investment

Fact checked by Betsy Petrick

With so many changes to the Department of Education and student loan servicing, it’s difficult to foresee how much Trump’s policies could cost the United States economy. Changes to repayment plans and collecting on defaulted student loans could make it challenging for borrowers to make payments. Additionally, the increased number of revoked international student visas is transforming the U.S. into a less attractive destination to study abroad, which could result in approximately $44 billion in lost revenue in a given year.

Key Takeaways

• Trump’s dismantling of the Department of Education and the administration’s proposed changes to income-driven repayment may make paying off student loans more challenging.
• The increased number of international students having their visas revoked and the crackdown on campus free speech may give rise to international students studying elsewhere.
• While it’s difficult to calculate the cost of Trump’s policies, the revenue loss from fewer international students in the U.S. could reach $44 billion per year.

What Has Changed for Students Since Trump Was Reelected?

Trump’s first 100 days saw sweeping changes for education, including federal student loan policy. Each of these shifts may negatively impact the U.S. economy, though by how much remains to be seen.

Trump’s Efforts to Eliminate the Department of Education

In March 2025, Trump made it clear he would like to dismantle the Department of Education, which would require Congressional approval. Following the announcement, the Department of Education stated it would cut 50% of its workforce as part of its “final mission.”

This move would entail the transfer of the management of federal student loans to the Small Business Administration (SBA). The Health and Human Services Inspector General, who’s responsible for government oversight, stated that the SBA has recently had a 40% reduction in its workforce and isn’t equipped to handle the sheer scale of the federal student loan portfolio. The Inspector General warns borrowers will experience “…erratic and inconsistent management of their federal student loans. Errors will prove costly to borrowers and ultimately, to taxpayers.”

Changes to IDR Plans

The status of the Saving for a Valuable Education (SAVE) plan has been tied up in the courts for months, but the block on the program was recently upheld. Although SAVE remains listed as a repayment option on the Federal Student Aid website, borrowers can no longer select it an option. The existing 8 million borrowers enrolled in SAVE will remain in an interest-free forbearance until the situation is resolved or servicers are able to bill borrowers for the appropriate monthly amount.

Defaulted Student Loan Collections Restarting Soon

Student loan repayment has been on and off again since the pandemic. However, the Department of Education began collecting on defaulted student loans on May 5, 2025. Borrowers who don’t make payments or sign up for a payment plan will see their wages garnished starting this summer. The collection process will impact the more than 5 million borrowers currently in default.

Tip

If it’s been a while since you logged in to your student loan account, be aware that your loan servicer may have changed.

International Students and Student Loans

Amid the massive shifts in the Education Department’s priorities and the crackdown on campus free speech, over 1,200 international students have had their visas or legal status revoked since late March.

Unlike U.S. citizens, international students studying in the U.S. cannot receive federal student loans. Since international students bear the responsibility for financing their education, they inject billions of dollars every year into the economy. During the 2023–2024 academic year, international students contributed nearly $44 billion and supported over 378,000 jobs in the U.S. If these students don’t see the U.S. as a safe and viable option, then other countries stand to reap these benefits.

The Bottom Line

Students, both domestic and international, have never faced more uncertainty when taking out student loans. For those local to the U.S., the massive changes to the Department of Education and workforce cuts will likely lead to confusion and costly mistakes.

If you have student loans, it’s important to document the payments you’ve already made (especially if you’re on an income-driven repayment (IDR) plan) and stay in touch with your loan servicer to avoid falling behind on payments.

Hint: You won’t have to pay taxes on withdrawals when you retire

Reviewed by Anthony Battle
Fact checked by Maddy Simpson

If you are in your 20s and ready to open an individual retirement account (IRA) to save for retirement, you’ll have two basic types to choose from: traditional or Roth. In most cases, a Roth IRA is a better choice for younger investors because they typically are in lower tax brackets when paying income taxes on the money.

Key Takeaways

• A Roth individual retirement account (IRA), rather than a traditional IRA, may make the most sense for people in their 20s.
• Withdrawals from a Roth IRA can be tax-free in retirement, which is not the case with a traditional IRA.
• Contributions to a Roth IRA are not tax-deductible, as they are for a traditional IRA. 
• Younger savers tend to be in lower tax brackets, which means that they benefit less from tax-deductible contributions to a traditional IRA than those in higher brackets.

Roth vs. Traditional IRAs

A traditional IRA provides a tax deduction for your contributions and a tax deferral on any gains in the account until you withdraw the money. Once you begin making withdrawals, they will be taxed based on your tax bracket at the time.

Roth IRA contributions, on the other hand, are not tax deductible, but your withdrawals can be tax-free if you follow the rules.

Younger investors who are just starting out in their careers tend to be in lower tax brackets and don’t benefit as much from the tax deductions for contributions to a traditional IRA as older investors in higher brackets may. In addition, the younger you are, the more time that your account will have to grow and compound—and with a Roth, all of that money can be tax-free someday.

Here’s a closer look at how each type of IRA works and why a Roth is usually a wiser choice for 20-somethings, especially if they can afford to forgo an immediate tax deduction.

Traditional IRA Tax Benefits

Traditional IRAs have been around since the 1970s and were once the only choice that people had. While their tax benefits provided an attractive incentive for Americans to save for retirement, the government wanted its cut eventually.

As a result, traditional IRAs can trigger a big tax bill when account holders begin to withdraw their money. The government also made withdrawals mandatory after a certain age, currently 73 if you were born between 1951 and 1959, and 75 if you were born in 1960 or after. Those are known as required minimum distributions (RMDs).

Here is a somewhat simplified example of how a traditional IRA can grow in value, while also accumulating a substantial tax obligation:

Suppose you’re 23 years old, earn $50,000 in taxable income, and contribute the maximum allowed of $7,000 for 2024 and 2025 to a traditional IRA. Because you are in the 22% tax bracket, your tax deduction for your IRA contribution will save you approximately $1,540 in federal income tax.

Important

A Roth IRA allows you to withdraw your contributions (but not investment gains) free of taxes or early-withdrawal penalties before age 59½, which is not the case with a traditional IRA.

Now, suppose you continue to contribute $7,000 each year to your traditional IRA until you are 63 years old (40 years multiplied by $7,000 = $280,000), and your traditional IRA grows to $1.8 million by that time (this is possible at an 8% annual return). If all of your contributions were fully deductible, then you saved $61,600 in taxes over the 40 years, assuming (for the sake of simplicity) that you remained in the 22% tax bracket.

At age 63, you decide to retire and withdraw $50,000 a year from your traditional IRA for living expenses. If you are still in that 22% tax bracket, you will owe $11,000 in federal income tax on each $50,000 withdrawal every year thereafter. In other words, you’ll net just $39,000.

If you’re in a higher tax bracket when you begin making withdrawals—either because you have more income or because tax rates have gone up overall—you could owe more still. And remember, once you hit age 75, you’ll have no choice but to start taking withdrawals and paying taxes on them.

