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A daily selection of business terms and their definitions / application.

Term: Moral Hazard

What Is a Moral Hazard?

Moral hazard is the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity. In addition, moral hazard also may mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles. Moral hazards can be present at any time two parties come into agreement with one another. Each party in a contract may have the opportunity to gain from acting contrary to the principles laid out by the agreement.

Any time a party in an agreement does not have to suffer the potential consequences of a risk, the likelihood of a moral hazard increases.

Key Takeaways:

  • Moral hazard can exist when a party to a contract can take risks without having to suffer consequences.
  • Moral hazard is common in the lending and insurance industries but also can exist in employee-employer relationships.
  • Leading up to the 2008 financial crisis, the willingness of some homeowners to walk away from a mortgage was a previously unforeseen moral hazard.

Understanding Moral Hazard

A moral hazard occurs when one party in a transaction has the opportunity to assume additional risks that negatively affect the other party. The decision is based not on what is considered right, but what provides the highest level of benefit, hence the reference to morality. This can apply to activities within the financial industry, such as with the contract between a borrower or lender, as well as the insurance industry. For example, when a property owner obtains insurance on a property, the contract is based on the idea that the property owner will avoid situations that may damage the property. The moral hazard exists that the property owner, because of the availability of the insurance, may be less inclined to protect the property, since the payment from an insurance company lessens the burden on the property owner in the case of a disaster.

Moral hazard can exist in employer-employee relationships, as well. If an employee has a company car for which he does not have to pay for repairs or maintenance, the employee might be less likely to be careful and more likely to take risks with the vehicle.

When moral hazards in investing lead to financial crises, the demand for stricter government regulations often increases.

An Example of Moral Hazard

Prior to the financial crisis of 2008, when the housing bubble burst, certain actions on the parts of lenders could qualify as moral hazard. For example, a mortgage broker working for an originating lender may have been encouraged through the use of incentives, such as commissions, to originate as many loans as possible regardless of the financial means of the borrower. Since the loans were intended to be sold to investors, shifting the risk away from the lending institution, the mortgage broker and originating lender experienced financial gains from the increased risk while the burden of the aforementioned risk would ultimately fall on the investors.

Borrowers who began struggling to make their mortgage payments also experienced moral hazards when determining whether to attempt to meet the financial obligation or walk away from loans that were becoming more difficult to repay. As property values decreased, borrowers were ending up deeper underwater on their loans. The homes were worth less than the amount owed on the associated mortgages. Some homeowners may have seen this as an incentive to walk away, as their financial burden would be lessened by abandoning a property.

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Term: Long Tail

What Is the Long Tail?

The long tail is a business strategy that allows companies to realize significant profits by selling low volumes of hard-to-find items to many customers, instead of only selling large volumes of a reduced number of popular items. The term was first coined in 2004 by Chris Anderson, who argued that products in low demand or with low sales volume can collectively make up market share that rivals or exceeds the relatively few current bestsellers and blockbusters but only if the store or distribution channel is large enough.

Long-tail may also refer to a type of liability in the insurance industry or to tail risk found in investment portfolios. This definition deals with the business strategy use of the term.

Understanding the Long Tail Strategy

Chris Anderson is a British-American writer and editor most notably known for his work at Wired Magazine. In 2004, Anderson coined the phrase “long tail” after writing about the concept in Wired Magazine where he was editor-in-chief. In 2006, Anderson also wrote a book titled “The Long Tail: Why the Future of Business Is Selling Less of More.”

The long tail concept considers less popular goods that are in lower demand. Anderson argues that these goods could actually increase in profitability because consumers are navigating away from mainstream markets. This theory is supported by the growing number of online marketplaces that alleviate the competition for shelf space and allow an unmeasurable number of products to be sold, specifically through the Internet.

Anderson’s research shows the demand overall for these less popular goods as a comprehensive whole could rival the demand for mainstream goods. While mainstream products achieve a greater number of hits through leading distribution channels and shelf space, their initial costs are high, which drags on their profitability. In comparison, long tail goods have remained in the market over long periods of time and are still sold through off-market channels. These goods have low distribution and production costs, yet are readily available for sale.

Key Takeaways

  • The long tail is a business strategy that allows companies to realize significant profits by selling low volumes of hard-to-find items to many customers, instead of only selling large volumes of a reduced number of popular items.
  • The term was first coined in 2004 by researcher Chris Anderson.
  • Anderson argues that these goods could actually increase in profitability because consumers are navigating away from mainstream markets.
  • The strategy theorizes that consumers are shifting from mass-market buying to more niche or artisan buying.

Long Tail Probability and Profitability

The long tail of distribution represents a period in time when sales for less common products can return a profit due to reduced marketing and distribution costs. Overall, long tail occurs when sales are made for goods not commonly sold. These goods can return a profit through reduced marketing and distribution costs.

The long tail also serves as a statistical property that states a larger share of population rests within the long tail of a probability distribution as opposed to the concentrated tail that represents a high level of hits from the traditional mainstream products highly stocked by mainstream retail stores.

The head and long tail graph depicted by Anderson in his research represents this complete buying pattern. The concept overall suggests the U.S. economy is likely to shift from one of mass-market buying to an economy of niche buying all through the 21st century.

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Term: Knuckle-Buster

What is a Knuckle-Buster

Knuckle-buster is a slang term for a manual credit card imprinter, a device merchants used to record credit card transactions before the advent of electronic point-of-sale terminals.

BREAKING DOWN Knuckle-Buster

A knuckle-buster is a colloquial term used to describe early manual credit card imprinting devices. Also sometimes known as zip-zap machines, the imprinters became known as knuckle-busters because frequent users of these devices would often skin their knuckles and develop calluses as a result of repeated use.

Knuckle-busters were ubiquitous for retailers and businesses from the the beginnings of the credit card industry until electronic point-of-sale terminals began to become popular in the 1980’s.

The device works by placing the customer’s credit card into a bed in the machine, then layering carbon paper forms over the card. By sliding a bar back and forth over the paper to create an impression from the embossed card data, multiple copies of the transaction are created. Customers sign these paper forms to authenticate the transactions. Copies of these forms would serve as customer receipts, and the the remaining copies would then be used by the business and its bank and credit card company to process and record the transactions.

Some manual imprinters would come equipped include a plate with the merchant’s name, address, and other identifying information. Other merchants would purchase carbon transaction forms pre-printed with their business information.

