These are the nine financial terms that everyone should know. Read on and find out how many of them you already know.
Financial Terms Everyone Should Know
1. Asset
An asset is something that a person, a company, or a country can own, hoping that it will provide a benefit in the future. An asset is something that can:
Increase its value over time so that you can make a profit by selling it (for example, gold)
Pay you interest in regular intervals (for example, fixed deposits)
Reduce your expenses (for example, owning a house so that you don’t have to pay rent anymore), or
Increase sales (for example, machines)
Characteristics of an asset
To figure out if something is an asset, ask yourself if it has the following qualities.
Ownership – belongs to you
Economic value – can be sold
Resource – can generate future-benefits
Types of assets
Going against the general norm of classification of assets, I have classified assets into the following types for better understanding.
Current assets
Current assets are short-term assets that you can convert to cash quickly (within a year). Examples include cash and cash-equivalents (investments that have low risk and low returns) like money market funds, short-term government bonds, etc.
Fixed assets
Fixed assets (also called non-current assets) are long-term assets that you do not wish to convert to cash within a year. These include land, building, furniture, factory, technology, patents, etc. Fixed assets can be further classified into tangible and intangible assets.
Tangible assets
Tangible assets are assets that have a physical presence. These include your house, furniture, factory, etc.
Intangible assets
Intangible assets are assets that don’t have a physical presence. These include brand recognition, patents, copyrights, trademarks, customer lists, etc.
Liquid assets
Any asset that can be converted into cash immediately, without losing its value is a liquid asset. Examples include cash, a savings account in your bank, stocks, and even costly jewelry (if it can be sold immediately).
Food for thought:
Is a credit card a liquid asset?
A credit card isn’t a liquid asset because even though you can take money out of a credit card, you are borrowing money. So, it doesn’t fall under the category of assets because it doesn’t have two of the properties of an asset – ownership, and resource. Hence, it is not a liquid asset.
Financial assets
Financial assets are investments whose value comes from a contract. These include stocks, bonds, cash, and cash equivalents, bank deposits, etc. They are further divided into current financial assets and non-current financial assets based on how fast you can turn them into cash.
Capital assets
Capital assets are properties that generate revenue over many years. These include land, furniture, jewelry, etc. for individuals; and factories, machines, equipment, stocks, bonds, etc. for companies.
Why is the understanding of assets essential?
Understanding different types of assets is necessary to categorize all the assets you own and formulate an effective asset management plan. An effective asset management plan does not just guarantee you a stable future, but also the ability to cope with emergencies, should they arise.
For example, if all your assets are fixed assets, then you won’t be able to get any cash during emergencies, without borrowing from others.
On the other hand, if all your cash is liquid, your money doesn’t generate a better return of investment in the long run.
Hence, diversifying your assets becomes crucial.
2. Liability
A liability is something you owe to someone else as a result of your past actions. It can be a legal obligation, a debt, or a loan. While an asset provides future benefits, a liability takes away future benefits.
Types of liabilities
Current liabilities
Current liabilities are similar to current assets. They are short-term liabilities that need to be paid back within a year. Examples include income tax payable, salaries payable, short-term loans, etc.
Non-current liabilities
Non-current liabilities are long-term liabilities that need to be paid back in more than a year. These include long-term product warranty, pension obligations, mortgages payable, long-term loans, etc.
Contingent liabilities
Contingent liabilities are uncertain liabilities. They may occur as a result of a future event. Examples include lawsuits that a company is facing and product warranties. Depending on whether the event has more than 50% chance of happening, and if one can estimate the resulting amount or not, a contingent liability may or may not occur.
Food for thought:
1. Why is a lawsuit classified as a contingent liability?
If someone sues the company for a million dollars, no liability will arise until the company loses the case. Until the company loses the trial, the company cannot be sure about the possibility of the payment and the amount of money it needs to pay. Hence, a lawsuit is a contingent liability.
2. Whenever a company purchases something from a supplier promising to pay the money at a later date, it results in accounts payable. Most suppliers demand that the company pays this amount within 90 days. Under what type of liability do accounts payable fall?
Current liability, because the company has to pay it within a year.
3. Equity
Equity is the degree of ownership in an asset after subtracting all the liabilities associated with that asset. Therefore, you can calculate equity using the simple formula:
Equity = Market value of the asset – Liabilities associated with that asset
The picture below explains how assets, liabilities and equity are calculated.
Calculation of Asset, Liability, and Equity – Picture credits
Shareholders’ equity
When the asset in question is a company, equity becomes shareholders’ equity. The formula is the same.
Shareholders’ equity tells us how much of the owners’ investment in the company remains after all the liabilities have been paid off.
What is the significance of equity?
Equity provides you the following details:
1. Find out if you are financially stable – If you have negative equity, it means your expenditure is more than your income. So, it is high time you start reducing your spending.
2. Find out if you should invest in a company – One look at the equity of a company will tell you if you can get a profit by investing in its shares. If the company has had negative equity consecutively for several years, it might be an indication that it is going towards bankruptcy. Hence, you should avoid investing in the company.
3. Find the net worth of a product/property – This is useful if you have a house and want to sell it. If your house’s market value is $200,000, and you have to pay $100,000 for its housing loan, the house is worth an equity of $100,000. This is the amount that will remain after selling your home and clearing the housing loan.
4. Net worth
Net worth is the measure of the wealth of a person, a company, or any other entity. It is the difference between total assets and total liabilities.
5. Capital gain
An increase in the market value of a capital asset in comparison to its cost price is called capital gain.
Types of capital gain
Unrealized capital gain
When the market value of the capital asset increases, but you haven’t sold the asset yet, it is called an unrealized capital gain.
Realized capital gain
When the market value of the capital asset increases and you sell the asset, it leads to a realized capital gain.
Why is the study of capital gains necessary?
Understanding taxes – Understanding capital gains and its different types are essential to figuring out how much tax a company should pay. For example, realized capital gains are taxable in most countries, but unrealized capital gains are not taxable.
6. Share
When a company wants to raise money for its business, it can either borrow money from a bank or sell its shares. Borrowing money is a liability since the company has to pay the money back eventually. So, most companies decide to sell their shares.
A share is the smallest unit of ownership of a company (or a mutual fund). If you buy a share of a company, you become its shareholder. As a shareholder, you get two advantages:
Whenever the company makes excess earnings, it can pay you a part of this profit (also called Dividends).
When the company’s shares rise in the future, you can sell them and make a profit.
7. Stock
A stock is a collection of shares of one or more companies. Stocks can be bought in fractions, whereas shares can only be purchased as a whole.
8. Stock options
Companies sometimes offer their employees stock options. Stock options enable employees to buy a fixed number of shares at a fixed price for a fixed amount of time. The number of shares that an employee can buy, the cost, and the duration are fixed by the company.
An example to help you understand
For example, company A can provide stock options for its employees to buy ten shares at $100 a share for two months, whereas each of its shares costs $200 in the stock market. Now, as an employee, you have two options:
Buy some or all of the ten shares for $100 within two months
Not buy any shares
If you don’t buy any share, you don’t lose anything, but at the same time, you don’t gain anything. Simply put, you are passing up on the incentive provided by the company.
However, if you choose to buy some or all the shares, then, again you have two options:
Sell the share after the duration provided by the company and make $100 profit on each of the shares instantly (Since you paid only $100 for each of the shares that cost $200).
Keep the shares, hoping that their value will go up and sell them at a later date.
Why do companies provide stock options?
Companies provide stock options because they want to encourage their skilled employees to stay by providing not just any incentive, but an incentive that gives them a sense of ownership in the company.
