailouts in 2008 or the PPP-loans in 2020. Those are examples of the government targeting spending to specific sectors of the economy to smooth the economic recessions.”

However, agenda-driven fiscal policy decisions may have a much longer time horizon. Whether it’s a change to the tax code or a new infrastructure plan, the impact of fiscal policy could play out be felt for decades to come.

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The Rule of 72 is a quick and simple formula to estimate when your investments will double

rule of 72
The Rule of 72 demonstrates how the magic of compounding helps investments to grow.

  • The Rule of 72 is a mathematical formula that estimates how long it’ll take an investment to double in value or to lose half its value.
  • To calculate the Rule of 72, you divide the number 72 by the rate of return of an investment or account.
  • The Rule of 72 can only be used on investments earning compound interest; it’s most effective on interest rates between 6% to 10%.
  • Visit Insider’s Investing Reference library for more stories.

Learning where and how to invest is intimidating. So intimidating that many people don’t make it to the next step of figuring out how to project the growth of their investments – even though that’s pretty crucial to your making financial plans and setting goals.

What if you could plug some numbers into a simple formula and find out how long it would take for your investments to double?

That’s exactly what the Rule of 72 does. Here’s what you need to know about how it works and why it’s a key tool to keep in your investing toolbox.

What is the Rule of 72?

The Rule of 72 is a mathematical principle that estimates the time it will take for an investment to double in value. The mention of math might make your jaw clench, but the Rule of 72 is actually a very basic formula that anyone can use.

Simply take the number 72 and divide it by the interest earned on your investments each year to get the number of years it will take for your investments to grow 100%. Or to drop by 50%.

However, you can only apply this rule to compounding growth or decay. In other words, you can only use it for investments that earn compound interest, not simple interest. With simple interest, you only earn interest on the principal amount you invest. Compound interest is “interest earned on interest”: It accrues on accumulated interest, in addition to the principal.

Because interest is essentially being added into your principal, and used as the base for fresh interest calculations, compounding makes your investment grow exponentially. Meaning: As interest accrues and the quantity of money increases, the rate of growth becomes faster.

It doesn’t have to be investment interest; anything that augments your principal creates “the magic of compounding.” For example, if you reinvest the dividends you earn on your investments, your earnings are being compounded. Therefore, the Rule of 72 applies.

On the other hand, if you choose to withdraw your dividends rather than reinvest them, your earnings might not compound, and the Rule of 72 wouldn’t work.

How to calculate the Rule of 72

To calculate the Rule of 72, all you have to do is divide the number 72 by the rate of return. You can use the formula below to calculate the doubling time in days, months, or years, depending on how the interest rate is expressed. For example, if you input the annualized interest rate, you’ll get the number of years it will take for your investments to double.

rule of 72

You’ll notice the formula uses the “approximately equals” symbol (≈) rather than the regular “equals” symbol (=). That’s because this formula offers an estimate rather than an exact amount, and it’s most accurate when used on investments that earn a typical rate of 6% to 10%.

While usually used to estimate the doubling time on a growing investment, the Rule of 72 can also be used to estimate halving time on something that’s depreciating.

For example, you can use the Rule of 72 to estimate how many years it will take for a currency’s buying power to be cut in half due to inflation, or how many years it will take for the total value of a universal life insurance policy to decline by 50%. The formula works exactly the same either way – simply plug in the inflation rate instead of the rate of return, and you’ll get an estimate for how many years it will take for the initial amount to lose half its value.

Rule of 72 example

Let’s say you invest $1,000 at a 9.2% annual rate of return, which is the average stock market return for the last 10 years. To calculate the doubling time using the Rule of 72, you’d input the numbers into the formula as follows:

72 / 9.2 ≈ 7.8

This means that your initial $1,000 investment will be worth $2,000 in about 7.8 years, assuming your earnings are compounding. If you instead invest $10,000, you’ll have $20,000 in just under eight years. This also means that $20,000 will double again in another eight years, assuming the same rate of growth – in other words, you’ll have $40,000 in less than 16 years.

All of this is also assuming you’re not adding to your initial investment over time, which makes the fact that your money is doubled in less than a decade all the more impressive.

Alternatives to the Rule of 72

The number 72 is a good estimator in most situations and, thanks to it being an easily divisible number, it makes for simple math. It’s best for interest rates, or rates of return, between 6% to 10%. Most investment accounts, including retirement accounts, brokerage accounts, index funds, and mutual funds fall into this range of return.