Roth IRA Tax Benefits

The Roth IRA, introduced in 1997, works differently. Suppose that you contribute the same $6,500 a year for 40 years to a Roth IRA. You don’t get any tax deduction, but the Roth IRA still grows to $1.8 million—assuming the same 8% annual return. At age 63, you start to withdraw $50,000 per year.

The difference now is that there is no tax due on the Roth withdrawal because distributions from a Roth are tax-free as long as you have had a Roth account for at least five years and reached age 59½. In this scenario, you can withdraw $50,000 (or as much as you want) and keep the full amount.

Another key difference between Roth and traditional IRAs is that Roth IRAs are never subject to RMDs during the original owner’s lifetime. So if you don’t need the money, you can simply pass it along to your heirs when you die. They’ll have to withdraw it eventually, but their withdrawals can also be tax-free.

How Much Can You Contribute to a Roth Individual Retirement Account (IRA)?

For tax year 2024, the maximum amount that you can contribute to a Roth or a traditional individual retirement account (IRA)—or the two accounts combined—is $7,000 for anyone under age 50 or $8,000 for anyone age 50 or old. These limits are unchanged for tax year 2025.

Who Is Eligible to Contribute to a Roth IRA?

To contribute to a Roth IRA, you first must have earned income from a job or self-employment that is at least as much as you plan to contribute. There are also income limits on your eligibility for contributing. For example, for tax year 2024, a single taxpayer is eligible to make a full Roth IRA contribution if their modified adjusted gross income (MAGI) is less than $146,000. In the $146,000 to $161,000 range, they are eligible for a partial contribution. Above $161,000, they are ineligible. For 2025, the income phase-out range is between $150,000 and $165,000.

Are Roth 401(k) Plans a Good Idea for Young Investors?

A designated Roth 401(k), if your employer offers one, has the same advantages as a Roth IRA. It also has considerably higher contribution limits, allowing you to save even more for tax-free income after you retire. Another good thing about a Roth 401(k) account is that the SECURE 2.0 Act exempted those accounts from required minimum distributions (RMDs) as of 2024. This means that your Roth 401(k) can continue to grow tax-free in your account. It is important to note that the RMD exemption applies to the original account owner but not to beneficiaries.

The Bottom Line

Because of the Roth IRA’s unique tax benefits, 20-somethings who are eligible should seriously consider contributing to one. A Roth IRA can be a wiser long-term choice than a traditional IRA, even though contributions to traditional IRAs are tax-deductible.

Advisor Insight

Stephen Rischall, CFP, CRPC
Navalign Wealth Partners, Encino, CA

In general, Roth contributions have an edge over traditional contributions for young people. Having tax-free distributions in retirement is great, especially if taxes go up in the future. Since younger investors have a longer time horizon, the impact of compounding growth benefits even more.

Most young people tend to be in lower tax brackets. The benefit of deferring taxes by making contributions to a traditional IRA may not have as much of a tax savings impact as it will in the future when you are earning more.

There are income limits that disqualify you from making Roth IRA contributions. One day, if your income surpasses that limit, you can’t add to it.

Ultimately, you should seek a balance of making both Roth and traditional contributions over your lifetime.

While your 401(k) might not be your first concern when switching jobs, how you handle your old and new retirement accounts could have important consequences for your long term retirement savings.

Switching jobs can lead to higher pay, new challenges, and better opportunities. But job hopping also comes with hidden financial risks, especially regarding your 401(k). Fiona Greig, Global Head of Investor Research and Policy at Vanguard, lays out three reasons your retirement savings couple be compromised: the fine print on your 401(k), changing savings rates, and leakage.

Key Takeaways

• Leaving a job before employer contributions are vested may cause you to lose part of your retirement savings.
• Default 401(k) savings rates at new jobs are often low, so you may unintentionally save less when switching jobs.
• Failing to properly roll over or invest your old 401(k) can cause a long-term “cash drag” that undermines your retirement growth.

The Fine Print on Your 401(k)

If you’ve never heard of a vesting schedule for a 401(k), you’re not alone.

“About two-thirds of people don’t know what the vesting schedule is, so this feature is not very salient to workers,” said Greig.

Many employers offer workers a 401(k) match, which means your employer will contribute to your account based on how much you contribute. While your contributions are always 100% vested—meaning you have complete ownership of that money—your employer’s matching contributions may be subject to a vesting schedule.

A vesting schedule determines when employer contributions become fully yours. Some plans require staying at a company for up to six years to get the full match. Leave too soon, and you could forfeit thousands. However, neglecting to read up on the fine print could end up costing you a lot of money because a significant number of 401(k)s have vesting schedules.

In January 2024, the median amount of time an employee had worked with their current employer was just 3.9 years, according to the Bureau of Labor Statistics. And a 2018 Vanguard study found that about 30% of workers who left jobs forfeited part of their 401(k). On average, they lost 40% of their retirement balance due to unvested employer contributions.

Another study published in the Yale Law Journal found that vesting schedules collectively cost retirement savers across 900 plans more than $1.5 billion.

Changing Savings Rates

When you switch jobs, you may be automatically enrolled in a new 401(k). But if you’re not paying close attention to your new workplace retirement plan, you could be auto-enrolled at a lower savings rate.

“Many people are overwhelmed are when they’re switching jobs. You can easily end up saving less in your next job, as a percent of your income, than you were saving in your old job,” said Greig.

This is, in part, because 401(k) plans have a default savings rate of 3%. So, if you were contributing at a higher rate to your old 401(k), you might end up contributing at a lower rate after switching jobs.

A 2024 Vanguard study found that while a median job switcher received a 10% raise, they also experienced a a 0.7 percentage point drop in their 401(k) savings rate. While these workers saved more in dollar terms at their new jobs, they could have boosted their retirement savings further if they had maintained the same savings rate from their previous plan.

Leakage

Depending on the size of your previous 401(k) balance, your retirement funds could be forced out when you switch jobs. Failing to roll over those funds into an individual retirement account (IRA) could result in a 10% early withdrawal penalty and a reduction in your overall retirement savings.

Greig refers to this as retirement plan ‘leakage’.

“When people switch jobs, a lot of people cash out of their retirement plans entirely,” she said. “If someone has less than $1,000 in their plan, they can literally be sent a check.”

For balances worth more than $1,000 but less than $7,000, employers may roll that money into an IRA. However, when funds are rolled over into an IRA, they’re not automatically invested, which means some investors could end up leaving their money in cash for years or even decades.

“One thing we observe in IRA accounts is this big cash drag. When you move money into an IRA, there is no default investment (like a target-date fund), so you’re defaulted into cash,” said Greig. “Many people, to the tune of 28% of investors, after a rollover, leave their money in cash for seven years or longer. They don’t realize their retirement assets are sitting in a money market fund.”

The Bottom Line

Frequent job changes can result in a smaller retirement nest egg, but they don’t have to. To minimize the impact job switching has on your retirement savings, pay close attention to the details of your old and new 401(k) plans.

For example, aim to maintain the same (or even a higher) retirement savings rate at your new job. And if you have an old 401(k), avoid cashing it out if possible. When you do roll over your 401(k) into an IRA, ensure that your money is invested.