The Effect of Technological Advancements on Knuckle-Busters

Electronic point-of-sale terminals began to become available in 1979, and provided many advantages over knuckle-busters. For one thing, terminals offered faster verification and approval for transactions on a credit card account. They also tended to be easier on the knuckles of all involved parties.

Carbon copies also tend to be fragile records, and transaction receipts could frequently become illegible, especially over time.

Nevertheless, knuckle-busters remain an advantageous backup plan for businesses that would like to continue to run transactions when electricity or computer networks become unavailable. They also remain useful for merchants, such as fair vendors, who require a portable method of recording transactions.

Even so, the ongoing utility of knuckle-busters is compromised by a number of factors. The availability of carbon forms is diminishing, making forms more expensive and inaccessible, and employees are often not trained in the use of manual imprinters even whey they are available. For merchants, manual entry of credit card transactions is more time-consuming, and each entry is at risk of not being authenticated. Additionally, credit card companies more and more frequently issue cards which are not embossed with customer data, making the knuckle-buster entirely useless in capturing customer data even when running a manual transaction.

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Term: Kin

What Is Kin?

While standalone cryptocurrencies like bitcoin have paved the way for the industry, more existing companies are venturing into the digital currency space with their own offerings. One of those companies is Kik, the popular messenger service. Kik’s cryptocurrency is called Kin.

As with many other company-specific digital currencies, Kin has special uses within the Kik messenger platform. Users are able to earn Kin for making contributions to the broader Kik community; they can also spend Kin on various goods and services within the Kik platform.

Kin Explained

Kin was first launched in September of 2017. It was launched via an ICO that raised roughly $100 million in investor funds over a period of about two weeks. Upon its launch, the founders of Kin described the Kin Ecosystem as “designed specifically to bring people together in a new shared economy,” with the cryptocurrency itself acting as a “foundation for a decentralized ecosystem of digital services.”

While most companies that launch their own cryptocurrency have a ready-made user base, Kik had an important advantage over its competitors in this regard. Kik already enjoyed millions of active users through its messaging platform. As such, the platform could drive mainstream consumer adoption of the Kin cryptocurrency. The Kik app was also able to house many of the traditionally third-party services and features for the currency, including the Kin wallet.

Kin Rewards Engine

Perhaps even more notable about the launch of Kin has been the Kin Rewards Engine. Through this mechanism, “Kin will be introduced into circulation as a daily reward, to be distributed among stakeholders by an algorithm that reflects each community’s contribution to the overall ecosystem.”

This is one of many ways that the makers of Kin have worked to incentivize the use of the cryptocurrency by the broader Kik community. Apps are still able to offer Kin to consumers in exchange for watching advertisements and providing feedback, as most cryptocurrencies operating in a similar fashion already do.

Besides this, though, consumers are able to engage in a much wider variety of activities in exchange for Kin tokens. The Kin development team assumes that consumers don’t enjoy having to watch ads in order to be rewarded in cryptocurrency, no matter how much they might like the reward. For that reason, it’s possible for Kik users to amass Kin tokens without ever having to watch advertisements.

Kik CEO and founder Ted Livingston has suggested that the Kin token is an opportunity to distribute value amongst developers. The idea is that Kik will give away value, incentivizing developers to “build an open and decentralized ecosystem of apps” on the Kik platform.

The Kin Foundation is a “manifestation of a not-for-profit governance organization that will ultimately be decentralized and autonomous,” helping to steer the development of the broader ecosystem, according to ETHnews. The ecosystem will not be based around advertising, as many social media platforms are, but rather on users being able to provide value to themselves and one another, and on those users then being rewarded for that contribution.

Besides being a digital currency, the Kin website describes the token as “different from other digital currencies because it is a cryptocurrency.” Kin is similar to bitcoin in that it makes use of the public blockchain and has monetary value. The fact that Kin is part of a blockchain allows its developers to control the creation and flow of tokens to prevent a surge. Blockchain support also allows a token to be guaranteed over the long term.

While many cryptocurrencies reward powerful mining operations and encourage users to stockpile tokens, Kin’s setup prompts Kik users to earn and spend their currency within the platform. Kin is seamlessly integrated into apps, with Kin-supported apps in the Kik platform set apart with a small “K” icon. Those icons link apps with the Kin Marketplace, where users can find many different opportunities to both earn and spend their tokens.

This is also the hub where developers are able to create and distribute content for Kin rewards. In these ways, Kik’s developers have worked to integrate the cryptocurrency into the app experience, assuring that customers do not have to go out of their way in order to become involved in the Kin economy.

Although Kin was only officially launched late in 2017, it comes on the heels of a large experimental campaign. Over a period of close to three years, Kik ran a project called Kik Points. This was very similar to Kin in that it offered Kik users the chance to earn and spend points within the app itself. At its highest levels, Kik Points reached transaction volumes equal to three times more than bitcoin. If Kin is able to achieve the same levels of interest and activity, the results could be phenomenal.

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Term: Guanxi

What Is Guanxi?

Guanxi (pronounced gwon-she) is a Chinese term meaning “networks” or “connections” that open doors for new business and facilitate deals. A person who has a lot of guanxi will be in a better position to generate business than someone who lacks it.

Generally an acknowledged fact, it is particularly true in China that the wheels of business are lubricated with guanxi.

How Guanxi Works

Guanxi is perhaps best understood by the old axiom, “it’s not what you know, but who you know that’s important.” Guanxi in the West comes in many forms—alumni networks, fraternity or sorority houses, past and present places of employment, clubs, churches, families, and friends.

In social sciences, guanxi is similar to some concepts understood in network theory, such as the idea of information or connection brokerage by well-positioned individuals in a social network, or their social capital.

The odds of gaining access to a business opportunity and then winning that opportunity are higher when you work your connections. If you are bidding for a contract in competition with others and you know someone on the other side of the deal, naturally you will try to utilize this contact to your advantage.

If you are a Wall Street executive with guanxi in Washington, you will certainly make a few phone calls to make sure lawmakers remain neutered and regulators stay off your back. If you are a CEO who wants to make an acquisition, you will tap your guanxi at the golf club to find a quicker route to your objective.

Key Takeaways

  • Guanxi is a Chinese term describing an individual’s ability to connect or network for productive business purposes.
  • Guanxi is perhaps best encapsulated by the axiom, “it’s not what you know, but who you know.”
  • Abusing guanxi through aggressive or dishonest business practices can jeopardize one’s reputation or present opportunities for corruption.

