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  • Does more money make people happier?

    The answer to this question is not very easy. I think it depends on a person’s income or wealth level and state of their mind.

    When someone is poor, any additional money they get will bring them a lot of happiness and satisfaction. The value of $100 is much more to a homeless person than to a millionaire.

    Happiness Economics

    A subfield of economics, known as happiness economics, studies various factors that affect the well-being of a person. In 1974, American economist Richard Easterlin came up with an interesting concept called Easterlin Paradox.

    His findings showed that happiness doesn’t increase with an increase in income or wealth after a certain point. This graph shows the Paradox of how the happiness curve rises with income in the initial stages but becomes flat when the income keeps rising.

    He based his findings on the belief that money has diminishing returns. What it means is that at a low level of income, you get more happiness and satisfaction with any additional money that you get. However, at higher levels of income, that additional benefit becomes less and less. In fact, after a point, it just does not bring any additional happiness.

    We value something when we have less of it, but when we have too much of it, we don’t value it as much.  It is as simple as this.

    If you study behavioral economics, you will know that the key assumption of conventional economics – human beings are rational, doesn’t always hold true. People do not always choose the option that maximizes their material well-being.

    Economics deals with humans and human minds are complex. Various factors, both at the macro and micro level play a role in determining what choices humans make.

    So what factors other than income affect your well-being?

    There are a lot of factors that affect a person’s happiness than just their income or overall wealth.

    The big, macro factors are the things we can’t directly control like:

    • good governance
    • good healthcare
    • clean air and water
    • right to good education
    • political stability in a country
    • availability of jobs for people in the labor market
    • good community and social support
    • good infrastructure
    • woman’s equality in that country
    • Corruption free society
    • and overall safety.

    Yes, I know many of these macro factors are more favorable in rich countries, as a lot of these cost money. Developed countries can provide good infrastructure, healthcare, public safety, and better jobs more easily.

    But there are factors beyond individual incomes and the economic development of a country, which affect the happiness of its people.

    World Happiness report findings

    The survey done by the World happiness report shows that the countries with the highest level of satisfaction in the world are not the ones with the highest GDP per capita.

    In 2021, Finland’s GDP per capita was $53,982, and the US GDP was $69,287 according to World Bank data. Even with a lower GDP compared to that of the US, Finland ranks first in the happiness index. The US, which has the 6th highest GDP per capita ranks lower in the happiness index, coming at number 16.

    Though the data shows a strong correlation between the countries with high GDP per capita and happiness, it is not perfect.

    According to the analysis done by World happiness report 2022, the six variables: GDP per capita, social support, healthy life expectancy, freedom to make life choices, generosity, and freedom from corruption are key in determining overall happiness.

    I got this table from their report and it shows their regression analysis. You may skip this section and scroll to the next if this seems very mathematical. But I want to explain their findings so you can understand.

    The weird part of economics is that it tries to explain the obvious through data and mathematics

    Regression analysis is an Econometrics tool to study how well different “independent factors or variables“ explain a phenomenon or the “dependent variable“.

    In their survey report, the six independent variables are the log of GDP per capita, social support, healthy life expectancy, freedom to make life choices, generosity, and perceptions of corruption.

    The dependent variable is the average happiness across countries. A total of 156 countries were surveyed using data from the years 2005 to 2021.

    In the table below, wherever you see three stars *** next to an independent variable value in paranthesis, it shows that the variable (of the six I mentioned) is statistically significant in explaining the average happiness (dependent variable).

    It means the majority of the people surveyed reported that factor to be an important determinant in explaining their happiness level.

    If you look at the statistics I circled above, called Adjusted R-squared, you will see a value of 0.753. This means together these six factors explained more than 75% of the variation in national annual average happiness scores.

    Thus, as you see real GDP per capita is only one of the indicators for measuring the prosperity of a country. Other variables that are part of the happiness index actually tell a better story of the well-being of a country’s population.

    Economist Simon Kuznets, who invented the concept of GDP, in his first report to the US Congress in 1934 said “the welfare of a nation can scarcely be inferred from a measure of national income.” So, we see that GDP per capita, has limitations and I will cover those in a separate post later.

