User's blog

Month: October 2022

  • Law of demand, price elasticity and its implications in our everyday lives

    What is a law of demand?

    When the price of something falls people usually demand more of it. This happens because you can now afford to buy more of it and also more people can afford it now. This is called the law of demand.

    This means the higher the price, the lower the demand is, and the lower the price, the higher the demand for any normal good or service. Undeniably, a change in people’s tastes, income, and preferences can affect the demand for something, but we will assume that these other factors don’t change, so we can only focus on the relationship between price and quantity demanded.

    The Law of demand is a key economic concept and has many uses and implications in our daily lives. The demand curve slopes downward when you plot the price on y-axis and the quantity demanded on the x-axis.

    But does it happen to every single item and is there a way to find out by how much?

    The answer to this is yes, and this brings us to another important topic, which is the price elasticity of demand.

    By how much does the demand change with a change in its price?

    The answer to this question depends on how responsive or sensitive the demand is to a change in price.

    Economists call it elasticity of demand. Similar to the concept of a stretch of an elastic, we can look at how much does the demand stretches (changes) in response to a change in the price.

    Many factors affect the elasticity of demand. Whether there are any substitutes for that good, if the good is a necessity or not, loyalty to a specific brand of good, time duration, and how much income you spend on that good all play a role in determining its elasticity.

    In economics, if the percent change in the quantity demanded is more than the percent change in the price, we call it elastic. Going with the same logic, if the percent change in the quantity demanded is less than the percent change in the price, we call it inelastic.

    Just if you are interested, here’s the formula to calculate elasticity.

    So if the value is greater than 1, it means the good is elastic and is sensitive to price change.

    So, those goods where a small change in price creates a big change in the quantity people demand, we call them having an elastic demand.

    Similarly, those goods and services, where a change in price do not cause a change in demand, have inelastic demand.

    Who uses this calculation anyway?

    Businesses and corporations use this calculation to see whether their total revenue will increase or decrease, due to a decrease or increase in price. This also helps them in deciding how much discount to give you during the holiday season.

    The government also uses price elasticity to select goods and services on which to impose excise duty for maximum revenue.

    If you are interested in knowing more uses, here is another article that lists some other ones.

    Let’s look at some real-life goods and services to understand this concept better.

    Inelastic goods

    A classic example of inelastic demand is gasoline in the short run. Anyone going to work every day needs gasoline to drive. Even if there is a rise in the price of gasoline, people will still need it. Some of us might find a carpool or use public transport, but for most of us, we will still need to fill up our gas tanks despite the high price.

    Addictive things like tobacco have inelastic demand as well. Smokers still use it even if there is rise in its price. Similarly, certain prescription drugs, like insulin, because of their limited substitute availability also have inelastic demand.

    Elastic goods

    Now, let’s look at some things which have elastic demand. If the price of Pepsi goes up, a lot of people can switch to a close substitute like Coke, unless they are die-hard Pepsi fans. So Pepsi has a very elastic demand. So any item that has a perfect substitute, will have an elastic demand.

    The duration of a price change and the category of the good or service also makes it more elastic. Too complicated! Let me example this with an example.

    In my example above, over the short run, people may not find alternatives to going to work if the gas price goes up, so the demand is inelastic in the short run. However, over the long run, people can find alternative options, like using electric cars or working from home. Thus, the demand for gas will be elastic in long run.

    A specific brand of milk can have elastic demand if people can substitute it with other brands, but milk in general will have more inelastic demand, as there are not many substitutes for dairy lovers. So here you saw the broad category of food has inelastic demand, meaning its demand won’t change if the price of milk goes up. However, a specific brand of milk can see a decrease in demand if its price increases.

    The first chart shows price elasticity > 1, the second shows price elasticity < 1, and the third shows price elasticity close to 1.

    Are there other types of elasticities as well?

    Yes, there are two other types – cross elasticity, which looks at the effect of a change in the price of a substitute or complementary good or service), and income elasticity (which looks at the effect of change in income on quantity demanded. These are important because changes in demand can also happen due to changes in income level and price of other supplements or complementary goods.

