money

Reviewed by Margaret James
Fact checked by Michael Rosenston

The process of budgeting for capital expenditures (capex) is essential for a business to operate and grow in a healthy and profitable way. Capital expenditures are expenses a company makes to sustain and expand its business over a period of years.

A capital expense is the cost of an asset that has usefulness, helping create profits for a period longer than the current tax year. This distinguishes them from operational expenditures, which are expenses for assets that are purchased and consumed within the same tax year.

For example, printer paper is an operational expense, while the printer itself is a capital expense. Capital expenditures are much higher than operational expenses, covering the purchase of buildings, equipment, and company vehicles. Capital expenditures may also include items such as money spent to purchase other companies or for research and development. Operational expenses are just what their name signifies, the expenses required for the company to operate from week-to-week or month-to-month.

Capital expenditures carry both benefits and risks. Investing in capex can improve the efficiency of a firm, can allow firms to gain a competitive edge, while at the same time they may fail to perform as expected, resulting in losses that could have been allocated elsewhere.

It’s important to create a sound capital expenditure plan to avoid any expense overruns. Because capital expenditures represent substantial investments of cash designed to show a return on the capital investment over a period of years, they need to be carefully planned. Taking into consideration all costs, market expectations, and business growth, is crucial when drafting a capex plan.

Capital Expenditure Planning

Preparing a capital expenditure budget varies from one company to another depending on such factors, such as the nature of the company’s business and the size of the company.

Separating Expenditure Budgets

Most companies budget their capital expenditures separately from other expenditures. Having a separate budget from operational expenses, for example, makes it simpler for companies to calculate the respective tax issues. For operational expenses, deductions apply to the current tax year, but deductions for capital expenditures are spread out over the course of years as depreciation or amortization.

Department Input

Much of the need for capex comes from the assessment of department heads, who run the day-to-day operations of a certain group. They are well aware of any issues within their group that would need updating or replacement. This bottom-up approach assessment helps determine whether any capex expenditures are beneficial for long-term growth, what is economically feasible, and what the return on the investment will be. In the end, capital expenditures are inevitably determined by upper management and owners.

Implementing a Budget Limit

Determining the max spend on capital is a crucial early step in capex planning. Making a thorough assessment of capex needs, whether this is for maintenance, new acquisitions, or growth, from different departments, determines the range in how much to budget for capex. Once a company decides its spend limit, it can shape a plan around that.

Measuring Capital Expenditure Returns

Once the input from different departments has been assessed, a budget decided based on need and business growth, and capital expenditures completed, it’s imperative a company determine the returns on their capital expenditure. This will allow them to determine if their valuations were correct, whether or not the investments are paying off, what went right and what went wrong, so during the next capex cycle, these decisions are continued or improved.

Many financial tools are available in assessing the returns of capital expenditures, particularly the timeframe in which the investments will start to payback. Return on investment ratios, hurdle rates, and payback periods are areas to analyze when determining the benefit of a capital expenditure.

Management’s Role in Capital Expenditures 

For one thing, capital budgeting involves very large expenditures, and it is management that must make the evaluation as to whether the investment in assets is worth the cost. Capital expenses almost always impact operational expenses as purchased items need to be maintained and the “big picture” needs to be considered.

Management must make the call on whether capital expenditures come directly from company funds or if they must be financed. Financing increases the debt level of a firm, which also needs to be taken into consideration. Leasing is an option as well, one that becomes appealing if a company is purchasing assets such as computers or other technology equipment—items that can quickly become obsolete.

In deciding on capital expenditure for a certain item, a company’s management makes a statement about its view of the company’s current financial condition and its prospects for future growth.

Capital budgeting decisions also give an indication regarding what direction the company plans to move in the years ahead. Capital expenditure budgets are commonly constructed to cover periods of five to 10 years and can serve as major indicators regarding a company’s “five-year plan” or long-term goals.

The Bottom Line

Capital expenditures are a large cost for a company but usually necessary. They come with many benefits and many risks, which is why it is imperative to create a sound and thorough capital expenditure budgeting plan that takes into consideration all variables. If a company can do this correctly and execute capex investments appropriately, it will lead to positive growth and success for the firm.

Reviewed by Charlene Rhinehart
Fact checked by Kirsten Rohrs Schmitt

Accrued Expenses vs. Accounts Payable: An Overview

Companies must account for any expenses incurred in the past because these are costs that come due in the future. Accrual accounting is the general accounting term that covers any of these liabilities. Companies use two methods to track these accumulated expenses: accrued expenses or accounts payable.

Both are liabilities that businesses incur during their normal course of operations, but they’re inherently different. Accrued expenses are liabilities that build up over time and are due to be paid. Accounts payable are current liabilities that will be paid in the near future.

Key Takeaways

• Accrued expenses and accounts payable are two methods used by companies to track accumulated expenses under accrual accounting.
• Accrued expenses are liabilities that build up over time and are due to be paid.
• Accounts payable are liabilities that will be paid in the near future.
• The amount owed under an accrued expense can change because it may be an estimate. An account payable comes at a fixed amount.
• Accrued expenses are adjusted and recorded at the end of an accounting period. Accounts payable appear on the balance sheet when goods and services are purchased.

Accrued Expenses

Accrued expenses are payments that a company is obligated to make in the future for goods and services that were already delivered. A company receives a good or service and incurs an expense. This expense is recorded on the books but is paid later.

The term “accrued” means to increase or accumulate. Its unpaid bills increase when a company accrues expenses. They’re recognized under the accrual method of accounting at the time they’re incurred, not necessarily when they’re paid.

Also called accrued liabilities, these expenses are realized on a company’s balance sheet and are usually current liabilities. Accrued liabilities are adjusted and recognized on the balance sheet at the end of each accounting period. Any adjustments that are required are used to document goods and services that have been delivered but not yet billed.

Examples of accrued expenses include:

• Utilities that were used for the month but an invoice wasn’t received before the end of the period
• Wages that are incurred but payments have yet to be made to employees
• Services and goods that were consumed but no invoice has been received yet

Important

Balance sheets are financial statements that companies use to report their assets, liabilities, and shareholder equity. They provide management, analysts, and investors with a window into a company’s financial health and well-being.

Accounts Payable

The term “accounts payable (AP)” refers to a company’s ongoing expenses. These are generally short-term debts that must be paid off within a specified period, usually within 12 months of the expense being incurred. They’re short-term IOUs issued by billing parties. Companies that fail to pay these expenses run the risk of going into default: the failure to repay a debt.

An account payable is essentially an extension of credit from the supplier to the manufacturer. It allows the company to generate revenue from supplies or inventory so the supplier can be paid. Companies can pay their suppliers at a later date. This includes manufacturers that buy supplies or inventory from suppliers that extend the terms for the payment.