But with a different range, you might want to fiddle a bit – same formula, but different numbers to divide by. An easy rule of thumb is to add or subtract “1” from 72 for every three points the interest rate diverges from 8% (the middle of the Rule of 72’s ideal range).

At really high interest rates, for example, using the number 78 will give more accurate results. On the other hand, 69 or 70 are more accurate for lower interest rates and interest that compounds daily. Daily compounding is rare in investing and mostly happens with savings products such as high-yield savings accounts and certificates of deposit (CDs).

The financial takeaway

The Rule of 72 offers a quick and easy way for investors to project the growth of their investments. By showing how quickly you can double your money with minimal effort, this rule beautifully demonstrates the magic of compounding for building wealth.

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A 1031 exchange is a tax-deferred way to invest in real estate

Two hands each holding a mini house surrounded by arrows, to signify using 1031 exchange
Real estate investors can swap properties for more profitable ones while deferring capital gains taxes with 1031 exchanges.

  • A 1031 exchange lets you sell one property, buy another, and avoid capital gains tax in the process.
  • There’s a strict time limit on 1031 exchanges. You must purchase your new property within 180 days.
  • A 1031 exchange can help you buy more profitable properties, diversify, or defer taxes associated with depreciation.
  • Visit Insider’s Investing Reference library for more stories.

A 1031 exchange is a type of real estate purchase allowed under Section 1031 of the US Internal Revenue Code. It allows you to defer capital gains taxes when selling a property, as long as the proceeds are used toward a similar investment within a certain time frame.

As Adam Kaufman, co-founder and chief operating officer of real estate crowdfunding platform ArborCrowd, explains: “By using 1031 exchanges, real estate investors are able to sell a real estate asset and reinvest the proceeds into a like-kind investment – another real estate asset – and defer the capital gains tax associated with the transaction.”

How a 1031 exchange works

The exact 1031 exchange process depends on the type you’re using (more on this later). In most cases, it works like this: First, you’d determine the property you want to sell, and identify the exchange facilitator you want to handle the transaction.

1031 Exchange Timeline

Then, like many investors, you’ll probably want to have a qualified intermediary hold the proceeds of your sale until you’ve identified the property or properties you’d like to purchase. After that, you have 45 days to find your replacement investment and 180 days to purchase it.

It sounds complicated, but there are many reasons you might use a 1031 exchange.

“In a typical real estate transaction, an investor can expect to pay as much as 40% of the taxable gain,” says Paul Getty, chief executive officer and president of First Guardian Group. “Now, with a 1031 exchange and with the ability to defer those capital gains taxes, investors can seek out a different sort of investment, diversify their holdings, expand their portfolio, or realign their investments with their long-term goals.”

You can also use a 1031 exchange to buy a property with better cash flow or reset the clock on depreciation. Depreciation essentially allows you to pay fewer taxes as a property experiences wear and tear over time. For residential rental properties, the benefit is gradually spread out over 27 ½ years.

Typically, if you used depreciation to your advantage, then you’d owe what’s known as depreciation recapture – or income taxes on the financial gains you realized from doing so – once you sell the home. Using a 1031 exchange can allow you to push these payments out to a later date.

While deferring these taxes (and capital gains) is a nice benefit, 1031 exchanges aren’t free. You’ll still owe a variety of closing costs and other fees for buying and selling a property. Many of these may be covered by exchange funds, but there’s debate around exactly which ones. To find out which costs and fees you may owe for a 1031 exchange transaction, it’s best to talk to a tax professional.

What are the rules for a 1031 exchange?

There are several rules that come with a 1031 exchange, so be sure you’re well-versed in them before selling your property.

  1. The replacement property must be of equal or greater value than the original.
  2. You can purchase as many as three properties without regard to the fair market value, or any number of properties as long as their aggregate value doesn’t exceed 200% of your original property’s sale price.
  3. You must identify your replacement property (or properties) within 45 days of selling the first property.
  4. The purchase of the replacement(s) must be completed within 180 days of your initial property sale.

If your property is financed or mortgaged, you’ll need to take on at least the same debt for the new property. As Kaufman puts it: “If an investor’s debt liability decreases as a result of the sale and purchase of a new asset using less debt, it is considered income and will be taxed accordingly.”