9. Depreciation
Depreciation is the reduction in value of an asset over time. This occurs mostly due to wear and tear.
For example, your car might have cost $50,000 when you purchased it. But after two years of usage, its market value might drop to $43,000 because the car is not new anymore. Several parts of the car might have undergone wear and tear and might not be as effective as new parts.
We hope that this blog post helped you learn about the nine financial terms everyone should know. If you liked this blog post, you may like the following blog posts too.
As you may already know, currencies are monitored and controlled by a central institution (the government). A country’s government can control the currency’s exchange rate, the amount of currency available in circulation, etc.
By determining the interest rates, governments and banks control the flow of money as well. In addition to that, banks and other financial institutions charge high transaction fees. Thus, in reality, people aren’t in control of their money, even though they work hard to earn it.
The cryptocurrency was invented during the global recession of 2008 to help people take control of their money by putting an end to the traditional monetary system.
A cryptocurrency is a decentralized digital currency, that eliminates the need for a middle man. It is a currency that does not exist physically, but only digitally. Since it is decentralized (distributed), no single authority can control it.
But since no single credible authority controls or monitors it, anybody can manipulate it. Traditional currencies are tracked, monitored, and controlled by governments and banks. If not for banks, you could add additional zeros to your bank account, or lie that your company hasn’t deposited your salary. But you cannot do this because banks keep track of your money and all your transactions.
But, in case of a decentralized digital currency, nobody monitors it, or tracks the transactions. So, anyone, say Mr.A, can claim that he had transferred 100 units of cryptocurrency to Mr.B. He can create a false transaction to prove this. In the worst-case scenario, Mr.B must pay the 100 units of cryptocurrency to Mr.A.
Thus, the lack of an authority to monitor transactions and detect frauds is one of the most significant problems of digital currencies. However, the first successful cryptocurrency, Bitcoin, solved this problem using Blockchain technology.
Blockchain
To understand what Blockchain is, let’s consider a simple example. Let’s imagine that you are a student in an examination hall. Your teacher distributes question papers to everyone, including you. Let’s assume everyone gets the same question paper.
If you don’t know the answer to a question, you cannot replace it with a question that you know the answer to. If you do so, your teacher can easily find out that you have tampered with the question paper. Since the question papers are copies of each other, all he/she needs to do is compare your question paper with that of another student.
Blockchain uses a similar technique for fraud detection. Blockchain is a technology that maintains a record of financial events (transactions, contracts, etc.) across several computers in a network. The transactions are stored in Blocks.
Blocks are linked to each other to form a Blockchain. As new transactions happen, more blocks are added to the existing Blockchain. A copy of the Blockchain is sent to everyone in the network whenever a Blockchain is updated. Since copies of the Blockchain exist in several computers, other computers will notice if someone tampers with a transaction in any block in the Blockchain.
Private and public keys
When you create a Blockchain wallet (similar to your bank account), you receive a public key and a private key. The private key gives you access to your account (to spend money), whereas the public key confirms the ownership of your account. The private key is kept secret, whereas the public key is shared with others.
When you initiate a transaction, three things are shared with the entire bitcoin network.
Your message (transaction).
Your digital signature, which is created by passing your message through a Hashing algorithm and then signing it using your private key.
Your public key.
If you go to a bank and deposit a check, the bank employee first makes sure that the account details are correct. Then he/she checks the authenticity of the check by verifying the signature. Finally, if everything matches and the said account has the required amount of money, you get the money.
In this bitcoin scenario as well, there are people who perform the job of the bank employees. They are called Miners.
Hashing algorithm
The Hashing algorithm plays a very important role in the Blockchain mechanism. It makes sure that nobody can hack your account using the message you send.
To understand what a hashing algorithm does, let’s consider an example. Assume you want to encode the text, “The Moon is black,” and send it to your friend. Let’s use numbers for each letter of the alphabet (a=01, b=02, z=26, and ‘ ‘=’/’).
So, the message will be encoded as:
The Moon is black = 200805/13151514/0919/0212010311
You can now write it on a piece of paper and send it to your friend. If he knows the encoding algorithm, he can reconstruct the original message easily. However, others won’t be able to decode the message because they don’t know how you encoded it.
The Hashing algorithm serves a similar purpose in the Blockchain mechanism. However, unlike our algorithm above, it is much more complex, with the following properties:
Regardless of the input’s length, its output always has the same length (256 bits = 64 hexadecimal digits).
Its input cannot be reconstructed using its output.
The same input will generate the same output, but no two inputs will generate the same output.
As you can see in point 2, it’s impossible to obtain the input from the output (hash). So, the only way to break the algorithm or get the input from the output is by Brute-Force, i.e., hash different inputs until you find the input that created that output. Since the number of bits in the hash is 256, this would take 2^128 tries on an average. A supercomputer that tries 15 trillion entries per second would take 47,956 trillion years to find the input.
If you’re interested, you can try to hash different texts using the hash calculator here.
Miners
We saw that Miners are similar to bank employees. The bank employee is hired and paid by the bank to do the job. Bitcoin miners, on the other hand, are not hired by anyone. They are users who volunteer for the job of verifying the messages (transactions) and get a reward for it. When a miner wants to verify the transactions, he selects a list of unchecked transactions. Then he starts verifying the transactions one after the other.
How does a miner check a transaction?
Whenever you make a transaction, your transaction details, digital signature, and public key are automatically shared with the entire bitcoin network.
Any Miner can take these details to check your transaction to ensure that you are the one who initiated the transaction. To do this, the message you sent is processed by a hashing algorithm. At the same time, your digital signature and public key are processed through a verification algorithm.
The hashes resulting from both these processes are compared. If they are the same, the message you sent and the message received by the miner are the same. If not, it indicates that someone has tampered with your message, and the miner rejects the transaction.
Then, the miner verifies that you have sufficient bitcoins to make the transaction. In the same way, he verifies as many transactions that can fit into a block.
But you should remember that the transactions are sent to the entire bitcoin network. Hence, several miners can start verifying these transactions simultaneously.
Even though many miners compete for the job, only one of them can be paid. But, since many miners may finish checking the transactions simultaneously, rewarding only one of them is difficult. So, they are assigned a very difficult puzzle to solve. The first one, to solve the puzzle in addition to checking the transactions, gets paid.
The puzzle
Each block is provided a target hash value (64 hexadecimal numbers). The Blocks contents, including the checked transactions and the hash value from the previous block, are hashed along with a random number (Nonce) to get a hash value. To solve the puzzle, the miner has to find a Nonce (between 0 and 2^31), so that the resulting hash value is less than or equal to the target hash value.
The reward
When a miner finds such a nonce, several things happen:
A new block is added, and the Blockchain is updated.
The verified transactions are removed from the available pool of transactions to verify.
The miner gets a reward for his work.
In 2016, the reward for a miner was 12.5 bitcoins. In addition to that, the miner also collects the transaction fees for the transactions he verified. Besides being a rewarding experience for miners, mining is the only way in which new bitcoins are introduced into the bitcoin network.
The reward for mining is halved every four years. In 2020, it is expected to become 6.25 bitcoins. The maximum number of bitcoins that can be created is 21 million. In 2040, the number of bitcoins will equal this amount, and the miners will get no bitcoins for mining, but only the transaction fees for verification.
Fraud detection
As you can see above, every block’s hash value changes depending on the hash value of the previous block as well as the transactions in that block. So, if someone changes a transaction in a block, the hash value of that block changes. Consequently, the hash values of all the subsequent blocks in the Blockchain change too. So, any attempts of fraudulence can be uncovered by comparing it with the blockchains stored in the network.