    So are there other factors that the report missed?

    There could be some internal factors that the report hasn’t covered explicitly. These are the factors that we have more control over.

    When we see on social media people vacationing and throwing big parties, we instantly assume that they must be very happy. Because we think this happiness can only come from the extra money they have, to afford that extravagant lifestyle.

    People start comparing themselves to their peers and get depressed. They are not unhappy because they have less money, but because their friends or relatives have more. People immediately associate more money with happiness.

    But is it always the case?

    Increased urbanization has taken away the simplicity of life. The materialistic nature of western countries has engulfed every single country now.

    To earn higher incomes, many times people live away from their families and work in jobs that increase their stress levels.

    Long working hours are physically and mentally draining for most people

    Their progress at work comes at a cost of missing family time because they are overworked. If people don’t have time to focus on their health, then that additional income is not even worth it. There is this huge opportunity cost to having a higher income, which we mostly overlook.

    Conclusion

    I feel a person’s health and relationships also play a huge role in determining the level of their happiness.

    In a true sense, a person’s happiness depends on their state of mind. They should have enough money to lead a fulfilling and healthy life. But we need to be aware that there will be, always, many people above or below us in terms of wealth and income.

    People should be able to meet their needs and most of their wants, but not at the price of their health and relationships. Wants are never ending and are different for each income level.

    For most people, money, and happiness can go together if they spend their extra money the right way.

    If people can pursue a quality life, then they could be actually happy. Worthwhile acts like donating to charities, getting the time to pursue their interests, having a work-life balance, and the ability to spend leisure time with family and friends, all affect the quality of life. In the absence of these, wealth alone may not bring true happiness.

    Similarly, people with less means can also lead a happy life. In fact, I notice that many times, people with low levels of income are more satisfied with their life. This could be because they have lower expectations and get content easily compared to relatively wealthy individuals.

    On a personal level, it is the state of my mind that influences my ability to find happiness. It could come from small things and moments in my life, and from the big ones, where I worked hard. Having a clean home, good health and a supportive family and friends are the things that make me truly happy.

    My ability to follow my interest and passions, share my thoughts about things that matter to me, and do charity give me happiness. Wealth matters, but being content with what I have achieved so far without comparing it with others matters more to me.

    What do you people think? Do share your views in the comment section below. It will be nice to know!

  • 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.

  • Where do I invest and when do I start?

    In my previous post, I wrote about the various types of assets you can use for investment. To have a diversified portfolio, you should invest in a variety of assets.

    Diversification can mean two things:

    The first is diversifying within the same asset class.
    The second is having different asset classes in your investment portfolio.
    We all need a diversified portfolio

    So, for example, if you are investing in fixed-income securities, you need to invest in different types of those such as government bonds, corporate bonds, CDs etc.

    Similarly, if you are investing in stocks, you should invest in multiple companies from different industries and sectors. But when you invest in individual company stocks, you may only be able to invest in 5, 10, or maybe 15 companies.

    To achieve diversification using individual stocks, you will need to do a lot of research and invest a lot of money buying stocks from different companies in different industries.

    Thus, if stocks comprise a majority of your investment portfolio, then your investment is risky because it is based on the performance of those companies you bought shares of.

    So what’s the solution?

    For a beginner investor, who doesn’t want to put too much money in several individual stocks, the best way is to start with investing in an index fund or a passively managed mutual fund.

    What’s an index fund?

    Index fund is a fund whose portfolio are built to mimic the constituents of a stock market index. The most widely used indices in the US are S&P 500 index or Dow Jones Industrial Average, or the Nasdaq Composite index.

    Generally, Index funds should give you the same return as the index they follow. These funds buy all the stocks that are part of the index in the same proportion. So, it is like you have invested a little bit in each of those companies that comprise that market index. So yes, that would give you a very well diversified investment portfolio.

    Also, index funds are less volatile and therefore are a good investment compared to individual stocks, esp. for long-term investing. So, they are a great option for investment for your retirement.

    In my next post, I will argue why I like index funds more than actively managed mutual funds. I feel if you are sticking to read my post this far, you will be interested to know more.