Staying Above Board with Guanxi

Depending on where you do business and how aggressive you are, using your guanxi can be innocuous or hazardous. It is commonly accepted as a way of conducting business affairs in the West, but you must be mindful of conflict of interests, whether governed by law or a company code of ethics and very serious cases that involve the Foreign Corrupt Practices Act (FCPA) if you do deals abroad.

In China, where the art of guanxi is practiced in high form, calling upon connections is the norm to get things moving. However, even there, one can go too far. Business leaders with guanxi in the government have engaged in illegal activity with dire consequences. Abusing guanxi is a bad idea in all but a few places on earth.

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Term: Hobby Loss

What Is a Hobby Loss?

These expenses, when paid in connection with a hobby, are deductible only to the extent of income earned by the hobby or recreational activity. A loss is not allowed for expenses in excess of hobby income.

Key Takeaways

  • A hobby is defined by the IRS as an activity you undertake for pleasure and not for profit: “from painting and pottery to scrapbooking and soapmaking,” according to the IRS factsheet.
  • If you and your children set up a lemonade stand on a busy corner on a hot summer day and make money from it, you must report the profit on your 1040.
  • You may be able to deduct some losses stemming from the activity if they don’t exceed the gross income for the activity.

How Hobby Loss Works

Expenses are an expected part of running a business — you have to spend money to make money. Expenses which are necessary to carry on a trade or business, incurred to produce income, or paid for investment in the company are deductible. When, despite a profit motive, your overall expenses exceed your earnings, the loss can offset unrelated income.

If an activity is not conducted for profit, but you still earn money from it, that money is taxable. Expenses related to that activity that result in a loss are deductible.

A hobbyist may deduct hobby expenses only to the extent of the hobby’s gross income during a particular taxable year. Losses due to activities not engaged in for profit are disallowed, and they do not carry forward to the next taxable year.

The hobby loss rules of the Internal Revenue Code (IRC) §183 attempt to curb perceived loss deduction abuses by hobbyists. The hobby loss rules apply to individuals, S corporations, trusts, estates, and partnerships, but not to C corporations. These rules limit deductions for activities not engaged in for profit.
Internal Revenue Service (IRS) warns that it will apply the hobby loss rules to disallow losses of activities it finds likely not to be engaged in for profit. It cited the following actions, among others: writing, auto racing, horse breeding, yacht chartering, and fishing. Taxpayers engaged in these activities must establish a profit motive to avoid the hobby loss limitations.

The IRS also publishes a tip sheet to help taxpayers distinguish between what’s a hobby and what’s a business.Assuming your hobby is a hobby and not a covert or nascent business, the IRS lists the following allowable deductions that can be claimed as itemized deductions on Schedule A, Form 1040. According to the IRS, “these deductions must be taken in the following order and only to the extent stated in each of three categories”:

  • Deductions that a taxpayer may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.
  • Deductions that don’t result in an adjustment to the basis of property, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
  • Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.

Real World Examples of Hobby Loss

The easiest way to avoid the hobby loss rules is to turn a profit more often than not. The hobby loss rules presume that an activity is for-profit if the operation was profitable for three out of the last five years ending with the current taxable year. For actions involving horses, the timeframe is two of the previous seven years.

If the presumption is not met, then the taxpayer must establish a profit motive. The following nine factors define hobby income and losses:

  1. Does the taxpayer, in carrying on the activity, have a businesslike manner
  2. Is the taxpayer an expert or an advisor
  3. Do they devote the necessary time and effort
  4. Is an appreciable asset created
  5. Are there success’ in similar activities
  6. What is the history of activity income or loss
  7. Have there been occasional profits
  8. Is there a stable financial status?
  9. Is this activity undertaken for personal pleasure or recreation

A taxpayer that fails to turn a profit or to establish a profit motive is not engaged in the event for profit. The hobby loss rules will apply. Hobby expenses that fail its three-tier deduction system are not deductible. Hobby expenses that exceed hobby income are disallowed as non-deductible hobby losses.

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Term: Random Walk Theory

What Is the Random Walk Theory?

Random walk theory suggests that changes in stock prices have the same distribution and are independent of each other. Therefore, it assumes the past movement or trend of a stock price or market cannot be used to predict its future movement. In short, random walk theory proclaims that stocks take a random and unpredictable path that makes all methods of predicting stock prices futile in the long run.

Key Takeaways

  • Random walk theory suggests that changes in stock prices have the same distribution and are independent of each other.
  • Random walk theory infers that the past movement or trend of a stock price or market cannot be used to predict its future movement.
  • Random walk theory believes it’s impossible to outperform the market without assuming additional risk.
  • Random walk theory considers technical analysis undependable because it results in chartists only buying or selling a security after a move has occurred.
  • Random walk theory considers fundamental analysis undependable due to the often-poor quality of information collected and its ability to be misinterpreted.
  • Random walk theory claims that investment advisors add little or no value to an investor’s portfolio.

Efficient Markets are Random

The random walk theory raised many eyebrows in 1973 when author Burton Malkiel coined the term in his book “A Random Walk Down Wall Street.” The book popularized the efficient market hypothesis (EMH), an earlier theory posed by University of Chicago professor William Sharp. The efficient market hypothesis states that stock prices fully reflect all available information and expectations, so current prices are the best approximation of a company’s intrinsic value. This would preclude anyone from exploiting mispriced stocks consistently because price movements are mostly random and driven by unforeseen events.

Sharp and Malkiel concluded that, due to the short-term randomness of returns, investors would be better off investing in a passively managed, well-diversified fund. A controversial aspect of Malkiel’s book theorized that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”

Random Walk Theory in Action

The most well-known practical example of random walk theory occurred in 1988 when the Wall Street Journal sought to test Malkiel’s theory by creating the annual Wall Street Journal Dartboard Contest, pitting professional investors against darts for stock-picking supremacy. Wall Street Journal staff members played the role of the dart-throwing monkeys.

After 100 contests, the Wall Street Journal presented the results, which showed the experts won 61 of the contests and the dart throwers won 39. However, the experts were only able to beat the Dow Jones Industrial Average (DJIA) in 51 contests. Malkiel commented that the experts’ picks benefited from the publicity jump in the price of a stock that tends to occur when stock experts make a recommendation. Passive management proponents contend that, because the experts could only beat the market half the time, investors would be better off investing in a passive fund that charges far lower management fees.

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Term: Plain Vanilla

What Is Plain Vanilla?