You can test this by changing the values in any peer in this link. The color of the corresponding block and all the subsequent blocks in that peer changes to red, whereas the Blockchain in other peers remain green. Each peer simulates a Blockchain user in the network.
Should you get into bitcoin mining?
The reward for bitcoin mining can be tempting (1 Bitcoin = $9,342 at the time of writing this article). However, the resources, processing power and electricity, needed for mining bitcoins successfully are costly. When bitcoin was introduced in 2009, the complexity of mining was very less, and the reward was high (50 bitcoins).
However, the rewards are halved every four years. Moreover, the complexity of the mining algorithm is adjusted depending on the number of miners. So, the complexity of mining increases with the increasing number of miners, which leads to increased processing power (and costs).
If you are entering the mining business now, you stand no chance against mining pools. A Mining pool is a large number of miners working together. If one of them mines a bitcoin, the profit is split among everyone.
There are several other cryptocurrencies out there. But the one that has the most market capital after Bitcoin is Ethereum, which was invented in 2015.
While the concept of Blockchain and mining are similar to Bitcoin, the use and the currency of Ethereum differ. Bitcoin’s use is to serve as a decentralized digital currency to monitor financial transactions. Ethereum, in contrast, serves as a digital currency to monitor smart contracts.
The digital currency of Ethereum is Ether. Unlike Bitcoin, however, there is no limit to the amount of Ether that can be mined. 18 million Ether are mined every year. This may lead to inflation, reducing the value of Ether eventually, when the supply of Ether overtakes its demand. However, due to the increase in demand as well as the complexity of mining over time, inflation may be slowed or even halted.
Smart contracts
In Bitcoin, a transaction in a block may look like:
Tom sends 100 BTC to Harry.
In Ethereum, a smart contract in a block may look like:
Send 100 ETH from Tom to Harry if Tom’s balance is more than 150 ETH and the date is 11.06.2020.
Smart contracts are digital contracts and can be programmed in a special language called Solidity. Unlike Bitcoin, which requires manual transactions, in Ethereum, smart contracts can automatically trigger transactions. Smart contracts are Dapps or Decentralized applications. Smart contracts can be used for a variety of purposes, not just financial transactions.
What should you know before you get into cryptocurrency trading?
Cryptocurrency trading is similar to forex trading in some ways. So, many pieces of advice that apply to forex trading apply to cryptocurrency trading as well.
Cryptocurrencies are volatile
The prices of cryptocurrencies can vary greatly within a day. So, investing in cryptocurrency trading can be risky if you are new to it.
Leverage
Just like in forex trading, the concept of leverage exists in cryptocurrency trading as well. It can lead to quick profits as well as quick losses.
What moves the prices
Several forces including supply & demand, integration into eCommerce, security breaches, press coverage, etc. can affect the price of cryptocurrencies easily.
Uncertain future
Despite cryptocurrencies being a marvel of this century, their future is uncertain. Just like the digital currencies before them, they may go extent in the future.
Compare fees
Always compare the fees of different cryptocurrency brokers, before you choose one for trading.
Pips
A Pip in cryptocurrency trading means the same as the pip in forex trading. However, the value of 1 Pip varies from one cryptocurrency to another.
Forex, which stands for Foreign Exchange, is the market for trading currencies. Currencies are not traded in an exchange. They are traded Over The Counter (OTC). So, they are traded 24 hours a day, 5 days a week.
How does Forex trading work?
Let’s say you are in Germany. You want to trade Euro against US dollars. The exchange rate is 1.5, i.e., €1 = $1.5. You exchange €1000 and get $1500. Now you hold the money in US dollars till the exchange rate goes down.
After a few days, the exchange rate goes down to 1.3. Now you exchange the US dollars back into Euros. So, you would get $1500/1.3 = $1154. Thus, you have made a profit of $154. This is how forex works.
Even though this sounds simple, choosing the right currency pair and the right time to trade is not easy. Depending on the economic and political conditions in each country, the value of its currency can rise or fall. The demand and supply for a currency can also affect its price in the forex.
Terms used in forex:
Currency Pair
The two currencies which are coupled for trading in forex form a Currency Pair. In the above example, we used the currency pair of Euro and Dollar. Similarly, other currency pairs can also be used. The six most commonly traded currencies in the forex are:
The US Dollar
The Euro
The Yen
The British Pound
The Canadian Dollar
The Swiss Franc
Lots
In forex, currencies are traded in lots.
1 micro lot = 1,000 units of the base currency (E.g., $1,000 or €1,000)
1 mini lot = 10,000 units of the base currency
1 standard lot = 100,000 units of the base currency
Pip
The smallest unit of movement of an exchange rate is called a Percentage in point (Pip). Generally, 1 Pip = 1/100th of a percentage = 0.0001. In Currency pairs, where the Japanese Yen is involved, 1 Pip = 1 percentage = 0.01.
Let’s understand what Pips are, with an example. Consider an investor who wants to trade 100,000 Euros.
Case 1:
Euro – US Dollar
Let’s say the Euro is trading against the Dollar at a rate of 1.5. When the trader exchanges €100,000, he will get $150,000. After a few days, it is trading at 1.499. If he exchanges it back, he will get, 150,000/1.49 = €100,671. So, a profit of (1.5 – 1.49)/0.0001 = 100 Pips generates a profit of €671. If you were trading the other way round, i.e., US Dollar – Euro, you would have made a loss of 100 pips.
Euro – Japanese Yen(¥)
Let’s say the Euro is trading against the Yen at a rate of 100. When the trader exchanges €100,000, he will get ¥10,000,000. After a few days, it is trading at 99. If he exchanges it back, he will get, 10,000,000/99 = €101,010. So, a profit of (100 – 99)/0.01 = 100 Pips generates a profit of €1,010.
Simply put, your returns depend on the change in the number of pips and the amount you are trading.
Leverage
In finance, leverage refers to the concept of buying assets using borrowed money. Many forex trading companies can offer their traders leverages. It enables you to reap higher returns when you make profits.
Leverages are normally expressed in ratios. If a forex trading company offers you a leverage of 10:1, and you use $1,000 for a trade, it is similar to using 1000 x 10 = $10,000. If you made a profit of 5% without leverage, it translates to 5% of $1,000 = $50. But, if you use a leverage of 10:1, your profit will be 10 x (5% of $1,000) = $500. However, the opposite is also true. A loss of 5% will mean that you lose $500, i.e., half of your investment.
What should you know before investing in forex:
Even though investing in forex to get rich quick can be tempting, it comes with great risks.
Lack of information
Unlike stocks which are traded publicly, currencies are traded over the counter. This leads to a lack of transparency. Therefore, big institutions that participate in the forex trade could have access to information that you lack. This could hurt your chances of success.
Time
Unlike experts, who know when to buy and when to sell the currencies, as a beginner, you may not know those tricks. For example, You may hold on to a losing currency, hoping that it will bounce back. If it doesn’t bounce back, you will end up losing more of your money.
Too much leverage
Too much leverage can amplify your losses. As a result, you may end up losing more money than your initial investment.
What should you look for in a forex broker?
Authenticity
Is the brokerage firm a legit one? How long has it been in existence? Do they enable you to transfer funds without any problem?
Costs
What are the transmission costs? Is there any minimum deposit requirement?
Currency pairs
How many currency pairs do they offer for trading, and what are they?
Leverage
If you really want to make huge profits, and want to use the leverage option, how high is the leverage offered?
Educational materials
What educational materials do they offer to help you learn forex trading? Is there a mock account to help you practice?
Software
Forex trading can be very volatile. Any delay, between the moment you click on ‘Buy’ and the moment the actual purchase is made, can cost you money. So, make sure that the software functions without any glitches, lags, and bugs.