Accounts payable are often simply called payables. They might not be due for another 30, 60, or 90 days. They’re considered current liabilities. Companies recognize their payables on the balance sheet when they purchase goods or services on credit. This requires a double entry on the general ledger:

• A credit to the company’s accounts payable upon receipt of the invoice
• An offsetting debit under the expense account for the credit purchase

Key Differences

Accrued expenses are the total liability that’s payable for goods and services consumed or received by the company. All companies have accrued expenses, but they reflect costs for which an invoice or bill hasn’t yet been received. Accrued expenses can sometimes be an estimated amount of what’s owed as a result. This is later adjusted to the exact amount when the invoice has been received.

Accounts payable is the total amount of short-term obligations or debt that a company has to pay to its creditors for goods or services bought on credit. The vendor’s or supplier’s invoices have been received and recorded. Payables should represent the exact amount of the total owed from all the invoices received.

Some other differences between these two expenses include:

• Timing: The major difference in identifying these two liabilities is their timing. Accounts Payable are recorded when an invoice is issued by a supplier. Accrued expenses are booked at the end of the accounting period to recognize the expenses that have been incurred but not yet invoiced.
• Recipient: Companies pay accrued expenses to their employees, property owners, and banks. Salaries, rent, and interest are common accrued expenses that companies owe. Accounts payable are owed to creditors, including suppliers for goods and services purchased on credit.
• Occurrence: Accrued expenses tend to be regular occurrences, such as rent and interest payments on loans. Accounts payable only occur when a business makes a purchase on credit.”

Differences Between Accrued Expenses and Accounts Payable
	Accrued Expenses	Accounts Payable
Types	Employee wages, rent, and loan interest	Supplies, raw materials, and any other orders made with suppliers and vendors
Accounting	As current liabilities on the balance sheet	As accounts payable on the balance sheet
Realization	At the end of the accounting period	When the bill is received for the purchase
Payable to	Employees, property owners, and banks	Suppliers, vendors, and other creditors
Occurrence	Regular occurrences for all companies	When purchases/orders are made on credit

Accrued Expenses vs. Accounts Payable Example

Let’s say a company pays salaries to its employees on the first day of the following month for services received in the prior month. An employee who worked for the entire month of June will be paid in July. The accrued expenses from the employees’ services for December will be omitted if the company’s income statement at the end of the year recognizes only salary payments that have already been made.

Now, imagine that a business receives a $500 invoice for office supplies. It records a $500 credit in the accounts payable field and a $500 debit to office supply expense when the AP department receives the invoice. Anyone who looks at the balance in the accounts payable category will see the total amount that the business owes all of its vendors and short-term lenders.

The company then writes a check to pay the bill so the accountant enters a $500 credit to the checking account and enters a debit for $500 in the accounts payable column.

Explain Like I’m 5

Consider a company that buys materials from a supplier to make its shoes but doesn’t pay for them right away. There are two ways the company can keep track of this expense: accrued expenses or accounts payable.

Both of these mean that a business needs to pay its supplier, but each happens at different times and in different ways. Accrued expenses mean when a company uses something, like its materials, but hasn’t gotten a bill yet. The company writes it down so it remembers to pay it later.

Accounts payable is when the company has gotten the bill, such as an invoice, and knows exactly how much it has to pay and when. The main difference between the two is whether the bill has arrived or not. If it hasn’t, it’s an accrued expense; if it has, it’s accounts payable.

When Should You Accrue an Expense?

Companies usually accrue expenses on an ongoing basis. They’re current liabilities that must typically be paid within 12 months. This includes expenses like employee wages, rent, and interest payments on debts that are owed to banks.

How Are Accrued Expenses Recorded?

Accrued expenses are listed on a company’s balance sheet. They should appear at the end of the company’s accounting period. Adjustments are made using journal entries that are entered into the company’s general ledger.

What Are Examples of Accounts Payable?

Accounts payable refers to any current liabilities that are incurred by companies. Examples include purchases made from vendors on credit, subscriptions, or installment payments for services or products that haven’t been received yet. Accounts payable are expenses that come due in a short period, usually within 12 months.

Is Rent an Account Payable?

Rent is generally not considered part of accounts payable. Companies incur rent as an accrued expense because this is a cost that’s paid consistently and monthly.

The Bottom Line

Companies use two methods to track accumulated expenses: accrued expenses or accounts payable. Both are liabilities that businesses incur during their normal course of operations, but they’re different. Accrued expenses are liabilities that build up over time and are due to be paid. Accounts payable are current liabilities that will be paid in the near future.

Reviewed by Michael J Boyle
Fact checked by Ryan Eichler

Have you ever thought of where your food comes from? The world’s top four food-producing countries by agricultural value are China, India, the U.S., and Brazil. These countries have large populations, ample land area, and climate zones suitable for growing a variety of crops. But, there are major differences in how food production plays in their economies. In this article, we examine the agricultural strengths and weaknesses of each of the four leading food producers.

Key Takeaways

• The world’s top food-producing countries are China, India, the U.S., and Brazil
• China is the world’s largest grain producer, yet is more dependent on food imports.
• Much of India’s output is produced by subsistence farmers and consumed locally.
• The U.S. is the world’s top food exporter thanks to high crop yields and extensive agricultural infrastructure.
• The world’s fourth-largest food producer and second-largest importer, Brazil is heavily dependent on imports from China.

China

As of most recent data from 2023, China was by far the world’s leading agricultural producer with annual output valued at $1.69 trillion—$1.65 trillion was attributed to food, according to the Food and Agriculture Organization (FAO) of the United Nations. A key factor was China’s status as the world’s second-most populous country with a population of 1.42 billion as of 2025, slightly under India’s 1.46 billion.

China has only 10% of the world’s arable land yet produces a quarter of the global grain output and leads the planet in the production of cereals, cotton, fruit, vegetables, meat, poultry, eggs, and fishery products, according to FAO. While much of China’s territory is too mountainous or too arid for farming, the rich soils of its eastern and southern regions are extremely productive.

China also has one of the world’s largest pools of agricultural labor. Though the proportion of workers in food production has decreased steadily from 60% in 1991, farm work still accounted for 25% of national employment as of 2019.

Despite the growth of China’s agricultural output, it reportedly went from full self-sufficiency in food production as of 2000 to relying on imports for more than 23% of its food needs by 2020. Declining soybean output, rising grain imports, and the continuing loss of farmland to industrial and urban development were blamed.

In 2023, China was the world’s top importer of agricultural products, with imports valued at $140 billion. The strong value of imports is largely due to rising consumer demand. Top exporters to China included Thailand, New Zealand, Brazil, and the U.S.