The different types of like-kind exchanges

A 1031 exchange is a like-kind exchange – a transaction that allows you to essentially swap one asset for another one of a similar type and value. Technically, there are several types of 1031 like-kind exchanges, including delayed exchanges, built-to-suit exchanges, reverse exchanges, and others.

Delayed exchanges

According to Getty, the delayed (also called deferred) exchange is “by far the most common 1031 exchange.” This is the traditional type of exchange noted above – wherein you must identify a new investment within 45 days and purchase it within 180 days.

Build-to-suit exchanges

A build-to-suit 1031 exchange allows an investor to use the proceeds of their property sale to not only purchase a new investment but fund improvements on the replacement property, too. As with other exchanges, the value of the replacement property (after improvements) must come out to be equal to or greater than the sale proceeds of the initial property.

Reverse exchanges

In a reverse exchange, the replacement property is purchased first, and then the initial property is relinquished afterward.

Timeline of reverse 1031 exchange

As in a delayed exchange, both steps must occur within 180 days. You’d use an exchange accommodation titleholder to retain the property while you sell your previous one.

Other types of exchanges

There are other types of exchanges, too – including a drop-and-swap exchange and a tenancy-in-common exchange.

The drop-and-swap exchange is used in the case of partnerships. “A drop-and-swap exchange occurs when an investor has partners that either want to cash out of the transaction or invest in the replacement property,” Kaufman explains. “In short, the ‘drop’ refers to the dissolution of the partnership and the partners cashing out. The ‘swap’ is when partners invest their common interests into the replacement property instead of cashing out.”

With a tenancy-in-common, as many as 35 investors can pool funds and purchase a property. When the property is sold, each can perform a 1031 exchange with their portion of the proceeds.

The financial takeaway

A 1031 exchange transaction can help you avoid short-term capital gains taxes and continue growing your wealth through real estate.

They are complicated purchases, though, so make sure you have an experienced intermediary on your side, and consider consulting a tax professional before moving forward. This can ensure you make the best decision for your long-term financial health.

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What is ROI? This simple metric can offer greater insight into the profitability of the assets in your portfolio

Acronym ROI (Return on investment) on a futuristic Button with circuit board texture background
Return on investment, or ROI, is a widely used financial ratio that measures the profit or loss from an investment relative to the amount of money initially put into it.

  • Return on investment (ROI) is a metric used to assess the performance of a particular investment.
  • ROI is expressed as a percentage and can be calculated using a simple ROI or annualized ROI equation.
  • Looking at ROI doesn’t take into account risk tolerance or time and may not show all costs.
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Return on investment (ROI) is a financial ratio that’s used to measure the profitability of an investment relative to its costs and is expressed as a percentage. When you consider investing in anything, you often hear about getting a “return on investment” but may wonder what that really means and how it works. Here’s what to consider with ROI.

Why ROI matters

When you invest, whether in the stock market or in your business, your goal is to earn money and get a return on your investment. You put up cash anticipating that what you put in offers an even greater ROI.

“ROI is expressed as a percentage and is calculated by subtracting the cost of an investment from its current value and then dividing by the cost,” explains Nicole Tanenbaum, partner and chief investment strategist at Chequers Financial Management in San Francisco. “It is a simple and straightforward formula that can be easily used to calculate the rough profitability of nearly any investment, from stock investments to business projects to real estate transactions.”

As an investor, it’s important to assess ROI as a financial metric to see how your particular investments are doing. In basic terms, are you getting more out than you put in? Or are your investments costing you, in the form of negative returns?

ROI goes hand in hand with risk and reward, meaning that with greater risks comes the potential for even higher rewards.

According to Investor.gov, a website run by the Securities and Exchange Commission (SEC), for many decades stocks have had the highest average rate of return but also tend to come with the highest risk.

ROI matters because it’s an easy-to-use metric to evaluate an investment’s performance. Expressed as a percentage, the higher the number, the greater the return.

If an investment doesn’t have a solid ROI, it may be a good time to rebalance your portfolio and sell off some assets that aren’t doing well. However, it’s important to consider any transaction costs and affects on your overall returns in the long run.

How to calculate ROI

In order to calculate ROI, you can use the following formula:

Formula for return on investment

Let’s break down the pieces of the ROI formula.

  • Net investment gain refers to the net return you get with an investment, after considering costs already put in.
  • The cost of investment is the total amount of money you’ve put in a particular investment.

To calculate ROI, you take the net investment gain and divide it by the cost of investment and multiply it by 100 (this converts it to a percentage).