Regardless of who you are and how old you are, investing today can make your tomorrow safer. While investing can be fruitful, choosing the right investment strategy is important too.
Depending on the investment strategy, a prince can become a pauper, and a pauper can become a prince. So, make sure you choose your investment strategy wisely.
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1” – Warren Buffett (Source)
This blog post will help you understand the different ways in which you can invest your hard-earned money. Depending on your country of residence, one or more of these investment options may not be available to you. So, try to find out which of these options are available in your country.
1. Stocks
A stock is a small unit of ownership of a company.
When you purchase a stock of a company, you buy a small piece of the company. This gives you a small fraction of ownership of that company.
By purchasing a stock of the company, you can gain two advantages:
When the company makes profits, the value of your stock goes up. You can then sell it to make a profit.
When the company makes excess earnings, it can pay you a part of its profits. These are called dividends.
Investing in stocks can be extremely risky. This is especially true when starting out.
How are stocks traded?
Stocks can be traded in an exchange or over the counter. Let’s see how they differ from each other.
Trading time
An exchange is a physical location. So, trading in an exchange happens only five days a week when the exchange is open.
In OTC trading, assets are purchased and sold between two parties (dealers and institutions), without the supervision of an exchange. Unlike in an exchange, trading is not done at a physical location. Trading is usually done over the phone, emails, or computer networks. So, OTC trading is done 24 hours a day, five days a week.
Transparency
Trading over an exchange is more transparent and subject to more regulations. Therefore the prices of the commodities you buy or sell in an exchange are openly known to everyone.
Trading over the counter is not so transparent. When commodities are bought or sold over the counter, the price of the transaction may not be known until the transaction is completed.
Assets
Stocks of big companies are traded in an exchange. Stocks of small companies and other assets, which cannot afford the fees and regulations of the exchange are traded Over The Counter.
Price
In exchange, the prices are determined by demand and supply of commodities. However, in OTC trading, prices are set by the dealers.
What should you know before getting into the stock market?
How much should you invest?
Investing in the stock market is a risky ordeal. There is a chance that you might lose all the money you invest. So, invest only the amount of money that you can afford to lose. As you gain experience, you can invest more.
How long should you keep a stock?
It might be tempting to invest in the stock market to become rich quickly. However, in the stock market, there are very few overnight millionaires.
Most successful people in the stock market are there for the long run. They investigate the company properly before investing in it. Once they invest in it, they hold the stock for months or years, sometimes even for decades, before selling it. You can also opt for a similar strategy.
How to choose the right stock to invest in?
Measuring volatility – The volatility of a stock indicates how much it fluctuates with the market. For example, let’s calculate the volatility of Facebook’s stock. Go to Yahoo Finance. Type Facebook in the search bar, and click on Summary. The variable called Beta indicates the volatility of Facebook’s stock.
A value of 1 is the average. Any value below 1 shows that the stock is stable. The stock’s price doesn’t fall ridiculously if the market comes crashing down. On the other hand, its price doesn’t soar to the sky if the market goes roaring up. Any value more than 1 indicates that the stock is volatile, and varies heavily with the market.
If you want to minimize your risks, you should go for a company whose Beta value is less than 1.
Measuring profitability
EPS (Earnings per Share) is a company’s profit divided by its total number of shares. This is the amount of profit you would get if you own one share of that company.
EPS is a measure of how profitable a company is. If a company is profitable, its EPS should grow steadily every year. In addition to that, its EPS should be higher than its competitors in the same category. So, to find a profitable company, compare its EPS to its past and with its competitors.
You can find the historical data (Revenue, Profit, EPS, etc.) from Yahoo Finance by clicking on the ‘Financials’ tab and then on the ‘Income statement.’ Data from the last four years are displayed free of cost.
How expensive is a stock?
You can use PE Ratio (Price to Earnings Ratio) to find out how costly a company’s stock is. It tells you how much you should pay to get a profit of $1.
The PE Ratio is the company’s stock price divided by its EPS. A higher PE Ratio could indicate that the company’s stock is overpriced, but its profits aren’t that huge.
A smaller PE Ratio could suggest that the company’s profits are higher, even though its stock is cheap. However, it could also mean that very few people invest in the company because they are wary of its performance. This could be an indication that the company’s profits are going to take a nosedive.
So, while a low PE Ratio means that the stock is cheap, it doesn’t necessarily mean you have to buy it. Compare the PE Ratio with other companies in the same category and also with the category average.
Before you buy a stock, find out why it is cheap. Gather more information about the company and the current market. Read about the companies’ future plans and products, the skills of the CEO, etc.
Estimating ROI
The inverse of PE Ratio gives you the ROI of a stock. You can use it to compare the ROI of the stock with other investment models like bonds, etc.
When should you buy a stock?
Identifying the trend – Before investing in a company’s stock, find out if it is following a bullish or bearish pattern. A bullish pattern implies that the stock’s prices have been rising steadily. It is an indicator that you can profit by investing in that stock. A bearish pattern indicates the opposite. This information is listed in Yahoo Finance, in the Summary tab, under the company’s chart.
How can you buy a stock?
Through the most part of the Twentieth century, people had to go to the stock market and wait for hours to buy a stock.
Nowadays, you can open an account with an online stockbroker and start trading immediately. So, choosing the right online stockbroker is very important. Figuring out the following details about a stockbroker can help you make an informed decision.
Opening an account
Does the stockbroker charge you money for opening an account? If the account is free of cost, do they offer access to a trading platform?
Minimum deposit
How much money should you deposit to open an account?
Maintenance fees
Is there a monthly or annual fee for maintaining your account?
Commissions
How high are the commissions? Do you have to pay a commission every time you buy or sell a stock? If so, how does it change depending on how often you trade? Does it increase when you trade often, or does it increase when you trade rarely?
Other investment options
Does the stockbroker offer additional investment options, like mutual funds, etc.?
Tools to learn
Does the stockbroker offer enough educational tools to help you learn? Can you open a demo account and learn to trade before actually jumping into the stock market? Are there professionals who can guide you when you are in need?
Security
How is your account protected against fraud? How is your money insured if the company offering stock brokerage goes broke?
These are the basics you need to know before buying stocks. If you want to invest in the stock market, consider reading more about it.
Scores
Savings ROI Ease of Accessibility Risk
NAVery High ( > Term deposit account)High Very High
Savings – NAROI – Very High ( > Term deposit account)Ease of Accessibility – High Risk – Very High
2. Bonds
Let’s understand what Bonds are, with the help of an example.
Let’s assume that you are in sudden need of money. If the amount you need is $100, you can ask a friend to lend it to you. However, if you need $2,000, a single friend may not be able to give it to you. So, in this case, you can ask 20 friends to lend you $100 each.
After a year, when you have enough money, you decide to return the money to your friends. But you don’t return them just the $100 you borrowed. Instead, you add $5 to the amount and give each of them $105 as a way of thanking them for helping you when you needed them the most.
Similarly, governments need money to build roads, construct schools, and other public welfare projects. Likewise, large companies need enormous funds to expand their businesses.
Banks may not be able to provide such huge amounts of money to these organizations. Or, they might charge high interests.
On such occasions, these organizations borrow fixed denominations of money (say $1000) from multiple people (investors). To each of these investors, they pay a fixed interest every year and return the borrowed amount after a fixed amount of time.
To do this, they issue bonds and sell them. When you purchase a bond, the company issuing the bond promises to pay you interests at regular intervals until the maturity period expires. Once the maturity period expires, it repays you the borrowed amount. The bond agreement lists the terms of borrowing, including the amount borrowed, the promised interest rate, and the period, after which the entire money should be returned.