Important

Agricultural output includes both food and non-food products. Examples of non-food agricultural goods include silk, rubber, wool, cotton, and tobacco.

India

The world’s largest country by population, India had the second-highest agricultural output at $553.69 billion in 2023. Of that total agricultural output, $516.62 billion was attributable to food production.

India is the world’s largest producer of milk, jute, and pulses (a class of legumes that includes dry beans, lentils, and chickpeas). India is also the world’s second-largest producer of rice, wheat, sugarcane, fruit, vegetables, cotton, and groundnuts.

Despite achieving self-sufficiency in grain production, India remains heavily reliant on subsistence agriculture as by far the poorest country on this list on a per capita basis. This has dictated the inefficient use of limited resources, particularly water, leaving output dependent on seasonal monsoons and crop yields below the global average. Shortcomings in infrastructure and the distribution systems for produce have caused post-harvest losses of up to 40% for some crops.

Despite such obstacles, India remains the world’s largest exporter of refined sugar and milled rice. Strong exports of rice, cotton, soybeans, and meat made India take the ninth place among global agricultural exporters in 2022.

The United States

The U.S. ranked third in 2023 agricultural output at $459.85 billion—$443.15 billion of which was food— despite employing a small fraction of the agricultural workforce of China or India. Corn, soybeans, dairy, raw milk, wheat, and sugar beets were the top five U.S. agricultural commodities by value in the same year.

Cereal crop yields and output have continued to rise despite a significant decline in planted acreage in recent decades.

The U.S. was by far the leading global agricultural exporter in 2023 with exports valued at $171.15 billion. Canada, China, Mexico, and Japan are also among the leading importers of U.S. agricultural products.

California accounted for 11.5% of U.S. agricultural production in 2023 with dairy, grapes, and cattle among its top commodities. Other major agricultural producers include Iowa, Nebraska, Texas, and Illinois.

Important

After a downturn in the early stages of the COVID-19 pandemic, the prices of key agricultural commodities rebounded in 2021, then soared to record highs in early 2022 as Russia’s invasion of Ukraine jeopardized supplies from two major grain exporters.

Brazil

Brazil was the world’s fourth-ranked agricultural producer in 2023 with output valued at $281.74 billion. Brazil’s agricultural output of food was $270.58 billion.

The Brazilian economy has historically focused on agriculture, particularly sugarcane. The proportion of the workforce employed in agriculture has declined steadily over the past three decades, from 20% in 1991 to 8% by 2023.

Brazil is the top global exporter of soybeans, raw sugar, and poultry. Its soybeans exports of $53.1 billion in 2023 were the largest for an agricultural commodity from a single country. China accounted for almost $56 billion of Brazil’s agricultural exports that year, almost 10 times more than the second-largest importer.

Which Countries Produce the Most Food?

China, India, the United States, and Brazil are the world’s top agricultural producers, in that order.

Which Country Is the Largest Agricultural Exporter?

The United States is the largest exporter of agriculture, accounting for 9.6% of total global export value in 2022.

Which Countries Produce the Most Food Waste?

Many countries contribute to food waste. According to the United Nations, an estimated 1.05 billion tonnes of food was wasted in 2022 globally. China, India, and Pakistan had the highest amounts of food waste in 2024, with 108.7 million, 78.2 million, and 30.8 million tonnes annually.

The Bottom Line

Many factors influence the level of food production in a country, including land area, size of population, climate, and the quality of agricultural infrastructure and technology. While the U.S. is the top exporter of agricultural commodities, other countries including China, India, and Brazil have emerged as major food suppliers.

How to decide if Medicare Supplement Insurance is worth it for you

Reviewed by Ebony Howard
Fact checked by Jared Ecker

If you are covered by Medicare you may be wondering if you need a Medicare Supplement Insurancepolicy, also known as Medigap. Read on to see what a Medigap plan is and how it works.

Key Takeaways

• Medigap pays some or all of the costs Medicare doesn’t cover, depending on the level of coverage you choose.
• Medicare alone may not cover extensive treatment or long-term hospitalization.
• Many private insurance companies offer Medigap policies.

What Is Medigap?

Medigap is a supplement to Medicare coverage and policies are designed to provide additional coverage for routine services Medicare covers and, in some cases, all or part of the expenses Medicare does not cover, such as long-term care, vision, or dental coverage.

A Medigap plan helps individuals get reimbursed for the costs they pay directly out of their pocket. These plans are offered by private insurance companies, so it is necessary to compare plans that fit your needs and financial situation.

What Medicare Covers

Medicare consists of Parts A and B along with Medicare prescription drug coverage found in optional Part D. Even routine services come with co-payments and deductibles. Prescription drugs can also deplete your budget if you need expensive medications.

Under the Affordable Care Act (ACA), the prescription price donut hole has been closing each year. At a certain level, $5,030 in 2024, you entered the notorious donut hole in coverage that requires you to pay up to 25% of covered brand-name and generic drug costs. When costs went above $8,000, you pass through the donut hole and owe only 5% of the cost of drugs.

What Medicare Doesn’t Cover

Medigap will help pay for costs that Medicare does not cover. If you are admitted to the hospital, you have 100% hospitalization coverage after the $1,676 annual deductible under Original Medicare Part A in 2025. However, you may owe up to 20% of some other costs, such as anesthesiologist fees.

If you are in the hospital for more than 60 days, you have to pay $419 per day in 2025. There are similar co-payments for long stays in nursing facilities and hospices. Regular doctor visits and outpatient medical care may cost you, too. Your deductible for 2025 is $257, but after that, you’ll pay up to 20% of the Medicare-approved amount for most doctor services. There is no upper limit.

If you do not have coverage for dental expenses, you may want to look into a standalone dental insurance plan. Many plans provide coverage for the types of dental procedures that Medicare recipients may need, including crowns, root canals, dentures, and tooth replacements.

Types of Medigap Plans

Medicare Parts A and B comprise basic coverage, while Part D is an optional prescription drug plan you can buy from a private provider and attach to your Medicare. If you opt for Original Medicare (A and B), plus Part D, and want a Medigap plan for more complete coverage, the most popular choices are Medigap Plan F and Medicare Plan G.

Medigap plans and benefits are fully defined at Medicare.gov.

Medigap Plan F: As of January 1, 2020, Plan F is no longer available to those newly eligible for Medicare. People who already have Plan F will be able to keep it, and people who were eligible for Medicare before 2020 but didn’t have a Medigap plan may still be allowed to choose Plan F.