Finally, while you can’t change your employer’s vesting schedule, consider whether a job switch is worth it, especially if it means give up part of your retirement savings.

Fact checked by Suzanne Kvilhaug

An annuity is a financial product designed to provide a steady income stream during retirement. It is a contract between you and an insurance company, where you make a lump-sum payment or a series of payments. In return, the insurance company provides you with regular income for a set period, typically for the rest of your life.

The Internal Revenue Service (IRS) considers annuities tax-deferred investments because they allow you to postpone paying taxes on your investment earnings until you withdraw or receive payments. This means you won’t have to pay taxes on the interest, dividends, or capital gains your annuity earns until you start withdrawing money. When you start receiving payments, you will owe income taxes on previously untaxed withdrawals at your ordinary income tax rate for the year you receive the payments.

Key Takeaways

• Withdrawals from annuities may be subject to taxes and early withdrawal penalties.
• Reporting annuity income correctly on tax returns is important.
• There are tax planning strategies that can help minimize taxes on annuities.

Taxation of Annuity Payments

According to the IRS, the general rule for taxation of annuity payments says: “The amount of each payment that is more than the part that represents your net cost is taxable.” No matter how your annuity is constructed, you typically owe taxes on the part of any payments you receive on which taxes were not originally paid.

The taxable part represents earnings and any tax-deferred contributions you make. Therefore, the portion that represents a return of principal is not taxed unless it was placed in the annuity on a pre-tax basis. The tax rate that applies to annuity payments depends on your tax bracket.

The tax-deferred growth offered by annuities can be especially beneficial if you are in a higher tax bracket during your working years and expect to be in a lower tax bracket during retirement. By deferring the taxes until retirement, you may be able to pay a lower overall tax rate on the earnings from your annuity.

Warning

If you withdraw money before the age of 59 1/2, you may be subject to a 10% penalty tax in addition to regular income taxes.

Reporting Annuity Income on Tax Returns

To report annuity income on your tax return, you first need to determine the taxable portion of that income. The insurance company that provides the annuity will send you a Form 1099-R showing the total amount of annuity income you received during the year and the taxable portion of that income. You should use the information provided on this form to complete your tax return.

To report this income, fill out Form 1040 or Form 1040-SR and any taxable portion of your annuity income on Form 1040 or Form 1040-SR, Schedule 1.

If you made after-tax contributions to the annuity, you may be able to exclude that portion of your annuity income from your taxable income. However, this exclusion is limited, and you will need to use Form 1040 or Form 1040-SR, Schedule 1, to calculate the amount that can be excluded.

If you are 65 or older or retired due to disability, you may be eligible for the Credit for the Elderly or the Disabled, which can reduce the tax you owe.

It is important to note that reporting annuity income on your tax return can be complex, and it may be helpful to consult with a tax professional to ensure you are reporting your annuity income accurately and taking advantage of any applicable deductions and credits.

Tax Planning Strategies for Annuities

Annuities offer several tax advantages that make them an attractive option for retirement planning.

• Contributions to a qualified annuity are made with pre-tax dollars, meaning the money invested in an annuity grows tax-deferred until withdrawal.
• Annuities have no contribution limits, so you can invest as much as you want, which can be particularly advantageous for high-income earners who have already maxed out their other retirement accounts.
• Annuity payouts are taxed as ordinary income, which can be beneficial if your tax bracket is lower in retirement than during your working years.
• Annuities allow for tax-free transfers between accounts, which can help you manage your tax liability and maximize your retirement savings.

In addition to these advantages, there are a few strategies to minimize the taxes you will pay.

• Transfer or convert deferred annuities into income annuities, which can reduce your tax liability.
• Take withdrawals from non-qualified annuities before taking them from qualified annuities since non-qualified annuities are funded with after-tax dollars, and only the interest or earnings are taxed as ordinary income.
• Take advantage of the tax-deferred growth annuities offer. This allows your investment to compound without being taxed until you receive distributions.

What’s the Difference Between Qualified and Non-Qualified Annuities?

Qualified annuities are funded with pre-tax dollars and are typically held in a tax-advantaged retirement account, such as an IRA or 401(k). Contributions to qualified annuities are tax-deductible, but withdrawals are taxed as ordinary income.

Non-Qualified annuities, on the other hand, are funded with after-tax dollars and are typically held outside of a retirement account. The contributions made to non-qualified annuities are not tax-deductible.

How Are Inherited Annuities Taxed?

Inherited annuities are generally subject to taxation, and the amount and timing of the taxes depend on a few factors, such as whether the annuity is qualified (funded with pre-tax dollars) or non-qualified (funded with after-tax dollars).

Another factor is whether the original owner had begun receiving payments from the annuity before passing away. If the original owner had started receiving payments, the beneficiary may be required to pay taxes on the remaining payments based on their tax bracket. Suppose the original owner had not started receiving payments. In that case, the beneficiary may have the option to either receive a lump sum payment or payments over a set period, which can affect the tax liability.

If you are the beneficiary of an inherited annuity, consult a trusted financial advisor or tax professional to determine the best strategy for minimizing taxes on your inheritance.

What Is the Exclusion Ratio?

The exclusion ratio is a tax term used to describe the portion of an annuity payment that is considered a return of the original investment and, therefore, not subject to taxation. It is calculated by dividing the investment in the contract (the amount of after-tax money invested) by the expected return. The resulting percentage is the portion of each payment that is excluded from taxation as a return of principal.

How Are Roth IRA Annuities Treated for Tax Purposes?

Generally, Roth IRA annuities are tax-free if you follow the rules. The money you contribute to your Roth IRA has already been taxed, so it’s not subject to taxes again when you take it out. If you’re over 59 1/2 and your Roth IRA account has been open for at least five years, any earnings on your contributions can also be withdrawn tax-free. However, there are some exceptions and special rules to be aware of, so it’s always a good idea to consult a tax professional for personalized advice.

What Is Publication 575?

Publication 575 is a document published by the Internal Revenue Service (IRS) that provides information about the tax treatment of pension and annuity income. It explains how to report these types of income on your tax return and includes examples to help you understand the rules. The publication also covers other topics related to pensions and annuities, such as determining the tax-free portion of your distribution and reporting lump-sum distributions.

The Bottom Line

Annuities are tax-deferred investments, meaning you won’t have to pay taxes on the interest, dividends, or capital gains your annuity earns until you start withdrawing money. However, when you start receiving payments, you will owe income taxes on previously untaxed withdrawals at your ordinary income tax rate for the year you receive the payments.

Additionally, if you withdraw money before the age of 59 1/2, you may be subject to a 10% penalty tax. It’s important to consult with a financial advisor or tax professional to understand how annuities fit into your financial plan and what tax implications may apply to your situation.

Reviewed by Robert C. Kelly
Fact checked by Michael Rosenston

Tier 1 and Tier 2 are two types of capital banks hold. Tier 1 capital is a bank’s core capital, which it uses daily. Tier 2 capital is a bank’s supplementary capital, which is held in reserve. Banks must hold certain percentages of capital on hand to help ensure the stability of the financial system. A bank’s total capital is the sum of Tier 1 and Tier 2 capital.