    Don’t put all your eggs in one basket!

    The main point is to diversify so that if one sector or asset class doesn’t perform well, you don’t lose all your money.

    The second key thing for diversification is having different asset classes in your portfolio, such as stocks, bonds, real estate, commodities, etc.

    This brings us to the concept of asset allocation. Asset allocation simply means you decide what percentage of your money you want to put into each type of asset class.

    Asset allocation will vary from person to person, depending upon their savings, age, risk tolerance and financial circumstances.

    Finance theory suggests that generally, your investment in stocks should be 100 minus your age. So, if you are 25 years old, it should be 75% stock and 25% fixed income.

    So yes, it means you need to keep changing your asset allocation as you grow older. Later in life, your investment in stocks should be less, and high in other fixed-income assets.

    Now comes the million-dollar question.

    When should you start investing?

    The easy answer is now if you haven’t started already.

    You can start investing as early as when you first start earning. Even kids can start investing their allowance money and add to it periodically.

    Time plays a huge role in making your money grow, more than the dollar amount you invest. This is due to the power of investing!

    Your money grows overtime exponentially!

    If you are not convinced, you can take a look at my post here, where I explain this concept by using some simple examples.

    How much money do I need to invest?

    In the past, you would need a substantial amount of money to start investing. But things are much more simple now. With no minimum, no commission brokerage accounts, and fractional ownership of shares, you can start investing with as little as $10 a month.

    You can set aside $1-$5 a day and make monthly contributions of $30-$150 a monthly.

    These are some of the top brokerage firms in the U.S. – Charles Schwab, Fidelity, TD Ameritrade, and Vanguard. Stay tuned for my post on how to open a brokerage account!

    I hope you found this information useful, I will cover Real estate and commodity investment in another post! But this is useful info to start investing now.

    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- https://www.freepik.com

  • Investment basics, you should know: part 1

    After we have established 6 months’ worth of saving in a bank for our emergency fund, what do we do with our remaining savings? Finance experts will tell us that if we want our money to grow, leaving the extra money in a bank will not take us anywhere. So, the best strategy is to invest your extra money.

    Now the question arises, without proper financial literacy, how do we know where can we invest our money? In this post, I will tell you some of the asset types where you can invest your money.

    Also, you will learn why diversification is very important for investing. By diversification, we mean, having a variety of assets so that if one asset doesn’t do well, you don’t lose all your money. This will also allow you to minimize risks from fluctuations in return from each asset class.

    Let’s begin by understanding an asset class!

    Asset class means a group of assets that display similar features. These assets will have similar risks and give you similar returns. They are also usually subject to similar tax laws.

    There are several types of asset classes, such as

    • stocks or equities,
    • fixed income assets (bonds and CDs),
    • mutual funds, ETFs
    • Cash and cash equivalents like money market funds
    • commodities like gold and silver, oil, etc
    • real estate (property)

    Asset class and allocation are very important concepts in investing. They help you diversify your investment, so you can have a well-balanced portfolio. I will cover more on asset allocation in another post.

    In this post, I will cover the first two types of assets

    Stocks

    Stocks are the shares in a company. People who buy a company’s stock actually get a share of ownership in that company. Companies typically issue their stock in the Initial public offering (IPO) to raise money (capital) for its growth.

    Stocks or shares mean the same and I am using them interchangeably throughout this post. Similarly, you can either say stockholders or shareholders, they are the same.

    When we buy stocks, we get payments in the form of dividends. When the company is doing well and earning profits, it pays its stockholders a share in the profit called dividends.

    Another way we get earnings from stocks is when the share price of that company increases, also called capital appreciation. This could be due to the company’s good earnings or any positive news in the company. The company’s share price reacts to the news as the market values its worth more now.

    Is there a safer way to invest in stocks?

    The answer is yes if you follow certain rules.

    The first thing to understand is that finance theory and the supporting research show that no one can beat the market. Even seasoned investors, like, Warren Buffet don’t recommend cherry-picking a few stocks, esp. for someone who is not a very risk-taking person.