Medigap Plan G: This plan has almost the same coverage as Plan F except for reimbursement of the Part B deductible. The average Plan G may be cheaper than Plan F. However, costs vary widely according to an applicant’s zip code, gender, and tobacco use, and increase with age.

Medigap Plan K: This plan provides less coverage than F or G and includes an out-of-pocket expense of $7,220 for 2025.

Medigap Plan L: This plan provides less coverage than F or G and includes an out-of-pocket expense of $3,610 for 2025.

Medigap Plan M: This plan offers similar coverage to F and G with some limitations.

Medigap Plan N: This plan offers similar coverage to F and G with some limitations.

Important

Part C, also known as Medicare Advantage, replaces all of the basic government coverage with a private insurance plan; if you choose Part C, you do not need a Medigap Plan.

Medigap vs. Plan C Medicare Advantage

A Medigap policy is a supplement to Parts A and B coverage and pays expenses that Original Medicare doesn’t. A Medicare Advantage Plan (Medicare Part C) is a private replacement for the public Medicare program.

Most of these plans are set up as health maintenance organizations ((HMOs) that replace all of the services of Original Medicare and add additional services, such as preventive health care, within a preselected network of doctors and hospitals.

A Medigap plan, however, gives you more freedom of choice than Medicare Advantage, provided your physician or facility accepts Medicare. As long as you pay your premiums, your policy is renewable for the rest of your life and will only be dropped if you stop paying premiums, you falsify your application, or the insurance company files for bankruptcy.

Warning

Individuals cannot have Medigap and a Medicare Advantage Plan C at the same time.

Is My Spouse Covered Under My Medigap Policy?

No. A Medigap policy covers only one person and doesn’t cover expenses incurred by your spouse. Medicare isn’t like an employer-sponsored plan; you can’t enroll your spouse under your coverage. This means you and your spouse have to purchase separate plans to be covered for supplemental insurance.

How Much Does Medigap Cost?

Since Medigap is privatized insurance, each insurance company offers different premiums for its Medigap policies. The price will be determined by factors such as your age, or how long you’ve been enrolled in Medicare.

Why Do I Need Medigap?

Medigap policy supplements your Original Medicare coverage. Medigap provides more choices and covers a large network of healthcare providers.

The Bottom Line

Medicare Parts A and B comprise basic coverage, while Part D is an optional prescription drug plan. A Medigap policy will supplement this coverage and help pay additional expenses or deductibles. Individuals who choose Medicare Part C, also known as Medicare Advantage do not need a Medigap Plan.

Reviewed by David Kindness
Fact checked by Vikki Velasquez

Prepaid expenses are payments for goods or services that will be received in the future. These expenses are not initially recorded on a company’s income statement for the period when the money changes hands.

Instead, prepaid expenses are first recorded on the balance sheet as an asset. But, as the products and services are received, prepaid expenses are recognized on the income statement for each period when the money is spent.

Key Takeaways

• Prepaid expenses are incurred for assets that will be received at a later time.
• Prepaid expenses are first recorded in the prepaid asset account on the balance sheet.
• The GAAP matching principle prevents expenses from being recorded on the income statement before they incur.
• Once expenses are incurred, the prepaid asset account is reduced and an entry is made to the expense account on the income statement.
• Insurance and rent payments are common prepaid expenses.

What Are Prepaid Expenses?

Prepaid expenses are payments made for goods and services that a company intends to pay for in advance but will incur sometime in the future. Examples of prepaid expenses include insurance, rent, leases, interest, and taxes.

Prepaid expenses aren’t included in the income statement per generally accepted accounting principles (GAAP). In particular, the GAAP matching principle requires accrual accounting, which stipulates that revenue and expenses must be reported in the period that the spending occurs, not when cash or money exchanges hands.

In other words, expenses should be recorded when incurred. Thus, prepaid expenses aren’t recognized on the income statement when paid because they have yet to be incurred.

We’ve outlined the procedure for reporting prepaid expenses below in a little more detail, along with a few examples.

Important

Unless the prepaid expense will not be incurred within 12 months, it is recorded as a current asset.

Recording Prepaid Expenses

When a company prepays for an expense, it is recognized as a prepaid asset on the balance sheet, with a simultaneous entry being recorded that reduces the company’s cash (or payment account) by the same amount. Most prepaid expenses appear on the balance sheet as a current asset unless the expense is not to be incurred until after 12 months, which is rare.

Then, when the expense is incurred, the prepaid expense account is reduced by the amount of the expense, and the expense is recognized on the company’s income statement in the period when it was incurred.

Note

Businesses cannot claim a deduction in the current year for prepaid expenses for future years.

Insurance as a Prepaid Expense

One of the more common forms of prepaid expenses is insurance, which is usually paid in advance. This means that the premium you pay is allotted to the upcoming time period.

For example, Company ABC pays a $12,000 premium for directors’ and officers’ liability insurance for the upcoming year. The company pays for the policy upfront and then, each month, makes an adjusting entry to account for the insurance expense incurred. The initial entry, where we debit the prepaid expense account and credit the account used to pay for the expense, would look like this:

Then, after a month, the company makes an adjusting entry for the insurance used. The company makes a debit to the appropriate expense account and credits the prepaid expense account to reduce the asset value. The monthly adjustment for Company ABC would be $12,000 divided by 12 months, or $1,000 a month. The adjusting entry at the end of each month would appear as follows:

Rent as a Prepaid Expense

Businesses may prepay rent for months in advance to get a discount, or perhaps the landlord requires a prepayment given the renter’s credit. Either way, let’s say Company XYZ is prepaying for office space for six months in advance, totaling $24,000. The initial entry is as follows:

Then, as each month ends, the prepaid rent balance sheet account is reduced by the monthly rent amount, which is $4,000 per month ($24,000 ÷ six months). At the same time, the company recognizes a rental expense of $4,000 on the income statement. Thus, the monthly adjusting entry would appear as follows:

Other Prepaid Expenses

Additional expenses that a company might prepay for include interest and taxes. Interest paid in advance may arise as a company makes a payment ahead of the due date. Meanwhile, some companies pay taxes before they are due, such as an estimated tax payment based on what might come due in the future. Other less common prepaid expenses might include equipment rental or utilities.

As an example, consider Company Build Inc., which has rented a piece of equipment for a construction job. The company paid $1,000 on April 1 to rent a piece of equipment for a job that will be done in a month. The company would recognize the initial transaction as follows:

Then, when the equipment is used and the actual expense is incurred, the company would make the following entry to reduce the prepaid asset account and have the rental expense appear on the income statement:

Regardless of whether it’s insurance, rent, utilities, or any other expense that’s paid in advance, it should be recorded in the appropriate prepaid asset account. Then, at the end of each period, or when the expense is incurred, an adjusting entry should be made to reduce the prepaid asset account and recognize (credit) the appropriate income expense, which will then appear on the income statement.