Bonds can be purchased or sold, and are traded publicly, like stocks.
Hold the bond until the maturity period expires. In this case, you receive regular interest payments until the maturity period expires. Once the maturity period expires, you get the original principal that was borrowed from you.
If the price of the bond increases, sell it, and make a profit.
Even though bonds are traded like stocks, they are not as risky as stocks. This is because stocks are small pieces of the company. So, their price depends directly on the performance of the company.
Bonds, on the other hand, are loans lent by you to the company. Their price doesn’t directly depend on the performance of the company.
How do bonds work?
Bonds are a bit complex to understand. So, we will explain this with the help of an example.
Let’s assume that a company XYZ issues bonds to generate funds to build a new branch in Australia. Each bond is worth $1000. This is called the Face Value of the Bond.
XYZ promises to repay the Face value in 20 years. This is the maturity period or the lifetime of the bond.
XYZ promises to pay yearly interests at a rate of 5% of the face value. This amounts to $50 p.a. This is called Coupon, and the rate is called the Coupon Rate. This is fixed for the lifetime of the bond. The Coupon rate offered by companies is generally the same or higher than the market interest rates when issuing the bond.
Case 1:
In the next year, let’s assume that the market rates drop to 3%. Now, new bonds cost $1000 but pay only $30 (3% of $1000) yearly as Coupon. Even the company that issued the bond to you last year is issuing new bonds, but only at a reduced rate (3%). So, the bond you purchased last year becomes attractive to other investors because it offers $50 yearly payments.
Now, people are willing to pay more to buy that bond from you. Hence, the price of your bond increases in the bond market. It can only increase up to a value of $1667, at which point, a 3% interest rate would pay $50 annually. If it increases beyond this value, no one will purchase it. Now, your bond is said to be trading at a premium because it is costlier than the Face Value.
Now, you have two choices:
If you are a bond investor, you can keep the bond. In this case, the Coupon rate doesn’t change for you. You will receive the same Coupon of $50/ year (5% of $1000) for another nineteen years. The Coupon payments you get during this time will add up to $50 x 19 = $950.
If you are a bond trader, you can immediately sell the bond and make a profit of $1667 – $1000 = $667.
Case 2:
In the next year, let’s assume that the market rates increase to 7%. Now, new bonds cost $1000 but pay $70 (7% of $1000) yearly as Coupon. Even the company that issued the bond to you last year is issuing new bonds, but only at an increased rate (7%). So, the bond you purchased last year becomes unattractive to other investors because it brings only $50 as yearly payments.
Now, people are not willing to buy that bond from you. So, if you want to sell it, you can only sell it at a lower price. Hence, the price of your bond decreases in the bond market. However, it can only decrease up to a value of $714, at which point, a 7% interest rate would pay $50 annually. If it decreases beyond this value, everyone will want to purchase it, but you will face higher losses. Now, your bond is said to be trading at a discount because it is cheaper than the Face Value.
Now, you have two choices:
If you are a bond investor, you can keep the bond. In this case, the Coupon rate doesn’t change for you. You will receive the same Coupon of $50/ year (5% of $1000) for another nineteen years. The Coupon payments you get during this time will add up to $50 x 19 = $950.
If you are a bond trader, you can immediately sell the bond and suffer a loss of $1000 – $714 = $286. You can then add another $286 to it and buy a new bond for $1000 at a 7% Coupon rate. Then the sum of Coupon payments you get over 19 years would add up to $70 x 19 = $1330.
Case 3:
The market rates remain the same next year as well. Then, the bond is said to be trading at par. You can either keep the bond or sell it, even though selling it wouldn’t give you an advantage.
What should you look for in a bond?
Default risk
This is the most important factor. Before purchasing a company’s bond, find out if the company can repay the bond. Sometimes, companies might list a physical asset as a mortgage for the loan. In some countries, bond ratings, issued by trusted institutions, can gauge a bond’s credibility.
If neither a mortgage nor a bond rating is available, find out if the company’s income is more than its debts. If not, stay away from the company’s bond.
While highly credible bonds are safer, less credible bonds pay higher interests. Thus, investors willing to take higher risks can get higher ROI by investing in these bonds.
Interest rate risk
If you plan to hold a bond till maturity date, you don’t have to worry about future interest rates. But if you purchase a bond with the sole aim of selling it at a higher price, there is a risk that the interest rates might go up in the future due to inflation. In turn, the price of the bond will go down, and you might be stuck with a bond that you cannot sell.
Alternatively, if the interest rates go down in the future, the price of your bond will go up. In such a case, you can profit by selling your bond.
Liquidity Risk
Based on the type of bond you purchased, selling it in a bond market can become difficult. Consequently, you might end up holding it till the maturity date. So, either buy a bond that you are willing to hold till maturity or a bond that you can sell without fail.
Call risk
There is a type of bond called a Callable bond. A Callable bond gives the issuer the option of paying off the debt before the maturity date while offering a higher interest rate. When the interests go down, the company can buy the Callable Bond back from you at face value. It can then issue it at a lower interest rate.
So, by purchasing a Callable bond, you can benefit from the higher interest rates. However, if the prices go up in the future, you will not be able to profit from it.
How much should you pay for a bond?
Once you find a Bond with a good Coupon rate, you might want to buy it as soon as possible. But, in your haste, don’t end up paying too much for an actually cheaper bond. Do due research to find out what price the bond was sold at recently, and what interest rate was offered.
Maturity period
When it comes to bonds, the maturity period is an important factor. Interest rates in the bond market generally don’t vary rapidly as in a stock market. In short-term bonds, which mature within four years, the risk of the interest rates going up, and the price of the bond declining is low.
However, in bonds with long maturity periods, this risk is higher. Hence, to compensate for this risk, bonds with longer maturity periods (10+ years) offer higher coupon rates.
So, depending on your strategy (investing or trading), you have to choose the maturity period wisely.
How to buy a bond?
There are several ways to buy a bond.
1. Buying directly from the government.
2. Buying through a brokerage firm – Brokerage firms have inventories of bonds that they purchased from an open market.
If you buy a bond in their inventory, it might appear as if you are not paying any commissions. However, they can mark up the price, i.e., sell the bond to you at a price higher than the price at which they purchased it. Brokerage firms normally don’t disclose the amount by which they mark up the price. However, you can calculate it out yourself by using Yahoo Finance to find the price at which the bond was sold recently.
Similar to a markup price, the brokerage firm may charge a markdown price when you sell a bond to the firm.
If you want to buy a bond that is not in their inventory, you have to pay a commission to the firm. Commissions are generally charged as a percentage of the bond’s price. You can ask the firm to find out how much this commission is.
These are some of the information you have to figure out before choosing a brokerage firm.
Types of Bonds
There are three major types of bonds. Depending on the risk you want to take, the amount you want to invest, and the amount of resulting taxes, you can choose one of these.
Corporate bonds – Corporate bonds are bonds issued by private companies. They are riskier but offer better interest rates. However, the interests are taxable.
Government bonds – These are bonds issued by the government. They offer lower interest rates. But, the interest could be exempt from state and federal taxes.
Municipal bonds – Municipal bonds are issued by a municipality, state, or country. Even though the interest rates are lower than other types of bonds, the interest is tax-free.
Scores (Bond investor)
Savings ROI Ease of Accessibility Risk
HighMedium ( > Term deposit account, but < Stocks)Very lowMedium (< Stocks)
Savings – HighROI – Medium ( > Term deposit account, but < Stocks)Ease of Accessibility – Very low Risk – Medium (< Stocks)
Scores (Bond trader)
SavingsROIEase of AccessibilityRisk
LowHigh ( > Term deposit account, but <= Stocks)Low Medium (< Stocks)
Savings – LowROI – High ( > Term deposit account, but <= Stocks)Ease of Accessibility – Low Risk – Medium (< Stocks)
3. Mutual funds
To understand what Mutual funds are, read the following example.