For example, let’s say you put an initial investment of $10,000 into a company’s stock. Then you decide to sell your shares three years later for $12,000.

Here’s the simple ROI formula in this case:

ROI = ($12,000 – $10,000) / $10,000

In other words, you take the final sale of $12,000 and subtract the initial investment of $10,000 which gets you a net investment gain of $2,000.

You then take that number and divide by the cost of investment.

ROI = $2,000/$10,000 = 0.2

The last part of the equation is to multiply the decimal by 100 to get the percentage.

0.2 X 100 = 20%.

This simple ROI formula is pretty standard when evaluating returns. But the drawback is that it doesn’t take into account the amount of time you held the investments or any opportunity cost.

Annualized ROI can offer more nuance in regards to how long you’ve held an investment and offer a more accurate ROI. Here’s the annualized ROI formula for our example:

Formula for annualized return on investment

A= (12,000/$10,000) (⅓) -1

A= (1.2) (⅓) -1

A= 1.063-1

A= 0.063

A= 6.3%

As you can see, the simple ROI vs annualized ROI numbers are quite different. Looking at the annualized ROI can offer greater insight into an investment’s performance if you’ve held it for a good chunk of time.

It’s also important to note the difference between a realized gain and unrealized gain.

  • A realized gain is the total you gain or profit from an investment that you actually sell. In that case, you’d want to use net income as part of the net investment gain and include any transaction costs, fees, etc.
  • An unrealized gain is a gain “on paper.” In other words, it reflects an increase in value but since it’s not actually sold, it’s unrealized. In this scenario, you’d take what your current investment is worth to calculate the net investment gain.

Pros and cons of ROI

While evaluating ROI is a good way to measure performance, there are some limitations, especially when it comes to the simple ROI formula. Here are pros and cons of ROI:

Pros Cons
  • It’s an easy-to-use calculation to evaluate performance of an investment
  • ROI can help you decide to stick with an investment or sell
  • A standardized way to compare investments
  • Simple ROI doesn’t include the time you held the investments
  • ROI doesn’t consider risk tolerance or your age, two crucial aspects when coming up with an investing strategy
  • May not consider the true cost, depending on the formula (such as looking at transaction costs, fees, taxes, etc.)

You want to evaluate the pros and cons and know where the ROI metric can fall short.

“ROI can be a useful tool in comparing performance across multiple investments. However, it is important to understand that ROI does not take into account the overall time frame of an investment, or how long it took to generate the overall profit from initial purchase to eventual sale,” explains Tanenbaum.

Time is a key consideration when evaluating the true ROI of a particular investment.

“Time is a factor which should always be considered when evaluating and comparing relative performance across investments,” says Tanenbaum. “Even if an investment earns a higher profit based on its ROI, the longer the time to realization, the less efficient the investment. Therefore, ROI should be used in tandem with other performance metrics such as the rate of return, which takes time and efficiency into consideration.”

Average ROI in the stock market

The reason investing is better than keeping money in a savings account is that the possibility for a higher return is much greater. Savings interest rates have been abysmally low, but the stock market historically has offered good returns over time.

According to the SEC, the stock market has provided annual returns of about 10%, or 6% to 7% when adjusting for the impact of inflation.

Some returns are much greater depending on the type of investment and the timeframe.

“On average, the S&P 500 Stock Index has generated an ROI of about 10% per year over time, but when looking at ROI across industries, they can vary greatly, with higher growth segments generating average an ROI that’s well above 10%, and more defensive industries generating single digits or in some cases, negative ROI,” notes Tanenbaum.

Aside from evaluating ROI, remember to account for “realized” vs. “unrealized” gains as well. This is also important for losses, too. So if the stock market is tanking, you don’t necessarily need to take any action because the loss is “unrealized” until you sell. If you sell at a loss, that’s final. But if you stay in the game, you could recover in the long-term.

The financial takeaway

Return on investment is a commonly used metric to evaluate investments and business decisions. Ideally, your ROI will be positive and growing over time, however it’s possible to get negative returns as well.

ROI can help you decide where to invest and whether you should sell or hold onto assets you already own.While the ROI percentage is useful, it’s important to understand its limitations when evaluating overall risk and time horizon.

Additionally, it’s important to understand the nuances between simple ROI vs. annualized ROI. You also want to be clear on total costs such as transaction fees, taxes, and more, so you’re getting a clearer picture on your actual return on investment.

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