How Do You Record Accrued Expenses on a Balance Sheet?

In finance, accrued expenses are the opposite of prepaid expenses. These are the costs of goods or services that a company consumes before it has to pay for them, such as utilities, rent, or payments to contractors or vendors. Accountants record these expenses as a current liability on the balance sheet as they are accrued. As the company pays for them, they are reported as expense items on the income statement.

Why Are Prepaid Expenses an Asset?

Prepaid expenses are classified as assets because they represent money that the company has not yet spent.

What Is the 12-Month Rule for Prepaid Expenses?

The 12-month rule allows taxpayers to deduct prepaid expenses in the current year if the asset does not go beyond 12 months from the date of the payment or the end of the tax year following the year in which the payment was made.

Who Benefits from Prepaid Expenses?

Individuals and companies both benefit from prepaid expenses. Individuals ensure that they don’t miss payments for important services like health insurance. Companies benefit by increasing cash flow, securing discounts, or qualifying for business deductions.

What’s the Difference Between Prepaid Expenses and Deferred Expenses?

Prepaid expenses and deferred expenses are both recorded as assets on a company’s balance sheet until the expense is realized. They are both advance payments, but there are some clear differences between the two common accounting terms. One of the key differentiators is time.

The Bottom Line

At times, payments are made for future benefits. In accounting, these payments or prepaid expenses are recorded as assets on the balance sheet. Once incurred, the asset account is reduced, and the expense is recorded on the income statement. The GAAP matching principle, however, prevents these expenses from being recorded on the income statement before the asset is realized.

Reviewed by Eric Estevez
Fact checked by Michael Rosenston

What Is Corporate Structure?

Corporate structure is how a corporation is set up. Modern corporations have a variety of different leadership positions, with different responsibilities. Most public companies have a two-tier corporate hierarchy: the management team reports to the board of directors, who in turn are responsible to the shareholders.

Key Takeaways

• The most common corporate structure in the United States consists of a board of directors and a management team. 
• A board of directors typically includes inside directors, who work day-to-day at the company, and outside directors, who can make impartial judgments.
• Most management teams have at least a Chief Executive Officer (CEO), a Chief Financial Officer (CFO), and a Chief Operations Officer (COO).

Understanding the Basics of Corporate Structure

A company may choose to follow several models of corporate governance. These can have traditional, pyramid-shaped leadership roles, or have flexible leadership structures. Most public corporations consist of a board of governors or directors, and one or more executives. In some cases, the same person may occupy multiple positions.

These bodies exist because the evolution of public ownership has created a separation between ownership and management. Before the late 19th century, many companies were small, family-owned, and family-run. Today, many companies are gigantic international conglomerates with thousands of shareholders.

The modern system of corporate governance exists to ensure that companies represent the interests of their owners (shareholders). The board of directors is elected by the shareholders of the corporation. They are responsible for overseeing the work of the management team, including the chief executive officer (CEO) and other C-suite executives.

The Board of Directors

Elected by the shareholders, the board of directors is made up of two types of representatives. The first type involves inside directors chosen from within the company. This can be a CEO, CFO, manager, or any other person who works for the company on a daily basis.

The other type of representative encompasses outside directors, chosen externally and considered independent of the company. The role of the board is to monitor a corporation’s management team, acting as an advocate for shareholders. In essence, the board of directors tries to make sure that shareholders’ interests are well-served.

Board members can be divided into three categories:

Chair: Technically the leader of the corporation, the board chair is responsible for running the board smoothly and effectively. Their duties typically include maintaining strong communication with the CEO and high-level executives, formulating the company’s business strategy, representing management and the board to the general public and shareholders, and maintaining corporate integrity. The chair is elected from the board of directors.

Inside Directors: These directors are responsible for approving high-level budgets prepared by upper management, implementing and monitoring business strategy, and approving core corporate initiatives and projects. Inside directors are either shareholders or high-level managers from within the company.

Inside directors help provide internal perspectives for other board members. These individuals are also referred to as executive directors if they are part of the company’s management team.

Outside Directors: While having the same responsibilities as the inside directors in determining strategic direction and corporate policy, outside directors are different in that they are not directly part of the management team. The purpose of having outside directors is to provide unbiased perspectives on issues brought to the board. By being detached from management, outside directors provide independent representation of shareholders, broaden the company’s thinking beyond management’s perspective, and help to ensure transparency, accountability, and ethical conduct.

Note

In some corporations, the same person may serve multiple roles on the management team and board of directors. For example, Boeing’s CEO is also the president and a member of the Board of Directors.

The Management Team

As the other tier of the company, the management team is directly responsible for the company’s day-to-day operations and profitability. They often work with lower-level staff managers, who, in turn, convey company orders to supervisors. Supervisors then work directly with junior staff members.

Chief Executive Officer (CEO): As the top manager, the CEO is typically responsible for the corporation’s entire operations and reports directly to the chair and the board of directors. It is the CEO’s responsibility to implement board decisions and initiatives, as well as to maintain the smooth operation of the firm with senior management’s assistance.

Often, the CEO will also be designated as the company’s president and, therefore, be one of the inside directors on the board (if not the chair). However, many believe that a company’s CEO should not also be the company’s chair to ensure the chair’s independence and clear lines of authority.

Chief Operations Officer (COO): Responsible for the corporation’s operations, the COO looks after issues related to marketing, sales, production, and personnel. Often more hands-on than the CEO, the COO looks after day-to-day activities while providing feedback to the CEO. The COO is often referred to as a senior vice president.

Chief Financial Officer (CFO): Also reporting directly to the CEO, the CFO is responsible for analyzing and reviewing financial data, reporting financial performance, preparing budgets, and monitoring expenditures and costs.

The CFO is required to present this information to the board of directors at regular intervals and provide it to shareholders and regulatory bodies such as the Securities and Exchange Commission (SEC). Also usually referred to as a senior vice president, the CFO routinely checks the corporation’s financial health and integrity.

Special Considerations

When you are researching a company, it’s always a good idea to see if there is a good balance between internal and external board members. Also check to see whether there’s a separation of CEO and chair roles and a variety of professional expertise on the board from accountants, lawyers and executives.

Explain Like I’m Five

With a public company, there are two levels: the board of directors, led by the chair of the board, and the management team, led by the CEO. The management team reports to the board, and the board reports to the shareholders.

What Does a Board of Directors Do?