Plain vanilla is the most basic or standard version of a financial instrument, usually options, bonds, futures and swaps. It is the opposite of an exotic instrument, which alters the components of a traditional financial instrument, resulting in a more complex security.

Plain Vanilla Basics

Plain vanilla describes the simplest form of an asset or financial instrument. There are no frills, no extras, and it can be applied to categories such as options or bonds.

Plain vanilla can also be used to describe more generalized financial concepts such as trading strategies or modes of thinking in economics. For example, a plain vanilla card is a credit card with simply defined terms. Plan vanilla debt comes with fixed rate borrowing and no other features, so the borrower has no convertibility rights.

A plain-vanilla approach to financing is called a vanilla strategy. Calls for this came after the 2007 economic recession when risky mortgages contributed to the housing market collapse. During the Obama administration, many pushed for a regulatory agency to incentivize a plain vanilla approach to financing mortgages, stipulating­ – among other tenets – that lenders would have to offer standardized, low-risk mortgages to customers.

Key Takeaways

  • Plain vanilla is the most basic version of a financial instrument and comes with no special features.
  • Options, bonds, other financial instruments and economic modes of thinking can be plain vanilla.
  • A plain vanilla strategy was deemed necessary after the financial crisis of 2007, which led to the creation of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Examples of Plain Vanilla

A vanilla option gives the holder the right to buy or sell the underlying asset at a predetermined price within a specific timeframe. This call or put option comes with no special terms or features. It has a simple expiration date and strike price. Investors and companies will use them to hedge their exposure to an asset or to speculate on an asset’s price movement.

A plain vanilla swap can include a plain vanilla interest rate swap in which two parties enter into an agreement where one party agrees to pay a fixed rate of interest on a certain dollar amount on specified dates and for a specified time period. The counter-party makes payments on a floating interest rate to the first party for the same period of time. This is an exchange of interest rates on certain cash flows and is used to speculate on changes in interest rates. There are also plain vanilla commodity swaps and plain vanilla foreign currency swaps.

Plain Vanilla Versus Exotic Options

In the financial world, the opposite of plain vanilla is exotic. So an exotic option involves much more complicated features or special circumstances that separate them from the more common American or European options. Exotic options are associated with more risk as they require an advanced understanding of financial markets in order to execute them correctly or successfully, and as such, they trade over the counter.

Examples of exotic options include binary or digital options, in which the payout methods differ. Under certain terms, they offer a final lump sum payout rather than a payout that increases incrementally as the underlying asset’s price rises. Other exotic options include Bermuda options and Quantity-Adjusting options.

Plain Vanilla and Dodd-Frank

There was a push to make the financial system safer and fairer in the wake of the 2007 global financial crisis. This was reflected in the passing of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, which also enabled the creation of the Consumer Financial Protection Bureau (CFPB). The CFPB enforces consumer risk protection in part through regulating financing options that call for a plain-vanilla approach.

In 2018, President Donald Trump signed a bill easing back some of the restrictions on all of the nation’s banks except those considered to be the largest. This included raising the threshold at which they are deemed too important to fail from $50 billion to $250 billion and allowing the institutions to forego any stress tests. The CFPB was also stripped of some of its power, notably its enforcement of cases involving discriminatory lending practices.

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Term: Overextension

What Is Overextension?

Overextension describes a loan or extension of credit that is larger than what the borrower can repay. Overextensions can require the borrower to consolidate his or her debts into a single loan. Consumers who must use more than a third of their net income to repay debt other than their mortgage are generally considered to be overextended.

Understanding Overextension

For securities traders and investors, overextension represents leverage in excess of his or her account equity and buying power. This can greatly amplify losses in a bear market and force the trader to meet steep margin calls. The inability to do this can result in forced liquidation of securities and the freezing of the account.

The idea of overextension will vary based on the financial characteristics of a borrower. Wealthy individuals and cash-rich businesses can take on proportionally more debt than weaker borrowers without overextending themselves.

At times, becoming overextended can be out of the control of a firm’s management. For example, during a steep economic downturn, such as a recession, a business’s financial condition can materially deteriorate largely out of the company’s control. During a rough economic environment, it is not uncommon for a once healthy business to become overextended as conditions move out of their favor. This can happen to entire sectors even during robust economic climates. For instance, traditional brick-and-mortar retailers have struggled to adjust to online and e-commerce competition — despite record growth in many segments of the economy.

Credit, debt, and overextension are tricky to model financially. Because these factors have something of a “snowball” effect, where conditions pile onto one another, conventional linear models do not account for the nonlinear, exponential nature of credit risk. Often, once strong credit issuers or borrowers can rapidly deteriorate to weak credits as Murphy’s law works against an individual or business: Anything that can go wrong will go wrong.

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Term: Lucrative

What is Lucrative?

Lucrative means to produce wealth. To be lucrative means that an item or idea can create a large volume of income. The term lucrative is generally used to describe something with the potential to make money. The potential revenue source can include anything from collecting coins, creating a new invention or idea, or a person. Lucrative can be used in both past and present tenses. If used in present terms there is no guarantee that a particular idea with be a profitable venture, but if used in the past tense it signifies that the idea has been proven to produce wealth.

For example, an analyst may suggest that a particular stock is highly lucrative. What the analyst is suggesting is that this stock has the potential to be profitable. People can suggest that the stock market is a lucrative place to make money, but it is also a place where large amounts of money can be lost. People will always have their own interpretation of whether an idea or item is lucrative.

Key Takeaways

  • To be lucrative means that an item or idea can create a large volume of income or return.
  • Lucrative can be used to describe individual or organizational efforts to produce profit on a short or long-term basis.
  • If used in present terms there is no guarantee that a particular idea will be a profitable venture, but if used in the past tense it signifies that the idea has been proven to produce wealth.

Ways of Becoming Lucrative

Lucrative can be used to describe individual or organizational efforts to produce profit on a short or long-term basis. Lucrativeness is more associated with the net earnings rather than gross revenue. An individual may want to pursue a lucrative career or want to launch a business, for instance, that provides a positive return on investment. Their occupation or venture might have the potential for high revenue generation. There may be additional costs, risks, and other forms of exposure related to that occupation that reduce the lucrativeness of that position. For example, a business owner may need to procure a variety of insurance coverage for themselves and the company in case of workplace accidents, product liability, or employee-related matters.

Compliance with regulatory requirements, such as disclosing material information on a consistent basis or adhering to operational guidelines, can incur additional costs that further reduce the lucrativeness of a business. For example, heavy industry may have to clean up waste material produced by their operations.