Key Takeaways

• Bank regulations require that Tier 1 and Tier 2 assets must be at least 10.5% of their risk-weighted assets.
• Tier 1 capital is the primary funding source of the bank and consists of shareholders’ equity and retained earnings. 
• Tier 2 capital includes revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves, and undisclosed reserves.

Bank Regulations

Under the Basel Accords, a bank must maintain a certain level of cash or liquid assets as a ratio of its risk-weighted assets. The Basel Accords are three sets of banking regulations that help to ensure financial institutions have enough capital on hand to handle obligations.

The Accords set the capital adequacy ratio (CAR) to define these holdings for banks. Under Basel III, a bank’s Tier 1 and Tier 2 assets must be at least 10.5% of its risk-weighted assets. Basel III increased the requirements from 8% under Basel II.

Note

The Basel Accords are international banking regulations that ensure banks have enough capital on hand both to meet their obligations and absorb any unexpected losses. They are set by the Basel Committee on Banking Supervision (BCBS).

Tier 1 Capital

Tier 1 capital consists of shareholders’ equity and retained earnings. It is a bank’s core capital and includes disclosed reserves on the bank’s financial statements. This money is used daily and is a primary indicator used to measure a bank’s financial health.

Tier 1 holds nearly all of the bank’s accumulated funds. Under Basel III, the minimum tier 1 capital ratio is 6%, which is calculated by dividing the bank’s tier 1 capital by its total risk-weighted assets (RWA). Additionally, the total capital must be at least 10.5%. RWA measures a bank’s exposure to credit risk from the loans it underwrites.

Assume a financial institution has US$200 billion in total tier 1 assets. If they have a risk-weighted asset value of $1.2 trillion, the capital ratio is 16.66%:

($200 billion / $1.2 trillion)*100=16.66%

This is well above the Basel III requirements.

Tier 2 Capital

Tier 2 capital is a bank’s supplementary capital and includes undisclosed funds that do not appear on a bank’s financial statements, revaluation reserves, hybrid capital instruments, junior debt securities, and general loan-loss or uncollected reserves.

Revalued reserves recalculate the current value of a holding that is higher than what it was originally recorded as, such as with real estate. Hybrid capital instruments are securities that have equity and debt qualities, such as convertible bonds. Tier 2 capital is less reliable than Tier 1 capital and more difficult to liquidate.

Under Basel III, the minimum total capital ratio is 10.5%, and a minimum of 6% must be Tier 1 capital. Therefore, 4.5% can be Tier 2 capital if a bank has exactly 10.5% total capital. If the bank from the example above reported Tier 2 capital of $30 billion, its Tier 2 capital ratio for the quarter would be 2.5%:

($30 billion/$1.2 trillion)*100 = 2.5%

Thus, its total capital ratio was 19.16% (16.66% + 2.5%). Under Basel III, the bank met the minimum total capital ratio of 10.5%.

What Does It Mean That Tier 2 Capital Is “Gone Concern?”

Tier 2 capital is a type of gone-concern capital. If a bank fails, its Tier 2 assets will absorb any losses before its creditors or depositors do.

What Does a High Tier 1 Capital Ratio Mean?

A bank’s tier 1 capital ratio compares its core equity assets to its risk-weighted assets. A high ratio means that the bank has enough liquid assets on hand and is more likely to absorb losses without the risk of a bank failure.

What Was Tier 3 Capital?

Previously, the tiers of capital included a third layer. Tier 3 capital is tertiary capital, which many banks hold to support their market risk, commodities risk, and foreign currency risk, derived from trading activities. Tier 3 capital was abolished under the Basel III accords.

The Bottom Line

Tier 1 capital is the primary funding source of a bank. It consists of shareholders’ equity and retained earnings. Tier 2 capital is less liquid and includes assets such as revaluation reserves, hybrid capital instruments, and undisclosed reserves. Banking regulations known as the Basel Accords require banks to hold a specific percentage of assets.

Most financial advisors recommend diversifying your retirement portfolio with a mix of stocks, bonds, and other assets. But some argue that going all-in on stocks could vastly increase your retirement wealth.

Putting 100% of your retirement portfolio into stocks is a big decision that depends on your risk tolerance, financial goals, and time horizon. The key is understanding whether you’re one of those who could benefit from this approach, which significantly changes the level of risk you’ll face.

Is an all-stock retirement plan worth the risk, or should you aim for a more balanced approach? Let’s dive into the pros, cons, and expert insights to help you decide what’s right for you.

Key Takeaways

• An all-stock portfolio can lead to more returns over time, though the relative returns of stocks and other assets like bonds can look very different depending on the period of time.
• This aggressive strategy works best if you have multiple income sources (like Social Security), low monthly expenses, and the ability to emotionally handle major market drops without panicking and selling.
• Balanced portfolios are still often the safer choice for retirees, offering more predictable income and better protection against market volatility.

Is An All-Stock Retirement Plan Right For You?

Noah Damsky, founder of the Los Angeles-based Marina Wealth Advisors, acknowledges that investing your whole portfolio in stocks “might not be the best idea for everyone.” But many people are good candidates for an all-stock portfolio, he said.

“A balanced portfolio can be great, but including a good chunk of your portfolio in fixed income leaves a lot of growth on the table,” he said, particularly for people who may live in retirement for over 20 years. “If your spending is low enough relative to your overall wealth that you run a very small risk of depleting your assets, a larger or full allocation to stocks can make a lot of sense. In that case, you might be more worried about what you’ll ultimately leave to your heirs.”

Put simply, this strategy could work if you have plenty of money saved and don’t need to spend much of it. For example, if you’ve saved several million dollars, have your house paid off, and live comfortably on Social Security, you might be a good candidate.

“Their day-to-day needs are more than sufficiently covered by Social Security income plus a large asset base, so their primary concern is legacy planning—or how they want to leave an inheritance to the next generation,” Damsky said.

A team of researchers led by Aizhan Anarkulova, a professor at Emory University’s Goizueta Business School, found that an all-equity retirement plan generated 50% more retirement wealth, on average, than a 60/40 portfolio of 60% domestic stocks and 40% bonds.

The portfolio they studied, however, wasn’t without diversification—they spread the stocks among domestic and foreign companies. Still, the researchers noted that all-stock portfolios are vulnerable to large drawdowns, which “can inflict intense psychological pain” on investors and cause some to “abandon their investments rather than stay the course.”

“Our results, as a whole, do not suggest that the all-equity strategy is safe; they merely suggest that it is safer than common alternatives,” the researchers concluded. “Given the relative safety and strong growth potential of equities, retirement savers and retirees would likely benefit from adopting a ‘set it and forget it’ strategy that fully invests in domestic and international stocks.”

When investing in an all-stock portfolio, you have to be comfortable, both financially and emotionally, with volatility. Damsky said he asks clients, “If we have another 2008 crisis, where markets plunge 20% quickly, or even 50%, what will your situation look like? How will your lifestyle be affected?” This prepares them for the risks involved.