A company’s board of directors is responsible for setting the long-term strategic direction of a company or organization. This can include appointing the executive team, setting goals, and replacing executives if they fail to meet expectations. In public companies, the board of directors is also responsible to the shareholders, and can be voted out in a shareholder election. Board members may represent major shareholders, or they may be executives from other companies whose experience can be an asset to the company’s management.

What Does a Company President Do?

In large companies, the CEO is the highest-ranking executive and the president is the second-highest. However, it is also possible for one person to hold both offices, or for a company to have a CEO and no president. A president is typically responsible for the day-to-day operations of a company, and their role may overlap with a chief operating officer.

What Is the Difference Between a CEO and a Chair of the Board?

In large corporations, the chairperson presides over the board of directors, ensuring effective governance and strategic planning. The management team, including the CEO, is responsible for executing that strategy and meeting the goals set by the board. It is possible for one person to hold both roles, although in larger companies they tend to be separate.

The Bottom Line

Together, management and the board of directors have the ultimate goal of maximizing shareholder value. In theory, management looks after the day-to-day operations and the board ensures that shareholders are adequately represented. But the reality is that many boards include members of the management team. 

Artificial intelligence (AI) is already changing how everyday investors manage their money—and proponents say it’s just getting started.

Sergey Ryzhavin, the head of B2COPY, a specialized trading technology company with 15 years of experience building AI trading systems, has witnessed this transformation firsthand. “There is a strong and growing trend toward outsourcing market analysis and trade execution on personal accounts,” Ryzhavin says. “Each year, fewer individual investors want to manually press the buy/sell buttons themselves.”

Nevertheless, he says, there are still specific areas where human judgment will remain irreplaceable. Below, we take you through what he expects in the coming years.

Key Takeaways

• AI is transforming investing through robo-advising, sophisticated stock screening tools, and automated trading systems that can detect market signals that human analysts often miss.
• While AI is great for data analysis, Ryzhavin says it has inherent limitations in predicting unprecedented events, making a combination of AI tools and human judgment the best approach for most investors.

How AI Is Changing Investing

AI is transforming how people invest, with three key technologies leading the way, according to Ryzhavin: robo-advisors managing diversified portfolios, AI-powered stock screening tools analyzing vast datasets, and automated trading systems executing transactions without human intervention. In addition, a recent industry survey found that more than 90% of investment managers are either using or planning to use AI, with more than half already having done so.

“I believe that AI will surpass human capabilities in almost every aspect of analysis within the next one to two years,” Ryzhavin says. “This includes long-term and short-term analysis, technical analysis, and even psychological insights based on social media data.”

AI is particularly good at detecting critical signals that human analysts might miss, he says. During the early days of COVID-19, Ryzhavin notes, Canadian AI company BlueDot identified an unusual pneumonia cluster in Wuhan nine days before the World Health Organization issued warnings. Similarly, AI models “identified Silicon Valley Bank’s (SVB) financial instability before its sudden fall” in 2023, detecting “liquidity risks and overexposure to long-term government bonds” that human analysts had overlooked, he says.

These systems work continuously, processing data at many times the speed of humans using traditional computing systems while never getting tired or becoming emotionally overreactive to market volatility.

AI’s Inherent Limitations

Ryzhavin noted, though, that AI didn’t just have a heads-up on SVB’s imminent failure. It also exacerbated the bank run once it began, flagging liquidity risks that amplified the rush of withdrawals that caused its collapse.

“AI doesn’t predict the future. It identifies patterns based on historical data,” Ryzhavin says. This means AI-driven investing does very well at data-driven trend analysis but may struggle with unprecedented events or factors that aren’t easily converted into numbers for its use.

AI is also susceptible to many of the same biases as human analysts, like overfitting to historical data, confirmation bias, and herd mentality, he says. Understanding these limitations is crucial for investors hoping to use AI effectively.

“While AI can process vast amounts of information faster than humans, it is still bound by the quality of its training data and underlying assumptions,” he says.

Ryzhavin says complex negotiations like mergers and acquisitions will likely remain human-driven the longest, given that they rely far more on relationship-building. Similarly, venture capital decisions often depend on the intuitive assessments of founders and analyses of future trends.

Ryzhavin recommends that retail investors use multiple AI advisors or instruments rather than relying on just one system, no matter how impressive its track record. “Diversification is important,” he says, noting that being disciplined about managing risk is essential even when using sophisticated AI tools.

‘AI Washing’

“One of the biggest misconceptions I frequently encounter is that AI is a perfect, infallible predictor of market movements—that it can consistently beat the market with little to no risk,” Ryzhavin said. The U.S. Securities and Exchange Commission uses the term “AI washing” in its warnings to investors about firms claiming to gain the benefits of AI and machine learning without ever using such systems.

The Bottom Line

AI is changing investing but Ryzhavin says it’s not the market oracle many suggest. He notes that AI excels at identifying historical patterns rather than perfectly predicting the future.

For retail investors, he argues, success will come from combining AI-powered insights with sound investment principles—diversifying across different AI tools and recognizing the technology’s limitations during unprecedented market events. The future of investing, he says, won’t be about choosing between humans and AI but taking advantage of the strengths of both.

Insurance is typically only top-of-mind for RIA owners when the renewal notice appears or when something unfortunate happens. The time to find out that you and your business are not adequately covered is not in a crisis.

In this episode of “The Deep Dive,” host Jay Hummel chats with Jessica Thayer of Starkweather & Shepley to help you discover where you might be vulnerable. 

Jessica Thayer: Jessica Thayer is the senior vice president and financial services practice leader at Starkweather & Shepley Insurance, where she has worked since 2018. Previously, she worked at Liftman Insurance in Boston and Marsh, a division of Marsh McLennan. Jessica is a Whitman School of Management graduate of Syracuse University and resides in the Greater Boston area. 

Reviewed by Natalya Yashina
Fact checked by Michael Rosenston

What Is an Impairment Charge?

An impairment charge is a process used by businesses to write off worthless goodwill or report a reduction in the value of goodwill. Investors, creditors, and others can find these charges on corporate balance sheets and income statements under the operating expense section.

These figures can be used to determine the financial health of a company. Creditors and investors often review impairment charges to make important decisions about whether to lend or invest in a particular company.

These charges began making headlines in 2002 as companies adopted new accounting rules and disclosed huge goodwill write-offs to resolve the misallocation of assets that occurred during the dotcom bubble. Some of the world’s largest companies reported major losses related to goodwill, including:

• AOL Time Warner: $45.5 billion in 2002
• McDonald’s: $99 million in 2004

Impairment charges came into the spotlight again during the Great Recession. Weakness in the economy and the faltering stock market forced more goodwill charge-offs and increased concerns about corporate balance sheets. This article will define the impairment charge and look at its good, bad, and ugly effects.