Lucrative comes from from the Latin word lucrativus, which translates to ‘has gained’.

The path to achieving lucrativeness can be complex. For instance, a startup company might raise capital through numerous funding rounds. The investors and the founders alike will need the company to pursue strategies that maximize the operating revenue and earnings, as well as create the potential for profitable returns for the investors. If the company were to sell to a buyer who offered less than the overall investment that was made into the company, plus its debts, the deal would not be considered lucrative.

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Term: Hot Issues

What Is a Hot Issue?

A hot issue is a highly coveted initial public offering (IPO). Prior to the offering, the company has built up hype, whether or not deserved, and has decided to bring its shares to the public. With only a limited amount of stock available, and many investors wanting a piece of the action, the IPO garners much attention and further stokes the fires of investor demand.

Understanding Hot Issues

A company that has developed a new and exciting technology, a biotechnology firm with a promising drug in a late-stage trial, a “sharing economy” company that is quickly penetrating markets—these can capture the imagination of public investors who await a potential IPO. The gestation period of a company prior to going public can be short or long, depending on preferences of the founders to yield some control and early investors, including these founders, to experience their liquidity event.

Key Takeaways

  • A hot issue is a highly sought after initial public offering.
  • Biotechnology companies with promising drugs or high tech companies with innovative products are often hot issues.
  • When only a limited number of shares are available, and the stock sees large gains after its IPO, the buzz can further stoke the fires of investor demand.
  • Some investors only participate in hot issues for quick short-term gains, while others are in it for the long term.

Sometimes a company may remain private either voluntarily or involuntarily, the latter case of which may be imposed upon the firm by unfavorable market conditions or changed business prospects. A fast-growing company may not be able to sustain business at levels that justify an IPO. Also, sometimes, a private company is taken out (acquired) before it hits the public equity market. But, when a company that investors are eager for, eventually makes it to the IPO stage, its shares become a hot issue.

How Hot Issues Work

A widely-followed company will first file a Form S-1 for its intended IPO. Roadshows often follow, sponsored by the main underwriter(s), in which key executives give slide presentations and answer questions from dozens of institutional investors, as they digest roasted chicken or grilled salmon lunches at an upscale hotel meeting room.

Convinced that this IPO will score big gains, the investors communicate their orders to the investment bank(s) taking the company public. Only a limited number of shares are offered, so the IPO ends up being oversubscribed, which usually prompts the lead underwriter to increase the indicated price of the IPO or convince the company to offer more shares.

Finally, a hot issue will price after the market close of the IPO date. The next day the hot issue will open for trading on a stock exchange. Sometimes the price of shares will pop 20%, 30%, 50%, or more right off the bat and continue to remain hot for a period of time.

In other cases, some of the volatility in shares of a hot issue is driven in part by speculative investors attempting to make profits from buying and selling of shares, sometimes within seconds of the IPO. These investors do not care about investing in the company long term, but only seek quick trading profits. This can cause a hot issue to see a lot of trading volume in the early days of the IPO, which then fades as the initial excitement wanes.

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Term: Glide Path

What Is Glide Path?

Glide path refers to a formula that defines the asset allocation mix of a target-date fund, based on the number of years to the target date. The glide path creates an asset allocation that typically becomes more conservative (i.e., includes more fixed-income assets and fewer equities) as a fund gets closer to the target date.

How Glide Path Works

Each family of target-date funds has a different glide path, which determines how the asset mix changes as the target date approaches. Some have a very steep trajectory, becoming dramatically more conservative just a few years before the target date. Others take a more gradual approach.

The asset mix at the target date can be quite different as well. Some target-date funds assume that the investor wants a high degree of safety and liquidity because he or she might use the funds to purchase an annuity. Other target-date funds assume that the investor holds onto the funds, and therefore includes more equities in the asset mix, reflecting a longer time horizon.

Target date funds have become popular among those who are saving for retirement. They are based on the simple premise that the younger the investor, the longer the time horizon he or she has before retirement, and the greater the risk he or she can take to increase returns potentially. A young investor’s portfolio, for example, should contain mostly equities. In contrast, an older investor would hold a more conservative portfolio, with fewer equities and more fixed-income investments.

Types of Glide Paths

Declining Glide Path

An investor who uses a declining glide path gradually reduces their allocation of equities each year they get closer to retirement. For example, at age 50, an investor who holds 40% equities in his or her portfolio may reduce their equity allocations by 1% each year. They would then increase their allocation of safer assets, such as Treasury bills.

Static Glide Path

A portfolio that uses a static glide path maintains the same allocations. For instance, an investor may hold 65% equities and 35% bonds. If these allocations deviate due to price changes in the assets, the portfolio is re-balanced.

Rising Glide Path

Portfolios that use this approach initially have a larger allocation of bonds compared to equities. The equity allocation increases as the bonds mature, as long as the stocks in the portfolio don’t decrease in value. For example, an investor’s portfolio might start with an allocation of 70% bonds and 30% equities. After a large portion of the bonds matures, the portfolio may hold 60% equities and 40% bonds.

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Term: Monopsony

What Is a Monopsony?

A monopsony is a market condition in which there is only one buyer, the monopsonist. Like a monopoly, a monopsony also has imperfect market conditions. The difference between a monopoly and monopsony is primarily in the difference between the controlling entities. A single buyer dominates a monopsonized market while an individual seller controls a monopolized market. Monosonists are common to areas where they supply most or all of the region’s jobs.

Understanding Monopsony

In a monopsony, a large buyer controls the market. Because of their unique position, monopsonies have a wealth of power. For example, being the primary or only supplier of jobs in an area, the monopsony has the power to set wages. In addition, they have bargaining power as they are able to negotiate prices and terms with their suppliers.

There are several scenarios where a monopsony can occur. Like a monopoly, a monopsony also does not adhere to standard pricing from balancing supply-side and demand-side factors. In a monopoly, where there are few suppliers, the controlling entity can sell its product at a price of its choosing because buyers are willing to pay its designated price. In a monopsony, the controlling body is a buyer. This buyer may use its size advantage to obtain low prices because many sellers vie for its business.

Monopsonies take many different forms and may occur in all types of markets. For example, some economists have accused Ernest and Julio Gallo–a conglomerate of wineries and wine producers–of being a monopsony. The company is so large and has so much buying power over grape growers that grape wholesalers have no choice but to lower prices and agree to the company’s terms.