Why a Balanced Portfolio May Be Right For You

A caveat of the above is what the Emory University study notes upfront: the results can change drastically depending on the period looked at. Keeping a mix of different investments might still make good financial sense for most Americans.

“In retirement, one of the things you really need from a financial planning perspective is predictability,” Ian Bloom, an advisor and founder of Raleigh, North Carolina-based Open World Financial Life Planning, told Investopedia. “Diversification into bonds, commodities, and real estate investments tends to provide slightly lower volatility overall—and that often translates to a [greater] sense of security.”

Bloom also says he ensures these clients have about two years of cash reserves, so they aren’t too worried about short-term market volatility. With this cushion, retirees can avoid selling investments at “dramatic” losses if there’s a market crash. After all, the average recovery period for major U.S. market crashes is about two years.

Bloom suggests alternatives like commodities funds or real estate investment trusts (REITs) for retirees who still want higher returns but are nervous about an all-stock portfolio. “That might be a middle ground that’s more palatable for a retiree who’s trying to invest exclusively in stocks,” he said.

The Bottom Line

While a 100% stock retirement portfolio offers the potential for higher returns, it’s essential to assess your financial situation, risk tolerance, and spending habits. Some experts suggest that retirees with a lot of assets and fewer expenses might benefit from a higher stock allocation. However, this approach also carries the risk of significant short-term losses during market downturns.

Fact checked by Suzanne Kvilhaug

San Diego, Calif., has a well-deserved reputation as one of the most desirable retirement destinations in the United States. Unfortunately, it is also among the country’s most expensive places to retire, according to new research from Travel + Leisure and Investopedia.

We examined property prices, state and local taxes, and the overall cost of living—as well as the many factors that make San Diego appealing despite the big price tag.

Key Takeaways

• San Diego is a prime retirement destination, based on climate, recreation, and access to health care.
• It is also expensive, with a high cost of living, driven primarily by housing.
• Taxes can also be high, depending on the retiree’s income sources.

Understanding the Costs of Retiring in San Diego

Overall Cost of Living

San Diego isn’t cheap. The website Payscale pegs the cost of living there as 44% higher than the national average. Breaking that down, the site found that housing costs were 115% higher, transportation costs 35% higher, utilities costs 20% higher, and grocery costs 14% higher.

According to the Economic Policy Institute’s Family Budget Calculator (which takes into account housing, food, transportation, health care, taxes, and other necessities), a household with two adults and no children living in San Diego County would spend $86,243 a year, on average.

That’s high even for a retirement haven. The comparable figure for Beaufort County, S.C., home to Hilton Head Island, is $74,229. For Maricopa County, Ariz., which includes Phoenix and Scottsdale, it’s $68,525.

Property Prices

The high cost of retiring to San Diego County starts with the price of admission: home prices. According to Census Bureau data, the median home price in San Diego was recently $791,600.

That compares with the national median home price of $403,700, as of May 2025, according to the National Association of Realtors.

A search of Realtor.com showed many homes in the $1 million-plus category, quite a few with $2 million and $3 million asking prices. Coastal properties are particularly desirable and, given that there is only so much coastline, are often in limited supply.

In other words, property prices alone can put the area out of reach for many retirees. 

Even for retirees who can scrape up the cash, devoting too large a portion of their budget to housing can mean forgoing other pleasures, such as travel or dining out. In fact, housing accounts for nearly 38% of San Diegans’ annual spending, compared with a national average of just over 33%.

Local Taxes

California is known as a high-tax state, and San Diego is no exception. While not specific to retirees, the Economic Policy Institute’s Family Budget Calculator estimates that a household with two adults and no children in San Diego County can expect to pay an average of $1,055 a month in taxes. Those taxes take a variety of forms.

Sales taxes: California has the highest state sales tax in the U.S., at 7.25%, according to the Tax Foundation. San Diego County adds another 0.5% to that, for a combined total of 7.75%.

Counterbalancing that somewhat, California exempts many of the items that are likely to be on retirees’ shopping lists, including prescription drugs and most food products, except for heated prepared foods.

Income taxes: California has a progressive income tax, with marginal tax rates ranging from 1% to 12.3%. A married couple whose income was between $80,490 and $111,732, for example, would pay a top rate of 6%.

Important

Unlike some states, California treats pension benefits and withdrawals from IRAs and similar retirement accounts as taxable income. On the plus side, it does not tax Social Security benefits.

Property taxes: California actually has relatively low property tax rates, due in part to the restrictions imposed by the passage of Proposition 13 in 1978. According to the Tax Foundation, residents pay an average effective rate of 0.68%. However, because of the high local housing values, that can still add up. In 2022, San Diegans paid median property taxes of $5,214.

Estate taxes: Also on the plus side, California doesn’t have either an estate tax or an inheritance tax, which can be a concern for wealthier retirees.

Health Care Costs

San Diego has abundant and high-quality health care. For example, the Medicare.gov website lists 18 hospitals within a 25-mile radius, many with coveted four- or five-star quality ratings.

Health care costs in San Diego tend to be no higher and, in some cases, lower than those in many other parts of the country. While its figures don’t focus specifically on retirees, the U.S. Bureau of Labor Statistics found that in 2022-2023, San Diegans had average health care expenses of $5,514 a year, compared with a national average of $6,042. In Denver, for example, the comparable figure was $7,118, and in Phoenix, $7,550.

What Makes San Diego So Expensive?

Desirable Coastal Location

The southernmost major city on California’s Pacific coast, San Diego offers agreeable weather year-round. The county’s 70 miles of coastline are dotted with an array of public beaches for swimming, surfing, and basic lounging.

For retirees on the go, San Diego also has an international airport and two downtown cruise ship terminals serving 10 major cruise lines. The Mexican border city of Tijuana is about 30 minutes away by car.

Strong Local Economy

San Diego has a solid, well-diversified economy with major sectors including aerospace, defense, life sciences, manufacturing, and tourism. The county is also home to two dozen universities, colleges, and community colleges.

Those employers draw a well-educated workforce, with salaries to match. The average household income in San Diego was $122,832 in 2022-2023, according to the Bureau of Labor Statistics, compared with the national average of $97,911. That accounts, in part, for higher local prices.          

Limited Housing Supply

The housing market in San Diego ranks as “very competitive,” according to the real estate website Redfin. That demand is driven by regular full-time residents and second-home owners, including retirees.

Another factor is local zoning policies. While not uncommon in California or much of the U.S., San Diego’s zoning policies heavily favor single-family homes over multi-family units. A 2022 report from the Othering & Belonging Institute at the University of California, Berkeley, concluded that, “the San Diego region’s residential areas are dominated by single-family-only zoning, stifling the development of denser housing options, perpetuating racial and economic exclusion, and shaping access to opportunity for millions of Californians.”

Note

In 2024, the San Diego City Council approved a set of initiatives known as Blueprint SD, intended to increase the development of new homes, among other goals.