Key Takeaways

• An impairment charge is an accounting term used to describe a reduction or total loss of the recoverable value of an asset.
• Impairment can occur because of a change in legal circumstances, economic conditions, technology, a brand’s reputation, the business’s situation in the market, or as the result of a casualty loss from unforeseen hazards.
• Impairment charges may be booked as goodwill for the acquiring company in an acquisition.
• Goodwill is an intangible asset that a company assumes after acquiring another company.
• The Financial Accounting Services Board’s rules for impairment charges of goodwill outline that companies must determine the fair market value of assets on a regular basis.

Understanding Impairment Charges

As with most generally accepted accounting principles (GAAP), the definition of impairment lies in the eyes of the beholder. The regulations are complex, but the fundamentals are relatively easy to understand. Under the new rules, all goodwill is to be assigned to the company’s reporting units that are expected to benefit from that goodwill.

Then the goodwill must be tested (at least annually) to determine if the recorded value of the goodwill is greater than the fair value. If the fair value is less than the carrying value, the goodwill is deemed impaired and must be charged off. It reduces the value of goodwill to the fair market value (FMV) and represents a mark-to-market (MTM) charge.

Individuals need to be aware of these risks and factor them into their investment decision-making process. There are no easy ways to evaluate impairment risk, but there are a few generalizations that often serve as red flags indicating which companies are at risk:

1. The company made large acquisitions in the past.
2. The company has high leverage ratios and negative operating cash flows.
3. The company’s stock price has declined significantly in the past decade.
4. Changes in technology or regulations
5. Changes in the companies operating environment, or changes to the supply and demand situation of its products

Note

Prior to the adoption of the new GAAP accounting rules by the FASB in 2001, companies were allowed to amortize goodwill over a finite time period, sometimes as long as 40 years.

The Good

If done correctly, impairment charges provide investors with really valuable information. Balance sheets are bloated with goodwill that result from acquisitions made during eras of financial bubbles when companies overpaid for assets by buying overpriced stock.

Over-inflated financial statements distort not only the analysis of a company but also what investors should pay for its shares. The new rules force companies to revalue these bad investments, much like what the stock market did to individual stocks.

The impairment charge also provides investors with a way to evaluate corporate management and its decision-making track record. Companies that have to write off billions of dollars due to the impairment have not made good investment decisions. Management teams that bite the bullet and take an honest all-encompassing charge should be viewed more favorably than those who slowly bleed a company to death by deciding to take a series of recurring impairment charges, thereby manipulating reality.

Note

Impairment can be affected by internal factors (damage to assets, holding onto assets for restructuring, and others) or through external factors (changes in market prices and economic factors, as well as others).

The Bad

The Financial Accounting Standards Board (FASB) has rules in place for private and public companies, including those surrounding goodwill. For instance, Accounting Standards Codification (ASC) Topic 350 and Topic 805 allow companies to exercise discretion when allocating goodwill and determining its value.

Determining fair value is just as much an art as it is a science. Different experts can arrive at different valuations. It is also possible for the allocation process to be manipulated to avoid flunking the impairment test. As management teams attempt to avoid these charge-offs, more accounting shenanigans will undoubtedly result.

To help combat this, companies must disclose the fair value measurement, the methods used, reasons for the measurement, and other relevant information.

Important

The goodwill impairment test involves comparing the asset to its fair market value to see if the fair market value has declined below the reported value. If so, impairment must be done.

The Ugly

Things could get ugly if increased impairment charges reduce equity to levels that trigger technical loan defaults. Most lenders require debtor companies to promise to maintain certain operating ratios.

If a company does not meet these obligations, which are also called loan covenants, it can be deemed in default of the loan agreement. This could have a detrimental effect on the company’s ability to refinance its debt, especially if it has a large amount of debt and is in need of more financing. However, this is not common from impairment alone. Usually, other factors would play into a default.

Example of Impairment Charges

Here’s a hypothetical example using a fictitious company to show how impairment charges work. Assume that NetcoDOA has:

• Equity of $3.45 billion
• Total debt of $3.96 billion
• Intangibles of $3.17 billion

To calculate the company’s tangible net worth, we need to use the following formula:

Tangible Net Worth = Total Assets − Liabilities − Intangible Assets

As such, NetcoDOA has a deficit net worth or negative tangible net worth of $3.68 billion ($3.45 billion – $3.96 billion – $3.17 billion). This means the company’s net liabilities are higher than its net tangible assets. Although it may be a cause for concern, companies like NetcoDOA may find themselves in a situation like this for several reasons, including times when changes in future projections impair any present value calculations for assets.

How Do Impairment Charges Work?

Impairment charges became commonplace after the dotcom bubble and gained traction again following the Great Recession. They involve writing off assets that lose value or whose values drop drastically, rendering them worthless. Goodwill refers to any intangible assets a company assumes as a result of an acquisition.

What Is Goodwill?

Goodwill is an intangible asset a company has that is related to the acquisition of one company by another. It represents the part of the purchase price that is higher than the combined total fair value of any assets purchased and liabilities assumed. This can be proprietary technology, employee relations, and brand names.

What Accounted for Cisco’s Impairment Charge in 2001?

Cisco reported an impairment charge of $289 million in 2001. This was the result of an all-stock deal worth $500 million when it acquired a startup company from Texas called Monterey Networks. The loss stemmed from the discontinuation of products Cisco assumed from Monterey following the acquisition.

The Bottom Line

Accounting regulations that require companies to mark their goodwill to market were a painful way to resolve the misallocation of assets that occurred during the dotcom bubble or during the subprime meltdown. In several ways, this metric helps investors by providing more relevant financial information, but it also gives companies a way to manipulate reality and postpone the inevitable.

Fact checked by Pete Rathburn
Reviewed by Charlene Rhinehart

Most investors are aware that the market undergoes periods of both bull runs and downturns. So what happens during periods of extreme market volatility? Making the wrong moves could wipe out previous gains and more.

By using either non-directional or probability-based trading methods, investors may be able to protect their assets from potential losses and may be able to profit from rising volatility using certain strategies.

Key Takeaways

• In financial markets, volatility refers to the presence of extreme and rapid price swings.
• Given increasing volatility, the possibility of losing some or all of an investment is known as risk.
• Directional investing, a strategy practiced by most private investors, requires the markets to move consistently in the desired direction.
• On the other hand, non-directional investing takes advantage of market inefficiencies and relative pricing discrepancies.
• Volatility allows investors to reconsider their investment strategy.

Volatility vs. Risk

It’s important to understand the difference between volatility and risk before deciding on a trading method. Volatility in the financial markets is the quantification of the speed and magnitude of an asset’s price swings. Any asset that sees its market price move over time, has some level of volatility. The greater the volatility, the larger and more frequent these swings are.