Key Takeaways

  • A monopsony refers to a market dominated by a single buyer.
  • In a monopsony, a single buyer generally has a controlling advantage that drives its consumption price levels down.
  • Monopsonies commonly experience low prices from wholesalers and an advantage in paid wages.

Monopsony and Employee Wages

Monopsony can also be common in labor markets when a single employer has an advantage over the workforce. When this happens, the wholesalers, in this case, the potential employees, agree to a lower wage because of factors resulting from the buying company’s control. This wage control drives down the cost to the employer and increases profit margins.

The technology engineering market offers one example of wage suppression. With only a few large tech companies in the market requiring engineers, major players such as Cisco, Oracle and others have been accused of conspiring on wages to minimize labor costs so that the major tech companies can generate higher profits. This example illustrates a sort of oligopsony in which multiple companies are involved.

Real-World Example

Economists and policymakers have increasingly become concerned with the domination of just a handful of highly successful companies controlling an outsized market share in a given industry. They fear these industry giants will influence pricing power and exert their ability to suppress industry-wide wages. Indeed, according to the Economic Policy Institute, a nonpartisan and nonprofit think tank, the gap between productivity and wage growth has been increasing over the last 50 years with productivity outpacing wages by more than six times.

In 2018, economists Alan Krueger and Eric Posner authored A Proposal for Protecting Low?Income Workers from Monopsony and Collusion for The Hamilton Project, which argued that labor market collusion or monopsonization might contribute to wage stagnation, rising inequality, and declining productivity in the American economy. They proposed a series of reforms to protect workers and strengthen the labor market. Those reforms include forcing the federal government to provide enhanced scrutiny of mergers for adverse labor market effects, the banning of non-compete covenants that bind low-wage workers and prohibiting no-poaching arrangements among establishments that belong to a single franchise company.

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Term: Long Jelly Roll

What is a Long Jelly Roll?

A long jelly roll is an option strategy that aims to profit from a form of arbitrage based on option pricing. The jelly roll looks for a difference between the pricing of a horizontal spread (also called a calendar spread) composed of call options at a given strike price and the same horizontal spread with the same strike price composed of put options.

Key Takeaways

  • A long jelly roll is an option spread-trading strategy that exploits price differences in horizontal spreads.
  • The strategy includes buying a long calendar call spread and selling a short calendar put spread.
  • The two spreads in this strategy are usually priced so close together that there is not enough profit to be made to justify implementing it.

How a Long Jelly Roll Spread Trade Works

A long jelly roll is a complex spread strategy that positions the spread as neutral, fully hedged, in relation to the directional movement of the share price so that the trade can instead profit from the difference in purchase price of those spreads.

This is possible because horizontal spreads made up of call options should be priced the same as a horizontal spread made up of put options, with the exception that the put option should have the dividend payout and interest cost subtracted from the price. So the price of the call spread should typically be a bit higher than the price of the put spread—how much higher depends on whether a dividend payout will occur before expiration.

Constructing a Jelly Roll Spread Trade

A jelly roll is created from the combination of two horizontal spreads. The spread can be constructed as a long spread, meaning the call spread was bought and the put spread was sold, or as a short spread, where the put spread is bought and the call spread is sold. The strategy calls for buying the cheaper spread and selling the longer spread. In theory, the profit comes when the trader gets to keep the difference between the two spreads.

For retail traders, the transaction costs would likely make this trade unprofitable, since the price difference is rarely more than a few cents. But occasionally a few exceptions may occur making an easy profit possible for the astute trader.

Long Jelly Roll Construction

Consider the following example of when a trader would want to construct a long jelly roll spread. Suppose that on January 8th during normal market hours, Amazon stock shares (AMZN) were then trading around $1,700.00 per share. Suppose also the following January 15th/January 22nd call and put spreads (with weekly expiration dates) were available to retail buyers for the $1700 strike price:

Spread 1: Jan 15 call (short) / Jan 22 call (long); price = 9.75

Spread 2: Jan 15 put (short) / Jan 22 put (long); price = 10.75

If a trader is able to buy Spread 1 and Spread 2 at these prices, then they can lock in a profit because they have effectively purchased a long position in the stock at 9.75 and a short position in the stock at 10.75. This happens because the long call and the short put position create a synthetic stock position that acts very much like holding shares. Conversely, the remaining short call position and long put position create a synthetic short stock position.

Now the net effect becomes clear because it can be shown that the trader initiated a calendar trade with the ability to enter the stock at $1,700 and exit the stock at $1,700. The positions cancel each other out leaving only difference between the option spread prices to be a concern that matters.

If the call horizontal spread can actually be acquired for one dollar less than the put option, then the trader can lock in $1 per share per contract. So a 10 contract position would net $1,000.

Short Jelly Roll Construction

In the short jelly roll the trader uses a short call horizontal spread with a long put horizontal spread—the opposite of the long construction. The spreads are constructed with same horizontal spread methodology but the trader is looking for the call spread pricing to be much lower than the put spread. If such a price mismatch were to occur that is not explained by upcoming dividend payments or interest costs, then the trade would be desirable.

Variations on the Jelly Roll Spread Trade

This strategy can be approached by implementing a variety of modifications including increasing the number of long positions on one or both of the horizontal spreads. The strike prices can also be varied for each of the two spreads, but any such modification creates additional risks to the trade.

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Inspirational Quotes: Marie Curie, Alex Korb, Amy Chua And Others

Read inspirational quotes about studying what scares you, staying focused on opportunity and building skills outside your comfort zone.

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Term: Jobber

What Is a Jobber?

A jobber is a slang term for a market maker on the London Stock Exchange prior to October 1986. Jobbers, also called “stockjobbers,” acted as market makers. They held shares on their own books and created market liquidity by buying and selling securities, and matching investors’ buy and sell orders through their brokers, who were not allowed to make markets. The term “jobber” is also used to describe a small-scale wholesaler or middleman in the retail goods trade.

Key Takeaways

  • A jobber, also known as a stockjobber, was a market maker on the London Stock Exchange.
  • Jobbers held shares on their own accounts and help boost market liquidity by matching investors’ buy and sell orders through their brokers.
  • The term jobber was used prior to October 1986, but little is known of their actual activities as they kept few records.
  • Jobbers left few records of their affairs and neither journalists nor other observers retained much in the way of detailed accountings of their work.
  • The jobber system evolved into a recognizably modern form during the course of the 19th century, as the range of securities types broadened.