Let’s say you have $3000 to invest. Several cases are possible, depending on your investing strategy.
Case 1: The Risk-taker and stocks
Let’s assume that you like to take risks that pay off well. So, you invest $3000 in a company’s stock. Based on its recent history, you expect it to perform well.
Positive scenario
Everything goes as per plan. In two years, your stock grows by 30% to $3900. You sell it and make a profit of $900.
Negative scenario
Nothing goes according to plan. In two years, your stock has come down by 30% to $2100. Market experts speculate that the company might shut down soon. So, you sell your stock and suffer losses amounting to $900.
Case 2: The Risk-taker and Bonds
Let’s assume that you like to take risks that pay off well. So, you buy three Bonds from a company totaling $3000. The company’s credit rating is poor. So, it promises a yearly interest rate of 30% and promises to pay back your $3000 in 2 years.
Positive scenario
Everything goes as per plan. In two years, you have gotten your $3000 back. In addition to that, you have made a profit of $900 + $900 = $1800 (assuming that you don’t reinvest the interest).
Negative scenario
Nothing goes according to plan. Within a year, the company has defaulted. After the company sells all its assets, you get back only $900. So, you have suffered a loss of $2100 by investing in the company’s Bonds.
Case 3: The Safe-player and Bonds
You are a person who likes to play it safe. So, you take the $3000 and invest it in secure Bonds for five years. But since the company has high credibility, you get only an interest rate of 2% p.a.
Positive scenario
In two years, you sell the Bonds when they are trading at $3090. So, now, you have made a profit of $3090 – $3000 = $90 + 2 x $60 (Interest payments every year) = $210. In addition to that, you have gotten your $3000 back.
Negative scenario
The Bonds you have purchased don’t do well in the Bond market. If you sell them, you will incur losses. So, at the end of two years, you have made a profit of 2 x $60 = $120. But, your initial investment of $3000 is still stuck in those Bonds.
You wait another three years till they expire. By the end of five years, you have made a profit of 5x$60 = $300 and got your initial investment of $3000 back. But in these five years, you have missed many opportunities for investing this $3000 to make better profits.
Case 4: The one who diversifies
You are a person who doesn’t keep all your eggs in a basket. So, you invest $1000 in the stock (Case 1), $1000 in the low-profile bond, and $1000 in the high-profile bond (Case 3). Since there are three investments in your portfolio, the chances of all of them generating profit or loss are meager. But for the case of argument, let’s consider the best- and worst-case scenarios.
Best-case scenario:
At the end of two years, you get profits from all of your investments.
Stock : 30% x $1000 = $300
Bond 1: 2 x (30% x $1000) = $600
Bond 2: 2 x (2% x $1000) + ($1030 – $1000) = $70
So, you get a total profit of $970 from all your investments at the end of two years. You also get your initial investment of $3000 back.
Worst-case scenario:
At the end of two years, you suffer losses from all your investments.
Stock : -30% x $1000 = -$300
Bond 1: -$700 (You get only $300 back from your original investment of $1000)
Bond 2: 2 x (2% x $1000) = $40
So, you suffer a loss of $960 (-$300 -$700 + $40) from all your investments at the end of two years. The initial amount of $1000 you invested in bond 2 is still safe. Of the remaining $2000 you invested, you have $1040 remaining to invest now.
As you can see, by diversifying, you can reduce your losses (Please note that the worst-case scenario mentioned above may never happen). At the same time, you won’t get the best gains out of it as well. Diversification makes sure that your investment remains safe while giving you reasonable returns.
This is exactly what a mutual fund does. It diversifies your investment portfolio. A mutual fund is a company that invests its money in different stocks, bonds, and other securities. By buying a mutual fund, you are purchasing a share (stock) of that company. The value of your mutual fund depends on the performance of the individual investments in the investment portfolio of that company.
By investing in a mutual fund, you can minimize your losses and keep your investments safe, while receiving better returns than a Term deposit account. Moreover, a mutual fund offers other advantages as well.
Less stressful – Even though diversification is a wise thing to do, choosing the individual investments to add to your profile can be stressful. If you are new to investing, it can be far too much for you to handle. Mutual funds take this stress away by choosing individual investments. Your job is to find a mutual fund that suits your strategy.
Affordable – To truly diversify your portfolio, you need a huge amount of money (>$10,000). But you can buy a mutual fund for a fraction of the cost (<$500).
Managing your funds – If you want to hire a fund manager who tracks your investments daily, it can cost you a lot. A lot of professional fund managers only manage the accounts of investors who have at least $100,000 to invest. Professional fund managers buy and sell securities in a mutual fund. By investing in a mutual fund, your money (as well as others’ money) will be invested in securities to meet your goals.
Easy withdrawal – Mutual funds deal with the investments of multiple people. So, they always have cash readily available, should any investor want to sell his/her mutual fund. So, you can be sure that you can get your money when needed.
Dividend reinvestment – Whenever a stock in a mutual fund pays dividends or a bond in a Mutual fund pays interest, mutual fund collects these payments. It then distributes these payments as mutual fund dividends to you and other investors. You can ask the company to automatically reinvest these dividends into the same or another mutual fund.
Also known as Stock funds, this type of mutual fund invests in stocks.
Based on the market cap of the companies they invest in, equity funds can be categorized into large-, medium- and small-cap funds. Market cap (=share price x number of shares) is the overall market value of a company.
Based on the investment strategy, equity funds can be categorized into value-, blend- and growth-funds. Value funds invest in undervalued stocks. These stocks have prices that are low at present but have high chances of increasing in the future. Growth funds, on the other hand, invest in high-performing, expensive stocks. These are the stocks that have shown nice growth in the past and can continue growing in the future. Blend funds are mutual funds that lie in between value and growth funds.
Industry (sector) funds, another category of equity funds, enable you to invest in the stocks of companies in a particular industry. For example, if you think companies like KFC, Mc. Donald’s and Subway will grow in the future, you can invest in the fast-food industry fund.
The risk in an equity fund is that it depends on the rise in the price of the underlying stocks.
Fixed-income funds
This type of mutual fund focuses on purchasing government and corporate debt. It is relatively safer than equity funds.
Also known as Bond funds, fixed-income funds invest primarily in bonds. The underlying bonds pay a percentage of the investment as interest every month. These interests, when added up, become the source of income for the fixed-income fund. This income is then passed on to the investors at regular intervals (usually every month).
Bond funds can also differ based on the strategy of investing. Some bond funds focus on secure government debts. Such a bond fund can keep your money safe but only offers low returns every month. In contrast, some bond funds focus on buying undervalued junk bonds to sell them at a profit. Such a bond fund can promise you high returns, but you may not get your money back.
Money-market funds
These are mutual funds that invest in short-term, safe debt (mostly government debt). The interest offered by a money-market fund is generally only slightly higher than a savings account. However, you can be sure that your money is safe and withdraw money whenever you need it. People nearing retirement are generally advised to invest their money here.
Balanced funds
These are mutual funds that invest in different asset classes (stocks, bonds, money market instruments, etc.) at the same time. There are two major types of balanced funds.
Specific allocation funds – You decide the percentage of your investment you want to allocate to each asset class. For example, you can allocate 40% of your money to stocks, 50% to bonds, and 10% to money market instruments.
Dynamic allocation funds – You give the fund manager the full freedom to allocate your money to different asset classes. Depending on your investment goals and the market’s performance, he/she can reallocate your money as he/she sees fit.