Retirement Considerations in San Diego

So, to sum up some of the major pros and cons of retiring to San Diego:

Pros: Beautiful Climate and Top-Tier Services

San Diego’s climate is likely a significant attraction for retirees who like to get out and about. As the National Weather Service explains, “The prevailing winds and weather are tempered by the Pacific Ocean, with the result that summers are cool and winters warm in comparison with other places along the same general latitude.” That means active retirees can enjoy the area’s many beaches, parks, and other outdoor attractions for much of the year.

San Diego also has many highly rated hospitals and health care facilities, as well as being well-situated for retirees who like to jump on a plane or cruise ship when the mood hits. Public transportation is limited, so residents are likely to want a car, but downtown San Diego and its coastal neighborhoods are pedestrian-friendly. 

Cons: High Housing and Everyday Costs

The major downside to a San Diego retirement, as we’ve indicated, is the cost of living. That’s driven primarily by housing prices, which are not only significantly higher than the national average but also higher than many comparable retirement hotspots.

Other, everyday costs, such as groceries and utilities, will also drive up the bill. So will state and local sales and income taxes. In particular, anyone whose prime sources of retirement income are likely to be pensions and IRAs, rather than Social Security, might want to look into a state that doesn’t tax them.  

The Bottom Line

San Diego’s considerable charms come at a price. Prospective retirees should consider how much of a premium they’re willing to pay for the area’s congenial weather, recreational opportunities, and top-flight health care, among other pluses. By comparing San Diego with other suitable retirement destinations, they can decide whether the high price tag is worth it. Many may decide that it is.   

Reviewed by Robert C. Kelly
Fact checked by Michael Rosenston

ETFs vs. Index Mutual Funds: An Overview

Both exchange-traded funds (ETFs) and index mutual funds are popular forms of passive investing, a term for an investment strategy that aims to match—not beat—the performance of a benchmark. Such passive strategies may use ETFs and index mutual funds to replicate the performance of a financial market index, such as the S&P 500 Index.

Active investing strategies require expensive portfolio management teams that try to beat stock market returns and take advantage of short-term price fluctuations.

Of note, passive strategies that involve ETFs and index mutual funds have grown dramatically in popularity versus active strategies. That’s not only due to the cost benefits of lower management fees, but also to higher returns on investment.

Index investing has been the most common form of passive investing since 1976, when Jack Bogle, founder of Vanguard, created the first index mutual fund.

The market for ETFs (the second most popular form of passive investing) has grown significantly since they were first launched in the 1990s as a way to allow investment firms to create “baskets” of major stocks aligned to a specific index or sector.

Both ETFs and index mutual funds are pooled investment vehicles that are passively managed. The key difference between them (discussed below) is that ETFs can be bought and sold on the stock exchange (just like individual stocks)—and index mutual funds cannot.

Key Takeaways

• Index investing has been the most common form of passive investing since 1976, when Vanguard founder Jack Bogle created the first index fund.
• ETFs have grown significantly since they were first launched in the 1990s.
• Because ETFs can be traded throughout the day, they appeal to a broad segment of the investing public, including active and passive investors.
• Passive retail investors often choose index funds for their simplicity and low cost.
• Typically, the choice between ETFs and index mutual funds comes down to management fees, shareholder transaction costs, taxation, and other qualitative differences.

The investing strategy behind an index fund—whether ETF or mutual fund—is that a portfolio that matches the composition of a certain index (without variation) will also match the performance of that index. Moreover, the overall market will outperform any single investment over the long term.

Exchange-Traded Funds

Diversification

In particular, an ETF is comprised of a portfolio of stocks, bonds, or other securities of a particular index and tracks the returns of that index. For example, ETFs can be structured to track a particular broad market index or a sector, an individual commodity or a diverse collection of securities, a specific investment strategy, or even another fund.

An ETF offers investors major diversification by providing exposure to a wide range of assets.

Intraday Trading

Unlike index mutual funds, ETFs are flexible investment vehicles that are highly liquid. They can be bought and sold on a stock exchange throughout the trading day, just like individual stocks.

Because investors can enter or exit an ETF position whenever the market is open, ETFs are attractive to a broad range of the investing public, including active traders (like hedge funds) as well as passive investors (like institutional investors).

Derivatives

Another reason why ETFs attract passive and active investors is that certain ETFs include derivatives—a financial instrument whose price is derived from the price of an underlying asset.

The most common ETFs that invest in derivatives are those that hold futures—agreements between buyer and seller to trade certain assets at a predetermined price on a predetermined future date. Other such ETFs may invest in options.

Available at a Brokerage

Another benefit of ETFs is that—because they can be traded like stocks—it is possible to invest in them with a basic brokerage account. There is no need to create a special account, and they can be purchased in small batches without special documentation or rollover costs.

Note

Investment research firms report that few (if any) active funds perform better than passive funds over the long term. In addition, compared to actively managed funds, passive ETFs and index mutual funds are low-cost investment options.

Index Mutual Funds

Similar to an ETF, an index mutual fund is designed to track the components of a financial market index. Index mutual funds must follow their benchmarks passively, without reacting to market conditions. Orders to buy or sell them can be executed only once a day after the market closes.

An index mutual fund can track any financial market, such as:

• The S&P 500 (the most popular in the U.S.)
• The FT Wilshire 5000 Index (the largest U.S. equities index)
• The Bloomberg Aggregate Bond Index
• The MSCI EAFE Index (European, Australasian, and Middle Eastern stocks)
• The Nasdaq Composite Index
• The Dow Jones Industrial Average (DJIA) (30 large-cap companies)

For example, an index mutual fund tracking the DJIA invests in the same 30 companies that comprise that index—and the fund portfolio changes only if the DJIA changes its composition.

If an index mutual fund is following a price-weighted index—an index in which the stocks are weighted in proportion to their price per share—the fund manager will periodically rebalance the securities to reflect their weight in the benchmark.

Potential for Strong Returns

Although they are less flexible than ETFs, index mutual funds can deliver the same strong returns over the long term.

Easy Accessibility

Another benefit of index mutual funds that makes them ideal for many buy-and-hold investors is their ease of access. For example, index mutual funds can be purchased through an investor’s bank or directly from the fund. There’s no need for a brokerage account. This accessibility has been a key driver of their popularity.

Key Differences

Certain features of each type of fund (described above) result in index mutual funds being less liquid than ETFs and lacking ETFs’ intraday trading flexibility. 

In addition, different factors related to index tracking and trading give ETFs a cost and potential tax advantage over index mutual funds:

• For example, ETFs don’t have the redemption fees that some index mutual funds may charge. Redemption fees are paid by an investor whenever shares are sold.
• Additionally, the constant rebalancing that occurs within index mutual funds results in explicit costs (e.g., commissions) and implicit costs (trade fees). ETFs avoid these costs by using in-kind redemptions rather than monetary payments for exited securities. This strategy can limit capital gains distributions for shareholders (but of course, capital gains taxes may still be owed when investors themselves sell their shares).
• ETFs have less cash drag than index mutual funds. A cash drag is a type of performance drag that occurs when cash is held to pay for the daily net redemptions that happen in mutual funds. Cash has very low (or even negative) real returns due to inflation, so ETFs—with their in-kind redemption process—are able to earn better returns by investing all cash in the market.
• ETFs are more tax efficient than index funds because they are structured to have fewer taxable events. As mentioned previously, an index mutual fund must constantly rebalance to match the tracked index and therefore generates taxable capital gains for shareholders. An ETF minimizes this activity by trading baskets of assets. In turn, this limits exposure to capital gains on any individual security in the ETF portfolio.