Understanding Jobbers

Little is known about jobbers’ activities because they kept few records, but in the early 19th century, London had hundreds of jobbing firms. Jobbers’ numbers declined dramatically over the course of the 20th century until they ceased to exist in October 1986.

,P>This month was when the “Big Bang,” a major shift in the London Stock Exchange’s operations, occurred. London’s financial sector was suddenly deregulated, fixed commissions were replaced by negotiated commissions, and electronic trading was implemented.

Jobbers left few records of their affairs and neither journalists nor other observers retained much in the way of detailed accountings of their work. Histories of banks, stockbroking firms, and other concerns have been and will continue to be the basis of any historical record relating to jobbers.

The Centre for Metropolitan History has compiled an archive of interviews with former jobbers which serves as a permanent record of the last half-century of a distinctive part of the financial life of London.

Special Considerations

The jobber system evolved into a recognizably modern form during the course of the 19th century, as the range of securities types broadened. At least half the members of the London Stock Exchange began to specialize in making a continuous market in one of the leading types of these securities.

The distinction between these market-makers, or jobbers, and the brokers who dealt with them on behalf of the public was a clear-cut one but was essentially based on custom and tradition until 1909 when a single capacity was formally embodied in the London Stock Exchange rules. By 1914, over 600 jobbing firms were in existence, along with many one-man jobbing operations.

Those numbers steadily declined as the institutional investor supplanted the private one, and the scale of required jobbing capital increased dramatically. By the eve of “Big Bang,” there were only five major jobbing firms on the floor of the London Stock Exchange, though this numerical decline did not necessarily denote a decline in the marketability provided by the system.

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Term: Keogh Plan

What Is a Keogh Plan?

A Keogh plan is a tax-deferred pension plan available to self-employed individuals or unincorporated businesses for retirement purposes. A Keogh plan can be set up as either a defined-benefit or defined-contribution plan, although most plans are set as defined contribution. Contributions are generally tax-deductible up to a certain percentage of annual income, with applicable absolute limits in U.S. dollar terms, which the Internal Revenue Service (IRS) can change from year to year.

Key Takeaways

  • Keogh plans are tax-deferred pension plans—either defined-benefit or defined-contribution—used for retirement purposes by either self-employed individuals or unincorporated businesses, while independent contractors cannot use a Keogh plan.
  • Profit-sharing plans are one of the two types of Keogh plans that allow a business to contribute up to 100% of compensation, or $57,000 as of 2020.
  • Keogh plans have more administrative burdens and higher upkeep costs than Simplified Employee Pension (SEP) or 401(k) plans, but the contribution limits are higher, making Keogh plans a popular option for many high-income business owners.
  • Because current tax retirement laws do not set apart incorporated and self-employed plan sponsors, the term “Keogh plan” is rarely ever used.

Understanding the Keogh Plan

Keogh plans are retirement plans for self-employed people and unincorporated businesses, such as sole proprietorships and partnerships. If an individual is an independent contractor, they cannot set up and use a Keogh plan for retirement.

The IRS refers to Keogh plans as qualified plans, and they come in two types: defined-benefit plans, which include profit-sharing plans and money purchase plans, and defined-contribution plans, also known as HR(10) plans. Keogh plans can invest in the same set of securities as 401(k)s and IRAs, including stocks, bonds, certificates of deposit (CDs), and annuities.

Types of Keogh Plans

Qualified Defined-Contribution Plans

Keogh plans can be set up as qualified defined-contribution plans, in which the contributions are made on a regular basis up to a limit. Profit-sharing plans are one of the two types of Keogh plans that allow a business to contribute up to 100% of compensation, or $57,000 as of 2020 ($56,000 for 2019), according to the IRS. A business does not have to generate profits to set aside money for this type of plan.

Money purchase plans> are less flexible compared to profit-sharing plans and require a business to contribute a fixed percentage of its income every year that is specified in plan documents. If a business alters its fixed percentage, it may face penalties. The contribution limit for 2020 for money purchase plans is set at 25% of annual compensation or $57,000 ($56,000 for 2019), whichever is lower.

Qualified Defined-Benefit Plans

Qualified defined-benefit plans state the annual benefits to be received at retirement, and these benefits are typically based on salary and years of employment. Contributions towards defined-benefit Keogh plans are based on stated benefits and other factors, such as age and expected returns on plan assets. For 2020, the maximum annual benefit was set at $230,000 ($225,000 for 2019) or 100% of the employee’s compensation, whichever is lower.

Advantages and Disadvantages of Keogh Plans

Keogh plans were established through legislation by Congress in 1962 and were spearheaded by Rep. Eugene Keogh. As with other qualified retirement accounts, funds can be accessed as early as age 59 1/2, and withdrawals must begin by age 72, or 70 ½ if you were 70 ½ before Jan. 1, 2020.

Keogh plans have more administrative burdens and higher upkeep costs than Simplified Employee Pension (SEP) or 401(k) plans, but the contribution limits are higher, making Keogh plans a popular option for many high-income business owners. Because current tax retirement laws do not set apart incorporated and self-employed plan sponsors, the term “Keogh plan” is rarely ever used.

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Term: Inflation Swap

What is an Inflation Swap?

An inflation swap is a contract used to transfer inflation risk from one party to another through an exchange of fixed cash flows. In an inflation swap, one party pays a fixed rate cash flow on a notional principal amount while the other party pays a floating rate linked to an inflation index, such as the Consumer Price Index (CPI). The party paying the floating rate pays the inflation adjusted rate multiplied by the notional principal amount. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap.

Understanding Inflation Swaps

The advantage of an inflation swap is that it provides an analyst a fairly accurate estimation of what the market considers to be the ‘break-even’ inflation rate. Conceptually, it is very similar to the way that a market sets the price for any commodity, namely the agreement between a buyer and a seller (between demand and supply), to transact at a specified rate. In this case, the specified rate is the expected rate of inflation.

Simply put, the two parties to the swap come to an agreement based on their respective takes on what the inflation rate is likely to be for the period of time in question. As with interest rate swaps, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged), but instead of hedging against or speculating on interest rate risk their focus is solely on the inflation rate.

Inflation swaps are used by financial professionals to mitigate hedge) the risk of inflation and to use the price fluctuations to their advantage. Many types of institutions find inflation swaps to be valuable tools. Payers of inflation are typically institutions that receive inflation cash flows as their core line of business. A good example might be a utility company because its income is linked (either explicitly or implicitly) to inflation.