Different risks to consider while choosing a mutual fund
Risk of falling prices
Mutual funds offer an excellent way to diversify your investment portfolio. Yet, the value of a mutual fund depends on the underlying assets. As a result, there is the risk that the Net Asset Value of a mutual fund can be lower when you want to sell it. Net Asset of a mutual fund is the difference between its assets (e.g., stocks it purchased) and its liabilities (e.g., salaries of its staff). When you divide the Net Asset by the total number of shares of the mutual fund held by all its investors, you get Net Asset Value. For example, let’s consider a mutual fund X that has stocks from companies A, B, and C. Let’s assume that the stocks of A are priced at $10 each, B at $20 each, C at $30 each. Let’s say the mutual fund owns 3, 4, and 2 shares of A, B, and C, respectively. So, the value of all the stocks the mutual fund owns is (3 x 10) + (4 x 20) + (2 x 30) = 170. Let’s say that the mutual fund made a profit of $5 on that day. It also had to pay staff salaries of $2, other operating costs add up to $0.25, and miscellaneous expenses of $0.5. Let’s assume that the number of shares of the mutual fund in the market is 10. Then, the NAV at the end of that day can be calculated, as shown below:NAV = Net Asset / Total number of outstanding sharesNAV = [Assets – Liabilities] / Total number of outstanding sharesNAV = [(170 + 5) – (2 + 0.25 +0.5)] / 10 NAV = $17.23Trading price – Thus, a mutual fund has a Net Asset Value (NAV). However, its price in the market may not always be equal to its NAV. Several factors, including supply and demand, the popularity of its fund manager, etc. influence its trading price. If the mutual fund is in high demand, but the supply is lower, its price might be greater than its NAV. The same is true when the fund manager is known to make the right stock purchasing decisions. The reverse is also true.
Risk of dilution
A mutual fund can post good profits when starting out. Hence, it becomes popular and receives more funds. However, as the investments increase, it becomes difficult for the fund manager to find new profitable investments.
Too much diversification also means high profits from a few investments would make little positive difference. Hence, as the mutual fund company grows too big, the returns might actually start to reduce.
Risk of losing out
Stocks can be bought or sold any time the market is open. However, mutual funds can be bought or sold only at the end of the day. Therefore, if the price of a mutual fund rises during the day, but falls at the end of the trading day, you end up missing out on the opportunity to profit from the rise during the day.
Risk of too much liquid cash
Many people invest and withdraw money from a mutual fund every day. So, typically, a mutual fund has a lot of liquid cash available at any moment. It means that you can withdraw your money at any time. However, this also means that this money is not invested in the market. In turn, this can affect the returns offered by a mutual fund.
Risk of too little diversification
A mutual fund that focuses mostly on high-risk or industry-specific stocks is still prone to high risk.
Risk of too much fees
A mutual fund is managed by a professional fund manager. Regardless of whether the mutual fund makes profits or losses, the fund manager gets paid. Hence, in times when the returns are meager or negative, you could actually end up losing money. Moreover, mutual funds do a lot of purchasing and selling of assets (e.g., stocks). This leads to increased brokerage commissions, also known as trading costs. This cost is also typically borne by the investors. Entry loads (money for joining the mutual fund) and Exit loads (selling your mutual funds before the specified time) also add to the costs.
What should you research before investing in a mutual fund?
Since investing in a mutual fund can quickly turn out to be a costly endeavor, research about the following beforehand.
The Fund manager
The returns of a mutual fund depend mostly on the fund manager. If he is too greedy and invests in high-risk assets, you may end up losing your money. So, before you invest your money, find out how his/her career has been. Find out if he/she has expertise in finance and how his/her track record in the industry has been.
Entry and Exit loads
Enquire about the entry and exit loads before you invest in a mutual fund.
Taxes
The returns of some of the mutual funds could be taxed (e.g., bond funds with monthly returns). So, inquire beforehand about the taxability of the returns.
Scores
SavingsROI Ease of AccessibilityRisk
LowMedium to high ( > Term deposit account, but < Stocks)HighLow (< Bonds)
Savings – LowROI – Medium to high ( > Term deposit account, but < Stocks)Ease of Accessibility – HighRisk – Low (< Bonds)
4. Index funds
To understand what Index funds are and how they work, we should first know what a market index is.
What is a Market Index?
A market index combines the values of several assets of a particular type (e.g., the stocks of several companies) to calculate an aggregate value. It is a measure of the performance of an entire sector or the whole market (e.g., the stock market of a country).
The market’s performance in the future can be predicted by observing the change of market index over time. Investors generally compare the evolution of a stock’s price over time with that of the market index to figure out if the stock can be profitable.
For example, the S&P 500 is a market index in the USA. It is the aggregate value of the stock prices of the 500 largest companies in the USA. In the S&P 500, bigger companies have a greater impact on the index value.
For example, let’s assume that there are three companies A, B & C. A has 3 shares, which cost $100 each; B has 5 shares, which cost $150 each; C has 8 shares, which cost $200 each. The total market value of the index tracking these stocks will be (3 x 100) + (5 x 150) + (8 x 200) = 2650.
Generally, the market index is assigned a base value at the beginning. Let’s assume this value to be 1000 here. Let’s see how the index value changes with the change in the market value of the index.
Market value Index value
Day 1 2650 1000
Day 2 2500 943.39 (= 1000 x 2500/2650)
Day 3 2700 1018.86 (= 1000 x 2700/2650)
Day 4 2800 1056.60 (= 1000 x 2800/2650)
Day 5 2829 1067.54 (= 1000 x 2829/2650)
Market value Index value
Day 1 2650 1000
Day 2 2500 943.39(= 1000 x 2500/2650)
Day 3 2700 1018.86 (= 1000 x 2700/2650)
Day 4 2800 1056.60 (= 1000 x 2800/2650)
Day 5 2829 1067.54 (= 1000 x 2829/2650)
Hence, the index value provides a benchmark for comparison. Comparing a company’s stock price with this benchmark can help you figure out its performance with respect to the market.
What is an index fund?
An index fund is a type of mutual fund. It is a collection of assets (e.g., stocks) created to resemble a particular market index. It was invented in the 1970s to be an alternative to the notorious mutual funds that charge high fees.
For example, there are index funds in the USA that resemble the composition of the S&P 500. They have stocks in all the same 500 companies that constitute the S&P 500. They may even use the same weights.
In a mutual fund, a fund manager actively selects the stocks to buy and sell so that maximum returns can be assured. However, as the mutual fund grows, the fund manager has to keep finding new profitable stocks. Therefore, as the mutual fund grows, the difficulty in managing it grows with it. Hence, the returns from a mutual fund could shrink with time. However, by creating an index fund using the same stocks used in a market index, the hassle of active management of stocks can be evaded.
Hence, the returns of an index fund don’t shrink with time. So, in the long run, an index fund can become more profitable than a mutual fund.
Costs
Mutual funds need an active fund manager who has to be paid every month. His salary is taken from the investments of the investors. So, mutual funds are costlier. On the other hand, index funds are passively managed. There is no active fund manager who needs to be paid every month. Moreover, there is no rapid active purchasing and selling of stocks. Consequently, they don’t pay high trading fees. Hence, index funds are cheaper than mutual funds. This lower expense in index funds translates into higher returns over the long term.
The randomness of a stock’s price
In a mutual fund, a fund manager tries to select undervalued assets (stocks, bonds, etc.) to sell at a higher price later. However, every other fund manager and investor is trying to do the same thing. So, he has to compete against other investors and fund managers to successfully outperform the market and make profits.