Important

In 2023, ETFs attracted $598 billion in assets while mutual funds saw $440 billion in outflows. In 2021, they attracted close to a $1 trillion.

Special Considerations

The benefits and drawbacks of ETFs versus index mutual funds have been debated in the investment industry for decades, but—as always with investment products—the choice of one over the other depends on the investor.

Typically, it comes down to preferences related to management fees, shareholder transaction costs, taxation, and other qualitative differences.

Despite the lower expense ratios and tax advantages of ETFs, many retail investors (non-professional, individual investors) prefer index mutual funds. They like their simplicity and their shareholder services (such as phone support and check writing) as well as investment options that facilitate automatic contributions.

While increased awareness of ETFs by retail investors and their financial advisers has grown significantly, the primary drivers of demand have been institutional investors seeking ETFs as convenient vehicles for participating in (or hedging against) broad movements in the market.

The convenience, ease, and flexibility of ETFs allow for the superior liquidity management, transition management (from one manager to another), and tactical portfolio adjustments that are cited as the top reasons institutional investors use ETFs.

What Is the Biggest Difference Between ETFs and Index Mutual Funds?

The biggest difference is that ETFs can be bought and sold on a stock exchange (just like individual stocks) and index mutual funds cannot.

Which Has Higher Returns: ETFs or Index Mutual Funds?

ETFs and index funds deliver similar returns over the long term. Of note, investment research firms report that few (if any) active funds perform better than passive funds like ETFs and index mutual funds.

What Triggers Taxable Events in Index Mutual Funds?

In nearly all cases, the need to sell securities triggers taxable events in index mutual funds. The in-kind redemption feature of ETFs eliminates the need to sell securities, so fewer taxable events occur. Of course, investors in either fund may owe capital gains taxes after selling their shares in the fund.

The Bottom Line

ETFs and index mutual funds can be two smart choices for investors saving for the long run. Both are used in passive investing strategies.

The biggest difference between them is that ETFs trade intraday at various prices during exchange hours and index mutual funds can be bought or sold only after the market closes each day, at a fund’s net asset value.

Reviewed by Michael J Boyle
Fact checked by Vikki Velasquez

The Federal Reserve uses tools it calls Open Market Operations, Interest on Reserve Balances, its Discount Window rate, and the rate at its Overnight Reverse Repurchase Agreement Facility to inject or remove money from the supply and influence interest rates, which encourages or discourages lending between banks, and between banks and customers, where most money is created.

Key Takeaways

• The Federal Reserve, as America’s central bank, is responsible for controlling the supply of U.S. dollars.
• The Fed purchases securities on the open market and adds the corresponding funds to the bank reserves of commercial banks, who create more money by lending it.
• It can also sell securities, which takes money out of circulation.
• The Fed sets a target federal funds rate range using the rates of other tools to affect interest rates throughout the economy and adjust the rate of money creation.

Open Market Operations (OMO)

The Fed uses open market operations (OMO), where it buys or borrows existing bonds on the open market from commercial banks and other financial institutions. When the central bank buys bonds, it pays for them by adding cash to the reserve accounts of member banks. These transfers increase the amount of money circulating.

Conversely, the Fed can sell or lend bonds to banks. It removes money from member banks’ reserve accounts and transfers the bonds to them, removing money from circulation.

The Discount Window Rate

The Federal Reserve acts as the lender of last resort for commercial banks in the U.S. It hosts facilities in each of its Reserve Banks called discount windows, where banks can go to take out loans. There are three interest rates banks might pay at these windows: a primary rate, a secondary rate, and a seasonal rate.

The primary rate is charged to the most creditworthy banks. It is called the discount window rate regarding setting the target rate range that the Fed wants to keep the federal funds rate within.

Overnight Reverse Repurchases (ON RRP)

The Federal Reserve uses repurchase agreements as another way to keep the federal funds rate within its target rate range. The Fed can buy (repurchase) bonds from banks with the intent to sell them back to them at a later date for a higher price. It can also sell bonds to banks (reverse repurchase) with the intent to buy them back at a later date for a higher price.

Important

The Overnight Reverse Repurchase rate helps the Fed keep the federal funds rate within the lower bound of its target rate range.

Interest on Reserve Balances (IORB)

Commercial banks are no longer required to maintain reserve balances at the Fed. However, they are incentivized to do so because the Fed pays them interest on the amount they hold in reserve. This interest is credited to the banks’ reserve accounts, essentially creating money. The banks can then use this money in loans, which creates more money.

IORB is the primary tool the Fed uses to keep the federal funds rate within the target rate range. The central bank sets the IORB rate so that banks must decide whether lending money to other banks or leaving funds in their reserve accounts and generating interest income is more profitable.

The Federal Funds Target Rate Range

The Federal Funds Rate, as it was known prior to 2019, was an interest rate set by the Fed as a rate for banks to use when initiating overnight loans from excess reserves. The Fed transitioned from a regime of abundant reserves to one of ample reserves, changing how the Federal Funds Rate was determined.

To encourage banks to lend to each other, and to affect how money is created, the Fed publishes a target rate range derived from the discount rate and the ON RRP rate. The rates for IORB, the discount window, and ON RPP (collectively called the administered rates) are set to keep the federal funds rate from exceeding or falling below the rate boundaries set by the Fed and encourage banks to act the way the Fed wants them to.

The Federal Funds Effective Rate is calculated using a weighted average of the rates banks charge each other overnight. It’s used by banks as a guide for all other interest rates, and it also helps dictate how much money is being created.

Does the Fed Create New Money?

Yes, but the Fed does not print paper money. That is handled by the Treasury Department’s Bureau of Engraving and Printing. The U.S. Mint produces the country’s coins.

Does the Fed Make a Profit?

No. The Fed earns interest on securities held and through fees. Once it pays its expenses, it turns over all remaining funds to the U.S. Treasury.

Does the Federal Reserve Create the Federal Budget?

No. The federal budget is created by Congress and the president. The Federal Reserve focuses on monetary policy.

The Bottom Line

The Federal Reserve creates money when it decides that the economy would benefit from it. It does not print currency but adds funds to the money supply by changing the Fed funds target rate range to affect other interest rates. It may also buy Treasury securities on the open market to add funds to bank reserves. Banks create money by lending surplus reserves to consumers and businesses. This, in turn, ultimately adds more to circulating money as funds are deposited and loaned again.

Reviewed by Michael J Boyle
Fact checked by Vikki Velasquez

Industry vs. Sector: An Overview

Although some may think they are the same, the terms “industry” and “sector” have different meanings. Industry refers to a specific group of similar types of companies, while sector describes a larger segment of the economy. In the stock market, the generally accepted terminology cites a sector as a broad classification and an industry as a more narrow one.