    A company’s shares can fluctuate a lot due to various reasons. People who think they can predict a company’s performance and hence its share price doesn’t know finance theory that well.

    Most of the time, people don’t have enough time to research individual companies. Also, investing in a variety of companies to make a truly diversified portfolio may require a lot of money.

    A good strategy for a new investor is to invest in an index fund that mimics the market such as an S&P 500 in the US. An index fund is a type of mutual fund that buys all the stocks that make up the market index in the same proportion. So, the money that you earn from investing in an index fund will be very similar to the return on the index it mimics.

    Another key feature of Index funds is that they generally follow a passive, rather than active, style of investing. This means they maximize returns over the long period by not buying and selling securities very often. 

    Because index funds are diversified, you don’t lose money when some stocks don’t do well. Index funds mimic the market and are less volatile and over the long term (like 10 years or more), they give good returns. Don’t put all your eggs in one basket rule should be the most important thing to follow when investing.

    The second way to minimize risks is to use a strategy called dollar cost averaging, where you invest a fixed $ amount every period, monthly, weekly, etc.

    I didn’t want to make this post super long that you loose interest, so if you want to learn about dollar cost averaging, you can read my post here.

    Let’s quickly turn to our fixed-income assets. The first one is bonds.

    Bonds

    Unlike stocks, if you buy a bond of a company, it doesn’t give you ownership in that company. Bonds are actually a loan a company takes to raise capital.

    Both individual companies and the government need to raise money and thus, issue bonds. Thus, when we buy bonds, we get interest payments on the money we loan to a company or the government. Along with interest payments, at the end of our loan period called “term”, we also get our Principal amount back. 

    Bonds are part of fixed-income investments. As the name suggests, they give a fixed amount of income with regular interest payments until maturity.

    Other fixed income assets include Certificates of deposits (CDs), municipal bonds, t-bills and t-bonds.

    Just like stocks, we can invest in fixed-income securities directly, or through Electronically traded funds called ETFs and mutual funds or index funds.

    As a bond owner, you bear less risk and you will get the interest amount, irrespective of how the company performs.

    Thus, a good part of owning a bond is that, if a company does bad and goes bankrupt, the bondholders still will get their money back. The company can pay them by selling their assets such as their buildings, factories, etc.

    However, this is not the case with shareholders. During bankruptcy, the stock price of the company crashes to a very low mark, and shareholders could lose all of their investments.

    Treasury bonds are considered very safe investment options. It is like lending money to the US government.

    Stocks usually pay more than a bond, but owning a stock is riskier than owning a bond. So, your decision to invest in stocks or bonds should depend on how quickly you want to grow your money and how much risk you are willing to take.

    So which one should we invest in?

    The answer is in everything. We all should have a diversified portfolio, consisting of stocks, bonds, and other assets, like commodities, real estate as well. Although this post covered investment in stocks and bonds, we can have a portfolio with more types of assets.

    Your age and risk tolerance will determine the percentage of each asset you should keep in your portfolio. For younger people, investments in bonds shouldn’t be the main part of the portfolio, simply because they don’t pay as much as stocks do.

    However, as we approach retirement age, our ability to bear risks falls. So, more investments in fixed-income assets like bonds, should be done later in life.

    I hope you found this post useful. Stay tuned for my next post on asset allocation and diversification.

    Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice. I recommend you consult a qualified financial advisor to make investment decisions.

  • How does people’s expectation about inflation affect the actual inflation?

    What people like you and me think about inflation directly impacts the actual inflation rate. So, if we think inflation will be high in the coming months, it will most likely be. In this post, I will explain how this phenomenon works.

    If we expect that overall prices are going to rise in the coming months, we may buy more things now, rather than in the future. If a lot of people do that, this increases the demand for goods and services.

    High inflation is directly linked to a higher demand that is not immediately matched by an increase in supply. As a result, firms increase the prices of goods and services when there is more demand. This enables them to make more profit. As a result, we see increased prices passed on to the consumers causing higher inflation.

    On the other hand, if people expect prices to fall in the future, they may delay spending now to get a better deal. This will result in a decrease in demand for goods and services and businesses will end up lowering prices to clear up their stock.