Key Takeaways

  • An inflation swap is a transaction where one party can transfer inflation risk to a counterparty in exchange for a fixed payment.
  • Inflation swap provides a fairly accurate estimation of what the market considers to be the ‘break-even’ inflation rate.
  • Inflation swaps are used by financial professionals to mitigate (hedge) the risk of inflation and to use the price fluctuations to their advantage.

How an Inflation Swap Works

One party to an inflation swap will receive a variable (floating) payment linked to an inflation rate and pay an amount based on a fixed rate of interest, while the other party will pay that inflation rate linked payment and receive the fixed interest rate payment. Notional amounts are used to calculate the payment streams. Zero coupon swaps are most common, where the cash flows are swapped only at maturity.

As with other swaps, an inflation swap initially values at par. As interest and inflation rates change, the value of the swap’s outstanding floating payments will change to be either positive or negative. At predetermined times, the market value of the swap is calculated. A counterparty will post collateral to the other party and vice versa depending on the value of the swap.

An example of an inflation swap would be an investor purchasing commercial paper. At the same time, the investor enters into an inflation swap contract receiving a fixed rate and pays a floating rate linked to inflation. By entering into an inflation swap, the investor effectively turns the inflation component of the commercial paper from floating to fixed. The commercial paper gives the investor real LIBOR plus credit spread and a floating inflation rate, which the investor exchanges for a fixed rate with a counterparty.

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Term: Holacracy

What Is a Holacracy?

A holacracy is a system of corporate governance> whereby members of a team or business form distinct, autonomous, yet symbiotic, teams to accomplish tasks and company goals. The concept of a corporate hierarchy is discarded in favor of a flat organizational structure where all workers have an equal voice while simultaneously answering to the direction of shared authority.

How a Holacracy Works

In a holacracy, instead of hiring a person to fill a pre-defined role (such as that outlined in a job description), people opt to take on one or more roles at any given time and have flexibility to move between teams and roles if they have skills or insights that would prove beneficial to the organization.

Holacracy looks to do away with managing from the top-down and gives individuals and teams more control over processes.

Arthur Koestler, author of the 1967 Book “The Ghost in the Machine,” coined the term holarchy as the organizational connections between holons (from the Greek word for “whole”), which describes units that act independently but would not exist without the organization they operate within.

Brian Robertson then developed the concept and dynamics of holacracy while running a software development company named Ternary Software in the early 2000s. In 2007, he and Tom Thomison founded HolacracyOne and published the Holacracy Constitution three years later. Companies that have publicly adopted holacracy in some form include Zappos.com.

Zappos.com, with 1,500 employees, is the largest company to adopt Holacracy.

Example of a Holacracy

One example of a holacracy is the video game software company Valve Corporation, maker of the Steam video games platform. At Valve, employees are allowed to work on whatever interests them, but also requires that they take ownership of their product and any mistakes they may make along the way.

Experts have argued that this structure works well for some, but that there are plenty of great employees for whom this type of organization is a terrible place to work.

Key Takeaway

  • A holacracy is a system for managing a company where there are no assigned roles and employees have the flexibility to take on various tasks and move between teams freely.
  • The organizational structure of a holacracy is rather flat, with there being little hierarchy.
  • The structure, which has a set of guidelines laid out as the Holacracy Constitution, works well for some but can be a bad fit for other employees that might otherwise be great in a more hierarchical system.

Special Considerations

Critics have pointed out that holacracy as a corporate management doctrine does not mean the end of the corporate hierarchy. Hierarchy is still an integral part of holacracy; in fact, hierarchies and the rigidity it creates in different actors’ roles may be more pronounced in holacracy.

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Term: Gain

What is a Gain?

A gain is an increase in the value of an asset or property. A gain arises if the selling price of the asset is higher than the original purchase price. A gain can occur anytime in the life of an asset. If an investor owns a stock purchased for $15 and the market now prices that stock at $20, then the investor is sitting on a five dollar gain. That said, a gain only truly matters when the asset is sold and the gains are realized as profit. An asset may see many unrealized gains and losses between purchase and sale because the market is constantly reassessing the value of assets.

Understanding Gains

A gross gain refers to the positive difference between the sale price and the purchase price. A net gain takes transaction costs and other expenses into consideration. A gain may also be either realized or unrealized. A realized gain is the profit that is received when the asset is sold, and an unrealized gain, also known as a paper gain, is the increase since purchase while the asset is still owned by the buyer. Another important distinction between gains is when they are taxable or non-taxable, as taxes can have a large impact on how much of a gain actually ends up in an investor’s pocket.

Key Takeaways

  • A gain is the positive difference between what you pay for an asset and what you sell it for. If the difference is negative, it is a loss.
  • Investors may talk about gains whenever the market price of an asset exceeds the purchase price they paid, but unrealized gains may come and go many times before an asset is sold.
  • Once an asset that has seen a gain in value is sold, an investor is said to have realized the gain – or put more simply, made a profit.

Gains and Taxes

In most jurisdictions, realized gains are subject to capital gains tax. As well as applying to traditional assets, capital gains tax may also apply to gains in alternative assets, such as coins, works of art and wine collections. Capital gains tax varies depending on the type of asset, personal income tax rate and how long the asset gets held. A capital gain can typically be offset by a capital loss. For instance, if an investor realized a $50,000 capital gain in stock A and realized a $30,000 capital loss in stock B, they may only have to pay tax on the net capital gain of $20,000 ($50,000 – $30,000).

However, if the gains accrue in a non-taxable account – such as an Individual Retirement Account in the U.S. or a Retirement Savings Plan in Canada – gains will not be taxed.

For taxation purposes, net realized gains rather than gross gains are taken into consideration. In a stock transaction in a taxable account, the taxable gain would be the difference between the sale price and purchase price, after considering brokerage commissions.

Here is an example of how a taxable gain works:

  • Jennifer buys 5,000 shares at $25 = $125,000
  • Jennifer sells 5,000 shares at $35 = $175,000
  • Jennifer’s commission is $200
  • Jennifer’s taxable gain is $49,800 ($175,000 – $125,000) – $200)

Compounding Gains

Legendary investor, Warren Buffet, attributes compounding gains as one the key factors to accumulating wealth. The basic concept is that gains add to existing gains. For example, if $10,000 is invested in a stock and it gains 10% in a year, it generates $1000. After another 10% return in the following year, the investment generates $1,100 ($11,000 x 10% gain), after the third year of a 10% gain, the investment now generates $1,210 ($12,100 x 10% gain). Investors who start compounding gains at a young age have time on their side to build substantial wealth.

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