Analysts and other financial writers might create confusion if they use the terms interchangeably or if they reverse the meanings behind the two terms. But they can avoid such confusion by referring to a sector as a broad economic segment that contains industries, while an industry falls within a sector and breaks down according to more specific companies and business activities.

Key Takeaways

• Industry refers to a group of companies that operate in a similar business sphere, and its categorization is narrow.
• Sector refers to a part of the economy into which various industries consisting of a great number of companies can be fit, and is larger in comparison.
• Investors often compare companies within the same industry for investment opportunities.
• Stocks of companies in the same industry will usually trade in the same direction, as their fundamentals can be affected by market factors in the same way.
• There are four types of sector groupings in the economy: primary, secondary, tertiary, and quaternary.

Industry

Industry refers to a specific group of companies that operate in a similar business sphere and have similar business activities. Industries are created by breaking down sectors into more defined groupings. Therefore, an industry is a subcategory of a sector.

Industry Examples

Examples of industries include banks, asset management companies, insurance companies, and brokerages. Companies that fall into the same industry offer similar products or services and compete for customers who require them. For instance, banks will compete with one another for customers who require checking and savings accounts. Asset management firms compete for investment clients.

Industries can be further categorized into more specific groups. For example, the insurance industry can be broken up into different, specialized divisions like home, auto, life, malpractice, and corporate insurance.

Investors often compare different companies within the same industry. These are apples-to-apples comparisons since the companies may share the same or similar production processes, customer type, financial reporting, or responsiveness to policy changes.

Moreover, the stocks of companies within the same industry will typically see price moves in the same direction, since they’re affected by the same (or similar) factors, including market changes. So, for example, within the healthcare sector, the stocks in the healthcare provider and services industry may respond in the same way when decisions about the Affordable Care Act (ACA) are made in Washington, D.C.

Important

The North American Industry Classification System (NAICS) facilitates the straightforward comparison of statistics of business activity across North America.

Sector

A sector is a general segment of the economy that contains similar industries. An economy can be broken down into about a dozen sectors which can describe nearly all of the business activity in that economy. Economists can obtain an understanding of the economy by looking at each sector.

There are four types of sector groupings in the U.S. economy:

• Primary Sector: This grouping deals with the extraction and harvesting of natural resources such as agriculture and mining.
• Secondary Sector: This grouping pertains to construction, manufacturing, and processing. Its sectors relate to the production of finished goods from raw materials.
• Tertiary Sector: This grouping includes services, such as retail sales, entertainment, recreation, and communications. Companies in the tertiary sector provide services to the primary and secondary sectors as well as to consumers.
• Quaternary Sector: This sector grouping deals with knowledge or intellectual pursuits including research and development (R&D) and education.

Sector Examples

The economy’s basic materials sector includes companies that deal with the exploration, processing, and selling of basic materials such as gold, silver, or aluminum. These materials are then used by other sectors of the economy. This is a primary sector.

Transportation is another sector of the economy. This sector includes automobile manufacturing, train, trucking, and airline industries. It is a tertiary sector.

Specific exchange-traded funds (ETFs) may track particular sectors. One such ETF is the Energy Select Sector SPDR Fund.

Investors can use sectors as a way to categorize the stocks in which they invest, such as telecommunications, transport, healthcare, and financials. Each sector comes with its own characteristics and risks.

Use in Financial Analysis

When evaluating companies, it is more prudent to evaluate those within an industry than those throughout a sector. This is so because, as noted above, each sector has many different industries.

For example, the transportation and warehousing sector includes a variety of industries relating to different types of transport, including air transportation. But if you want to compare companies that build planes, such as Boeing and Airbus, it would be best to look at the aerospace industry within this sector, and not the sector as a whole.

Though all of the companies in the sector could be affected by similar factors, they have completely different purposes, capital expenditures, cash flows, operating margins, and so on.

Therefore, when utilizing financial ratios to compare one company to the next, again, look at companies in the same industry. In other words, compare Boeing to Airbus as opposed to an airline catering service.

Key Differences

Industry

• An industry groups similar companies together. It exists as a subset of a particular sector.
• As an economic component, an industry is smaller than a sector.
• An industry can grow or otherwise shift with time. As innovations emerge, an industry could become obsolete and disappear.
• Industries are classified according to the products and services that the companies within them offer.
• As a subset of a sector, and representing such specific economic contributors, industries rank lowest in the economic order.
• An analysis of an industry provides a drilled-down view of companies and their performances, as well as the overall performance of the industry.
• Industry oversight can be straightforward and strictly enforced because of the limited, well-defined business types and activities.

Sector

• A sector groups various industries together.
• A sector represents a larger swath of the economy than an industry because it can contain thousands of industries.
• Due to their broader scope, sectors are typically more stable than industries, especially the secondary and tertiary types (because of their essential industries).
• Sectors are classified broadly according to common business practices among industries.
• In the overall economic order, sectors rank second because they contain all economic contributors.
• An analysis of a sector provides a higher-level view of the economy compared to the view offered by an industry.
• Sector oversight is more relaxed or general due to the huge number of industries that sectors contain, and the oversight already in place for industries.

Quick Reference Comparison
	Industry	Sector
Defined	Groups similar companies	Groups similar industries
Breadth	Contains many companies	Contains thousands of industries
Change Potential	May grow or shrink over time	Normally, remains stable due to broader diversification
Classification	According to products and services of companies	According to commonalities among industries
Ranking	Last in the economic order	Second in the economic order
Analysis	Targeted view of companies’ details and performances	Higher level view of industries’ performances
Gov’t Oversight	Stricter enforcement possible due to limited business types and activities	Less involved due to large number of industries and existing industry oversight

Explain Like I’m Five

Sector and industry are terms used to make generalizations about a large group of companies. A sector is a larger category than an industry, though. Manufacturing is considered a “sector,” while auto manufacturing is an industry within that sector.

Analysts often compare companies in the same industry because they tend to be very similar. If you compare any two companies in the same sector, they will probably be very different.

Which Is Bigger, an Industry or a Sector?

A sector is the larger of the two. It can group thousands of industries together. An industry groups similar companies.

Is Manufacturing a Sector or an Industry?

Manufacturing is a sector. It contains companies that mechanically, physically, or chemically change materials, substances, or components into different products.

Who Classifies Industries and Why?

The U.S. government uses the North American Industry Classification System (NAICS) to classify industries. It does so to gather, analyze, and report a range of data about the U.S. economy.

The Bottom Line

Industry vs. sector. The two terms are often used interchangeably but they have distinct meanings for investors, analysts, and the federal government.

An industry represents a group of similar business establishments. It is a subset of the larger sector. A sector groups industries, based on their common features and according to the sector type into which their business practices fit (primary, secondary, tertiary, or quaternary).

Grouping companies into specific categories that reflect their similarities allows for a more effective view and comparison of their functions, operating activities, and business results.