    So, now we understand how inflation expectations affect actual inflation. If you want to know more about inflation and how it is calculated, you can refer to my post here.

    What is the current inflation expectation in the U.S.?

    After suffering from really high inflation close to 8%-9% for over half a year, we foresee some good news. A survey conducted by the Fed reserve bank of New York shows a decrease in these expectations.

    People in the U.S. feel that one and three-year-ahead inflation are now going to be 5.7 % and 2.8 % respectively.

    These are clearly lower than 6.2 % and 3.2 % in June for one and three years ahead inflation rates respectively. In the figure from the Federal Reserve of New York website, you can see how there is a decline in the curve of the expected inflation rate towards the end. This is the survey done in the month of August 2022 about what people think inflation may look like for 1 year and 3 years.

    It shows that people’s expectations are consistent with what the Fed is trying to achieve. By raising interest rates, the Fed is trying to slow down the demand in the U.S. When borrowing becomes expensive, people generally tend to borrow less for things like cars, mortgages, etc.

    In their September 20 meeting, the Fed is most likely going to raise the key federal funds rate by another 75 basis points. The Fed has been raising interest rates to fight the high inflation in the U.S for the last 6 months. Central banks in a lot of other countries fighting inflation have been doing the same.

    To learn more about the role of the central bank, stay tuned for my next post.

  • What is a 529 plan in the U.S.?

    In my earlier post, I wrote about ways to fund your child’s college education. One of them was opening a 529 account. In this post, I will talk about what these plans are.

    529 plan is a tax advantage account, where people invest money to fund the college education of their kids. You can open an account for your education as well.

    529 plans are state government-sponsored plans and each state has its plans.

    Advantages of 529 plans

    The first advantage is that you invest your post-tax money and it grows tax-free. This is similar to a Roth IRA or 401 K. The other advantage is that there is no maximum contribution limit.

    Additionally, if the original beneficiary can’t use his account for any reason, there is an option to change the beneficiary anytime.

    Who can open the account?

    Mostly parents or grandparents open this account to fund money for their child or grandchild’s higher education.

    Anyone with a Social Security Number (SSN) or Individual Taxpayer Identification Number (ITIN) can open this account. Though non-U.S. citizens living outside the U.S. can’t open the account, they can still contribute to a child’s 529 plan.

    Also, anyone can contribute to a 529 plan, a grandparent, a friend, or a relative.

    Only U.S. citizens or resident aliens with a Social Security Number or Individual Taxpayer Identification Number can be the beneficiary.

    Also, you don’t have to be a resident of that state to apply for that plan. Most states offer it to both residents and nonresidents. However, there are six 529 plans that are only available to in-state residents:

    Two types of 529 plan

    • Savings plans: This is where you are building up money, which you can use toward almost any college tuition and related expenses in the US. This can also be used for K-12 education as well.
    • Prepaid tuition plans: This lets parents lock in today’s tuition rates for a child’s future education (but may limit where a child can go to school). The money can’t be used for room and boarding.

    Choosing the right 529 plan

    Savings plans tend to be more popular than prepaid tuition ones, as they are less restricting. Not all states offer prepaid tuition plans.

    Many families choose their state’s plan because their state can offer more tax benefits to them. However, you are free to choose any state’s plan. One tip is to compare different plans and choose the one with a low expense ratio.

    Disadvantages of 529 plan

    Since the money invested should only be used for education purposes, if you use it for anything else, you pay a 10% penalty and will owe taxes on the capital gains.

    Also, you can’t control which assets these plans invest in.

    Should you invest in 529 plan?

    Despite these limitations, it is still a great plan for funding college education if you think your child will go to college.

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

  • How to fund higher education in the US?

    Before I answer this question, I want you to look at the income of people with a college education vs people who don’t. Publicly available data and our observation show that people with a bachelor’s degree or a master’s degree get higher-paying jobs.

    Below chart, I copied from the U.S. BUREAU OF LABOR STATISTICS. It shows the median earnings by education level in the United States from the 2021 population survey.