    But to not make the post overly long, I only focused on price elasticity in today’s post, as we wanted to see the effect of a change in price only.

    Hope you found this microeconomics post helpful, to see my other microeconomics posts, please click here. And, yes, if you can think of another elastic or inelastic good or service, please write in the comment below.

  • What factors influence the exchange rate?

    The exchange rate is the rate at which one country’s currency trades or exchanges against another country’s currency. Simply put, if there are two countries US and India, how many Indian Rupees equate to 1 USD? You can also write it as the ratio of one currency over another currency.

    Many factors influence how the exchange rates are set. In this post, you will learn about those, but first, let’s understand where the currency exchange takes place.

    Foreign Exchange Market is the biggest market in the world by volume and it determines the exchange rates of currencies against each other

    The currency exchange happens in the foreign exchange market, also called the forex market. It is the global marketplace that sets the exchange rate for currencies around the world. It is a decentralized or over-the-counter market for the trading of currencies at their current market price.

    Foreign exchange markets include large international banks, central banks, multinational companies, investment banks, forex dealers, hedge funds, etc. All of these buy, sell, exchange, and make guesses on the relative exchange rates of any two currency combinations.

    Why do we care about exchange rate fluctuations?

    For any international currency transaction, you need to know the exchange rate. So, if the current exchange rate is 1 USD=80 Indian Rupees, this means when you go to India, you would get approx. Rs 80 for 1 USD. Similarly, if an Indian comes to the US, they would have to pay approx. Rs 8000 to get $100. In real life, foreign exchange dealers make a small profit on any foreign exchange transaction.

    USD appreciated against major currencies of the World

    Recently, in the news, you must have heard that the US Dollar has appreciated against major currencies of the world. I found this chart from IMF’s Oct 4, 2022 blog post and it shows the US dollar vs major currencies. You can see how the USD appreciated against the British Pound sterling, Japanese Yen, Indian Rupee, Euro, and many others since the start of 2022.

    The IMF post stated that economic fundamentals are a major factor in the appreciation of the dollar. Rising US interest rates and its more favorable terms-of-trade compared to other countries in Eurozone, UK, Japan and China have caused the US dollar to emerge stronger.

    Don’t worry if this isn’t clear to you yet, I will explain this mechanism in just a bit.

    What factors influence a price of a currency against another currency?

    The answer to this question lies in the fundamental economic concept of excess demand. The price of a currency relative to another currency will go up if there is more demand for it.

    A country’s exchange rate can either Appreciate, which is an increase in the value of the currency, or the exchange rate

    Or

    Depreciate/devalue, which is a decrease in the value of a country’s currency or the exchange rate.

    Below I have a chart from google finance showing a continued appreciation of USD or the depreciation of Indian Rupees. Twenty years ago, the exchange rate for 1 USD was around 45 Rupees. Since then, the demand for USD has been rising and the price of USD relative to the Indian Rupee has been rising. As of Oct 15, 2022, it is 82 Rupees to 1 USD.

    In the graph below, you can see how the intersection of demand and supply determines the price or exchange rate. We will take call point A as the year 2014 when the exchange rate for 1 USD was 65 Indian Rupees, where demand and supply met.

    With a continued increase in demand for USD, the demand curve shifted up to the right. With the same supply, the new intersection happens at point B, at this point the price of 1 USD is 80 Rupees in Oct 2022. Thus, if the demand for a currency is high relative to another currency, its exchange rate will go up. The opposite will happen when the demand for a currency is low relative to another currency.

    What causes a change in the demand for a currency?

    Many factors can influence the currency’s demand and the exchange rate. Let’s understand the most important ones below. Since we are looking at the appreciation of the USD against major currencies, I will use USD as an example to explain it.

    • Relative Interest rates

    When interest rates are higher in a country there are more money inflows in the US. This happens because international investors would invest there to get better returns. As investment happens in the USD, there’s more demand for USD. This causes the USD value or the exchange rate to appreciate.

    • Relative inflation

    A low and stable inflation rate also plays a key role. Many developed countries such as the US, and the UK have had inflation of around 2% in the past. Although this has changed recently after the pandemic and Ukraine war, it is still lower than in many other countries.