Risk, on the other hand, is the possibility of losing some or all of an investment. There are several types of risk that can lead to a potential loss, including market risk (i.e., that prices will move against you).

As the volatility of the market increases, market risk also tends to increase. In response, there can be a marked increase in the volume of trades during these periods and a corresponding decrease in the holding periods of positions. In addition, hypersensitivity to news is often reflected in prices during times of extreme volatility as the market overreacts.

Thus, increased volatility can correspond with larger and more frequent downswings, which presents market risk for investors. Luckily, volatility can be hedged away to some degree. Moreover, there are ways to actually profit directly from volatility increases.

Hedging Against Volatility

Perhaps the most important thing for most long-term investors is to hedge against downside losses when markets turn volatile. One way to do this, of course, is to sell shares or set stop-loss orders to automatically sell them when prices fall by a certain amount. This, however, can create taxable events and, moreover, removes the investments from one’s portfolio. For a buy-and-hold investor, this is often not the best course of action.

Instead, investors can buy protective put options on either the single stocks they hold or on a broader index such as the S&P 500 (e.g., via S&P 500 ETF options). A put option gives the holder the right (but not the obligation) to sell shares of the underlying as a set price on or before the contract expires.

Say that XYZ stock is trading at $100 per share and you wish to protect against losses beyond 20%. You can buy an 80 strike put, which grants the right to sell shares at $80, even if the market falls to, say, $50. This effectively sets a price floor.

Important

Note that if the stock never falls to the strike price by its expiration, it will simply expire worthless and you would lose the premium paid for the put.

Trading Volatility

Investors who wish to take a directional bet on volatility itself can trade ETFs or ETNs that track a volatility index. One such index is the Volatility Index (VIX) created by CBOE which tracks the volatility of the S&P 500 index. Also known as the “fear index,” the VIX (and related products) increase in value when volatility goes up.

You may also consider buying options contracts to profit from rising volatility in addition to hedging your downside. Options prices are closely linked to volatility and will increase along with volatility. Because volatile markets can lead to swings both upwards and downwards as prices gyrate, buying a straddle or a strangle are popular strategies. These both involve simultaneously buying a call and a put on the same underlying and for the same expiration. If prices move a great deal, either strategy can increase in value.

Warning

Because of the way VIX exchange-traded products are constructed, they are not intended to be long-term investments. Rather, they are meant to make short-term bets on volatility changes.

Non-Directional Investing

Most investors engage in directional investing, which requires the markets to move consistently in one direction (which can be either up for longs or down for shorts). Market timers, long or short equity investors, and trend followers all rely on directional investing strategies. Times of increased volatility can result in a directionless or sideways market, repeatedly triggering stop losses. Gains earned over years can be eroded in a few days.

Non-directional equity investors, on the other hand, attempt to take advantage of market inefficiencies and relative pricing discrepancies. Importantly, non-directional strategies are, as the name implies, indifferent to whether prices are rising or falling, and can therefore succeed in both bull and bear markets.

Equity-Market-Neutral Strategy

The principle behind the equity-market-neutral strategy is that your gains will be more closely linked to the difference between the best and worst performers than the overall market performance—and less susceptible to market volatility. This strategy involves buying relatively undervalued stocks and selling relatively overvalued stocks that are in the same industry sector or appear to be peer companies. It thus attempts to exploit differences in those stock prices by being long and short an equal amount in closely related stocks.

Here is where stock pickers can shine because the ability to pick the right stock is just about all that matters with this strategy. The goal is to leverage differences in stock prices by being both long and short among stocks in the same sector, industry, nation, market cap, etc.

By focusing on pairs of stocks or just one sector and not the market as a whole, you emphasize movement within a category. Consequently, a loss on a short position can be quickly offset by a gain on a long one. The trick is to identify the standout and the underperforming stocks.

Volatile markets make risk control measures such as stop losses even more important.

Merger Arbitrage

The stocks of two companies involved in a potential merger or acquisition often react differently to the news of the impending action and try to take advantage of the shareholders’ reaction. Often the acquirer’s stock is discounted while the stock of the company to be acquired rises in anticipation of the buyout.

A merger arbitrage strategy attempts to take advantage of the fact that the stocks combined generally trade at a discount to the post-merger price due to the risk that any merger could fall apart. Hoping that the merger will close, the investor simultaneously buys the target company’s stock and shorts the acquiring company’s stock.

Relative Value Arbitrage

The relative value approach seeks out a correlation between securities and is typically used during a sideways market. What kinds of pairs are ideal? They are heavyweight stocks within the same industry that share a significant amount of trading history.

Once you’ve identified the similarities, it’s time to wait for their paths to diverge. A divergence of 5% or larger lasting two days or more signals that you can open a position in both securities with the expectation they will eventually converge. You can long the undervalued security and short the overvalued one, and then close both positions once they converge.

What Causes Market Volatility?

In general, market volatility increases when there is greater fear or more uncertainty among investors. Either can result from an economic downturn or in response to geopolitical events or disasters. For instance, market volatility rose due to the credit crisis in 2008-09 that led to the great recession. It also spiked when Russia invaded Ukraine in 2022.

What Investments Track the VIX Volatility Index?

Futures on the VIX trade on the CBOE and are available to customers of some brokerages. For those who do not have access to futures, there are also ETFs and ETNs, including the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX), the iPath Series B S&P 500 VIX Mid-Term Futures ETN (VXZ), and the ProShares VIX Short-Term Futures ETF (VIXY).

What Is Probability Based Investing?

In addition to hedging, one can also look to fundamental analysis to understand the risk of an individual stock. Even with liquid and pretty efficient markets these days, there are times when one or more key pieces of data about a company are not widely disseminated or when market participants interpret the same information differently. That can result temporarily in an inefficient stock price that’s not reflected in its beta. Holders of that stock are thus implicitly taking on additional risk of which they are most likely unaware.

Probability-based investing is one strategy that can be used to help determine whether this factor applies to a given stock or security. Investors who use this strategy will compare the company’s future growth as anticipated by the market with the company’s actual financial data, including current cash flow and historical growth. This comparison helps calculate the probability that the stock price is truly reflecting all pertinent data. Companies that stand up to the criteria of this analysis are therefore considered more likely to achieve the future growth level that the market perceives them to possess.

The Bottom Line

The first thing to do in a turbulent market is to step back and examine your purpose for investing. It’s hard not to panic when the market goes down or to become an ostrich and do nothing, but neither furthers your goals. Market volatility offers more opportunities to profit in a short amount of time, but it also brings more risk.