    People with bachelor’s degrees earned 48% more than people who don’t complete their degrees. Clearly, completing the degree has a huge positive impact on median earnings. Also, people with professional degrees such as doctors, engineers, and lawyers earn even higher amounts.

    Ways of funding college education

    How to fund their child’s higher education is an important decision all parents will have to make at some point. Planning early for a college education is better than planning later and it is esp. true when you have more than one child.

    In the US, there are several ways you can do that:

    529 plan

    You can create a college fund using a 529 plan. A 529 plan is a tax-advantaged college savings account offered by either your state government or college.

    The tax advantage is the main benefit of it. Tax advantage means you invest your post-tax money, but it grows tax-free. Also, when you withdraw your money for college, you don’t have to pay taxes on it, as long as it is used for education purposes.

    If you are aware of 401k plans, 529 plans are similar to those. However, this money you withdraw can only be used for education. There is a penalty of 10% for non-educational use and you will have to pay income tax on it.

    To know more about this option, you can look at this website for all the details.

    Loans

    If you can’t afford to pay for your child’s college education from your own savings or investment, you can borrow.

    I am going to get a little sidetracked here, but from what I learned from various finance books and legit websites is worth sharing. I feel borrowing for good investments pays off in long run.

    Loans taken for higher education, starting or growing a well thought business, or real estate are all good investments. As there is a very high chance of you earning more from these investments. It is like you are investing for your future. So even if you have to pay interest on your loan, your earnings increase much more in comparison, to compensate for it.

    However, borrowing to pay for things that will ultimately depreciate, such as cars, furniture, and vacation isn’t worth it.

    Coming back to the topic, alternatively, you can also borrow for higher education if your savings or investment can’t cover the cost.

    Take loans from either the Federal government or from private banks

    These student loans can be used for tuition, accommodation, books, and other miscellaneous costs related to college. The interest rates on Federal loans are usually lower compared to private banks.

    As of today, interest rate on federal unsubsidized loan is 4.99% for bachelor’s degree and 6.54% for professional and graduates degrees. The repayment period defaults to 10 years but can be extended up to 30 years. For more info, you can refer to the Federal student loan website.

    On Aug. 24, 2022, the U.S. Department of Education (ED) extended COVID-19 emergency relief for student loans through Dec. 31, 2022. Please see here for more details.

    https://studentaid.gov/help-center/answers/article/what-is-current-interest-rate-for-direct-unsubsidized-loans

    How much can I borrow for a student loan?

    For the undergraduate level, you can borrow each academic year between $5,500 and $12,500 depending on your year in school and dependency status. For graduate or professional level, you can borrow up to $20,500 per year.

    Types of Federal loans

    The main difference between Direct Subsidized Loans and Direct unsubsidized loans is the financial need element. Direct subsidized loan are available to undergraduate students with financial need, so the US government pays interest on your behalf.

    Direct unsubsidized loans are not based on financial need and hence you pay the interest on the loan. On these loans, interest accrues (adds up) every day.

    Borrow from private banks

    The other option is to borrow from private banks. Usually, the rates are higher than Federal student loans.

    With private loans, the payments get due while you are still in college. In the case of a Federal direct unsubsidized loan, payments are not due until after you graduate.

    My two cents

    Get higher education even if it requires borrowing. Also, you have to understand how much money you should borrow. The main aim is that it should cover your tuition and basic living expenses, if you are staying away from home.

    It may be tempting for you to go to a great location, a beautiful campus, and choose a college with the best athletics. But, you should decide if taking a bigger loan for these extra amenities is even worth it, esp. when you have to pay interest on your loan.

    Another option is to check with a nearby college. From my experience, degree from UCLA or USC counts equally well as a degree from UC Berkeley, if you are applying for jobs in and around LA. If your nearby college has a decent rating, living at home and attending local universities will save a lot money on accommodation.

    Some kids also join two years of community college and then attend two years at their local public university This is a much cheaper option and can save you thousands of dollars.

    Also, make sure to submit your student loan FAFSA (form) as early as possible for the best grant and loan opportunities. You can also check for grants or scholarships from your local civic organizations, your local community colleges and universities, and even your parents’ employers.

    I hope you found this information useful. Adios, until next time!

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