    A lot of times more than one factor play a role in influencing the exchange rate

    A low Inflation rate in the U.S. relative to another country, such as India, can cause the US currency to appreciate. Let me explain why this happens. Low inflation in the US will mean US imports become cheaper to India and India will demand more US-made goods. I just want to point out that when India imports from the US, it pays for those in USD. So, increased demand for US imports will lead to increased demand for USD. This will cause its relative value or exchange rate to rise against the Indian rupee. For more than a year US economy has been witnessing high inflation. The reason USD is going strong is because other countries are dealing with even higher inflation.

    • Current account surplus

    A current account is the balance of trade between a country and other countries it does international trade with. It includes all the payments between countries for physical goods, services, interest, and dividends.  A deficit in the current account shows a country’s imports are more than its exports. To cover this deficit, that country will usually borrow capital from other foreign countries. This causes its currency to depreciate.

    • Relative Strength of the economy

    Also, the relative strength of the US in comparison to other developed countries plays a role too.  If the world is worried about other developed countries’ performances such as the UK, EU, and Russia, the U.S. dollar price will rise in the international market.

    • Speculation

    Also, expectation and speculation play a role in determining a currency exchange rate. If more people believe that the value of the U.S. dollar will rise relative to other currencies in the future, they will demand more of the US dollar to sell it later for a profit. This is going to further increase the demand for the U.S. dollar causing an increase in its value.

    • Relative Competitiveness

    If businesses in the US become more competitive relative to the UK, this will also cause an increase in demand for US-made goods causing an appreciation or increase in the value of the U.S. dollar compared to the pound sterling.

    Conclusion

    In the long run, how strong a country’s economy is and how competitive it is relative to its other countries will determine its exchange rate. A technological innovation that leads to higher productivity will strengthen that country in the international market and will lead to an appreciation in its value.

    What has caused exchange rate fluctuations can be hard to pinpoint, as most of the time several factors play the role.

    Clearly, an appreciation in the US dollar has made travel to the UK and other countries much more affordable for the US people. To see who all benefit from the appreciation or depreciation of a currency, stay tuned for my next post.

    Credit: Images from Freepik

  • Funds basics: part 2

    Should I invest in a mutual fund, index fund, or in ETF?

    In my previous post about funds, I mentioned that there are mainly four main types of funds. These are mutual funds, exchange-traded funds or ETFs, index funds, and hedge funds.

    Today we will look more closely at each one of these funds but will focus on the first three types. Hedge funds are for very wealthy people, so let’s not worry about those for now.

    Also, for comparison purposes, we will only look at funds that invest in stocks or what we call equity mutual funds for simplicity.

    We will learn how these three funds are similar and how they differ from each other. I think it is good to know their characteristics because often people don’t know the distinction and use them interchangeably.

    So let’s start with mutual funds- the oldest of all three!

    Mutual funds have been there for the longest time. The first mutual fund was created in the U.S. in 1924.

    You can buy mutual funds from mutual fund companies or through stockbrokers. The price of a mutual fund is set at the end of each trading day based on its net asset value or NAV.

    Benefits of mutual funds

    The main benefit of a mutual fund is the diversification it offers you. Diversification is an investing strategy that reduces your risk by spreading out your portfolio. I talked about this in my earlier post, that you don’t want to put all your eggs in one basket. By investing in a mutual fund, you get a tiny slice of each of those companies that are in the fund.

    The other benefit is convenience. Investing in a mutual fund reduces your cost and the transactions you have to do. When you invest in mutual funds, you only make one purchase when you start. You get a share of each of the stocks that are in the fund, without having to pay a commission on each company’s stock trade. You can then invest more money in it periodically.

    Without a mutual fund, if you want to buy a lot of stocks, this will involve a considerable amount of your time and money.

    Are there any cons of investing in a mutual fund?

    The second key feature is that mutual funds are mostly actively managed Funds. What do we mean by actively managed?

    It simply means some finance professionals are doing the research and selecting the stocks for you based on their judgment. The main aim of these professionals is to pick and choose securities that can beat the market return. For their service and time, they typically charge you 1%- 2% of your account balance annually.

    Fund manager doing analysis in an actively managed fund

    This is irrespective of the performance of that fund. So, even if the stocks they chose in the fund are not performing well and your account balance goes down, you still have to pay the fees annually.

    This 1%-2% fee might seem low but if you have a bigger balance, then this will eat into your invested money over time.

    Also, historically, the data shows that most of the time these fund managers are not good at beating the market. This means that the stocks that they cherry-pick do not give you better returns than the broad-based market index such as the S&P 500 index.

    Mutual funds also have some holding restrictions in terms of the minimum duration of time you need to hold the fund.  There could be a penalty if you sell it before that time depending on the type of mutual fund.

    Let’s look at index funds now!

    An American investor, John Bogle created the first index fund that mirrored the S&P500 index in Dec 1975. He believed in a long-term investing strategy over day trading and speculation. He also didn’t like paying high unwanted fees to mutual fund managers. So, an index fund was a perfect solution!

    Thus, unlike traditional mutual funds, Index funds are passively managed funds. They just track a certain market index such as S&P500, Dow Jones Industrial Average, or some other index. This is how they got their name index funds. Simple, right?

    The index fund mimics a market index and is a form of lazy but worthwhile investing

    Index funds buy and sell securities based on the index they copy. So, their portfolio will reflect any type of change in the index they follow.

    Here, I would argue that for a beginner investor, an index fund would be a better choice for many reasons. Even investing experts like Warren Buffet favors index funds.

    Advantage of an Index fund

    First, they are very well diversified because they invest in all the stocks that make up an index.

    Another advantage of investing in index funds is that they are passively managed and have incredibly low fees. Vanguard S&P 500 index fund has fees as low as 0.04%. The main reason for that is you don’t have to pay the brokers and research analysts to pick and choose companies to invest in.

    Data has shown that Index funds are less volatile and give decent returns over the long run compared to individual stocks. Thus it makes sense to make these the main part of your portfolio, especially for retirement accounts like 401k and IRA.

    You know what is really cool about index funds is that they allow you to do automatic reinvestment. You can set up a monthly recurring deposit from your bank account to the fund. This is a free automated feature and goes well with the dollar cost averaging strategy of investing.

    Are there any disadvantages of index fund?

    The only limitation of index funds is that some of them like the Vanguard 500 index fund VFIAX have a minimum requirement of $3000 for investment.

    But a lot of other options like those from Charles Schwab and Fidelity index funds don’t have any minimum constraint.

    VFIAX is one of the most popular index funds. As S&P 500 stock market index is a widely recognized benchmark for US stock market performance. Rather than looking at individual companies’ performances, you can simply look at the index direction, whether it’s going up or down.

    Here are the top three S&P 500 index funds I found that you can check out. You will find expense ratio and minimum investment requirements, dividend yields, and 5-year trailing return comparison.

    Moving on to the newest category of funds, the exchanged traded funds or the ETFs.

    Exchange-traded funds have features of both index funds and stocks. They were first created in the 1990s.

    ETFs like index funds can mimic a variety of indices such as the S&P500 or medium or small companies indices.

    The added feature of ETFs is that they trade on a stock exchange. However, these are still usually passively managed like index funds.

    Also, you don’t need a large amount of money to start investing. You only need enough to buy an ETF for the price of one stock, which could be from $50 to a few hundred dollars.

    Since ETF trades like a stock, its price can fluctuate throughout the day. Depending on what time you’re buying or selling that’s the price you pay or receive.

    So the difference is the option of intraday trading in ETF versus end-of-the-day trading in a mutual fund or index fund.

    So is that even worth it?

    But this flexibility might not be good for long-term investing. The reason is that when you see the price of ETF going up and down you will be tempted to sell and buy, but this is not what long-term smart investing preaches. Most people just buy once and sell when they retire, so this added feature doesn’t help.

    Another downside if you compare them with index funds is that ETFs don’t have the automatic reinvestment feature as index funds do. You manually have to buy more shares of ETF every month which means more fees and more work.

    Also, some ETFs could also be actively managed mutual funds. Actively managed ETFs have expense ratios just like mutual funds. So actively managed ETF costs more than a passively managed index ETF.

    How do you make money from these funds?

    So how do we make money from Mutual funds, index funds, or ETFs? Just like stocks do, through dividends and or capital appreciation. So if you sell your fund for more than what you bought, you’ll make money. You’ll also benefit if the securities in your fund pay dividends or interest.

    Which type of fund is the right choice for you?

    To summarize, first, we only had mutual funds, which gave everyone this convenience and diversification of pooled investment.

    Then came the index funds, which are passively managed mutual funds and mimic an index. Index funds, over the long run, actually perform better than actively managed mutual funds. Also, index funds have much lower expense ratios and fees.

    Remember, all index funds are mutual funds, but not all index funds are mutual funds.

    Lastly, we have the ETFs which have everything an index fund does with an added option of intraday trading. However, ETFs don’t have an automated option for reinvesting and you have to manually do it every time.

    From a tax point of view, mutual funds incur more taxes than ETFs.

    So out of three options, my choice would be to invest in an index fund. But I would still recommend you do more research before you make any investment decision.

    Last but not the least – Hedge funds

    Before closing, I want to quickly go over Hedge funds with you. Hedge funds originally were aimed to hedge risk but now have become high-risk high return types of actively managed funds.

    Also, they are mostly meant for institutional investors and rich people. This is because their minimum requirement for investment is a huge amount of money. Most of us will not even qualify for an investment in a hedge fund.

    So there you have it, my friends, your must-have knowledge of different types of funds to begin or improve your investing journey. I hope you found this information useful. Please share your feedback in the comment section below.

    Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice on an individual basis. 

    Credits: Images from https://www.freepik.com

  • What are funds?

    A fund is a collection of money from many investors. This pool of money can be invested in stocks, bonds, in a specific sector, or a combination of them. The main advantage of investing in a fund is the diversification it provides to us by spreading our risk. So, a fund can invest in places where an individual investor may not be able to.

    Depending on how much money you invest in the fund, you’ll get a share in the fund. In investing theory, we call them units. So, the value of your units can go up or down based on the performance of the fund.

    Funds can be actively managed or passively managed. In my next post, we will learn about these in more detail.

    Where do funds invest?

    A fund can invest in a variety of asset classes or in specific assets like only stocks or only bonds. The name of the fund usually states its purpose.

    Equity funds, as the name suggests, invest in stocks, while fixed-income funds will invest in bonds – both corporate and government bonds.  Some balanced funds invest in both stocks and bonds together.

    Growth funds only want to invest in growth companies because they see a high potential for growth in these companies. Most technology companies are growth companies.  This is the fast and furious approach to investing, where the fund manager will try to find companies with growing revenue, cash flows, and profits. These companies generally tend to be new companies, with a few exceptions.

    On the contrary, Value funds invest in stocks of undervalued companies that pay high dividends. This approach is the slow and steady approach.  Value fund tends to invest in companies that are well-established and mature. They usually offer investors a steady stream of income.

    Funds could also be sector-specific, like energy funds that only invest in energy companies.

    Some funds only invest in large-cap companies like those in S&P 500 index. So, when you invest in those index funds you are investing in many large-cap companies without bearing the risk of owning stocks of individual companies.

    Investing in a fund that mimics a broad-based index will save you a lot of money. Also, most large-cap companies’ stock price trade at a very high value, and it will require a lot of money to buy several different stocks of different companies. Something that a lot of us can’t do.

    You don’t need a lot of money to invest in a fund!

    Did I tell you that you don’t need a lot of money to invest in a fund? Most funds like ETFs and index funds do not have minimum requirements.

    A pool of money from many investors

    So, hopefully, you got an idea about the purpose of the funds.

    There are mainly four types of funds you will most often hear about

    • Mutual funds (actively managed by professionals)
    • Exchange-traded funds or ETFs (similar to mutual funds and stocks, could be active or passively managed)
    • Index funds (passively managed, my favorite)
    • Hedge funds (need a lot of money to invest in these, so many of us don’t qualify)

    I will cover each of these in detail in my next post. So stay tuned if you want to know the advantages and disadvantages of each of these four and which one could be a better choice for a new investor.