In sectors where the information about companies is publicly available, fund managers compete against each other using the same information. Therefore, fund managers can’t outperform the market in the long run. For example, let’s assume that, on a particular day, the S&P 500 index opens at $1000 and closes at $1002. An index fund that tracks this index could make a profit of $2 at the end of the day. For a mutual fund to outperform this index fund, it should make a profit more than $2 during the same duration.
For this to happen, the mutual fund’s fund manager should be able to find a combination of stocks that performs better than the market index. He has to keep doing this again and again, for a mutual fund to remain profitable for a long time. Please note that the above scenario ignores the additional costs that come with maintaining a mutual fund.
Wrong decisions
A fund manager selects a stock based on its expected future profits, calculated using its past values. But, there is no assurance that a stock’s future values will follow the same trend as its past values. Therefore, eventually, a fund manager might make wrong decisions and lose money. Since an index fund is passively managed and depends on the market, the risk of losing money is lesser. Therefore, compared to a mutual fund actively managed by a fund manager, a low-cost index fund that mimics a particular market index can become profitable in the long run.
What should you know before selecting an index fund?
Index funds are profitable only in the long run. For short-terms less than years, actively managed mutual funds can give you higher returns. An index fund’s goal is not to beat the market and get profits better than everyone else. It is to match the returns of the market, believing that the market always wins. By investing in an index fund, you probably won’t make remarkable profits in the short term. However, you will get results consistent with market growth in the long run. If your goal is to invest in large-scale companies with consistent growth, an index fund is the right choice. However, if your goal is to invest in small-scale companies that are still undervalued to make short-term profits, mutual funds are better. Index funds are not risk-free. If the entire market is in a state of decline, returns offered by index funds will decline as well. On the other hand, in a mutual fund, an excellent fund manager can sense market decline and reinvest your money to avoid losses. Index funds are traded like mutual funds. They can be traded after the markets close at the end of the day. If you want to buy or sell a mutual fund, you only get the price it has at the end of the day. If stock prices rise during the day and fall at the end of the day, you cannot benefit from this rise. Similar to a mutual fund, the dividends from an index fund can be automatically reinvested. Index funds can be bought from a mutual fund company or a brokerage firm.
Scores
SavingsROI Ease of AccessibilityRisk
LowHigh ( > Mutual funds)HighLow (< Mutual funds)
Savings – LowROI – High ( > Mutual funds)Ease of Accessibility – HighRisk – Low (< Mutual funds)
5. Exchange-Traded funds (ETF)
ETFs were invented in the 1990s to serve as a cheaper alternative to mutual funds. They are similar to index funds in the fact that they track an underlying index. However, the difference is that ETFs can be traded like stocks. They can be bought and sold like stocks at any point in the day. As an ETF is bought and sold, its share price rises and falls in response.
ETF offers several advantages over a normal mutual fund. To understand these advantages, we have to understand how an ETF works.
How does an ETF work?
Whenever an ETF wants to create new shares of its own fund, it seeks the help of an Authorized Participant.
The ETF gives the AP (Authorized Participant) the list of assets (e.g., stocks) that constitutes an ETF. AP is generally a person or institution with a lot of buying power.
Creation and Redemption
The AP purchases these stocks from the open market and delivers them to the ETF. In turn, the ETF gives the equivalent number of ETF shares to the AP. Each share of the ETF is priced at its Net Asset Value (NAV). This is called Creation.
Conversely, if the AP wants to get rid of the ETF shares, it can give back the ETF shares and get back the underlying stocks from the ETF. It can then sell these underlying stocks to get back the money it invested for the ETF.
How does the AP benefit from this?
Like mutual funds and index funds, the trading price of an ETF can be different from its NAV. So, the AP is always watching the ETF in the market for price deviations.
Case 1:
Let’s assume that the NAV of an ETF is $100. But due to its demand, its price goes up to $105, while the NAV is still $100. This means that the EFT price has increased without a rise in the costs of the underlying stocks. Now, the AP starts selling ETF stocks at $105.
So, the supply of the ETF stocks increases, and its price reduces. At the same time, the AP goes and purchases the underlying stocks that make up the ETF at $100. So, the prices of the underlying stocks go up. The NAV of the ETF increases as a result. The AP does this until the trading price of the ETF and its NAV equalize (say $101).
During this process, the AP sells the ETF at $105 and purchases the underlying stocks at $100. So, it has made a profit of $5. At the same time, the NAV of the ETF increases to $101, attracting more investments. Therefore, both the AP and the ETF benefit from this mechanism.
Case 2:
Now let’s consider the opposite case. Let’s assume that the ETF’s price has gone down to $95, even though its NAV is $100. The AP purchases several shares of the ETF at the reduced price of $95. This increases the demand for the ETF, thereby pushing its price up. Then, the AP approaches the ETF and exchanges some of the ETF shares for the underlying stocks.
Finally, it sells these underlying stocks in the market, thus increasing their supply. Therefore, the prices of the underlying stocks go down. This process continues until the price of the ETF and its NAV equalize (let’s say $99).
The AP purchased the ETFs at a discounted rate of $95 and redeemed them at the NAV of $100. So, the AP has made a profit of $5. At the same time, the AP has increased the ETF’s price from $95 to $99 to equalize it to the NAV. So, it is profitable to the ETF as well.
ETFs vs. mutual and index funds
Costs
In a mutual fund, a lot of purchasing and selling happens, incurring a lot of transaction fees. In an ETF, all the purchasing and selling are done by the AP. So, there aren’t any transaction costs incurred by the ETF. If an investor wants to sell his shares, the mutual fund has to sell its underlying stocks. This incurs transaction costs, which affect the returns of the mutual fund. On the other hand, an ETF can sell its shares to another investor to raise the money. So, there aren’t any transaction costs in this case as well.
Transparency
A mutual fund is not obliged to disclose the identity of its underlying stocks. The stocks underlying an ETF is information that it provides to its APs. This information is freely available. So, before investing in an ETF, you can find out where your money will go.
Tax
Whenever a mutual fund sells underlying stocks, it has to pass on these gains (in some countries) to its investors. If these gains are big enough, you have to pay taxes. In an ETF, when the AP redeems the ETF shares for underlying stocks (case 2 above), the ETF can choose which shares to surrender to the AP.
Most of the time, it gives away the stocks that are highly profitable at the moment. So, if, at a point in time, the ETF sells its underlying stocks, there may not be any gains. So, it doesn’t have to pass on any money to its investors. So, you may not pay any tax until you sell the ETF.
Fair play
If the price of a mutual or index fund increases or decreases with respect to its NAV, there is nobody to regulate it. However, in an ETF, the APs regulate the market, ensuring that the EFT’s price always equals its NAV. So, you can always be sure that you are paying the fair price for an EFT.
Trading
Mutual and index funds can be traded only after the market closes at the end of the day. ETFs, however, are traded like stocks. They can be bought or sold throughout the day. So, you can sell an ETF when its price is high during the day and make profits.
What should you know about ETFs before buying one?
Tax benefits
Not all ETFs offer the underlying tax benefits. If an ETF consists of bonds, it might pay you dividends every month, which is taxable.
Index
Not all ETFs track an index.
Types of ETFs
There are different types of ETFs, including Currency ETFs, Bond ETFs, Commodity ETFs, and Industry ETFs. The tax benefits may vary from one type of ETF to another.
Diversification
Not every ETF offers diversification and reduces risks. Industry ETFs, for example, track a particular industry or sector. They offer less diversification and are prone to risks, because an entire industry may suffer losses. An example of this scenario would be the airline ETFs during the Corona outbreak.
Trading fees
ETFs can be traded throughout the day when the market is open. This creates the urge to sell or buy ETFs, thus incurring transaction costs. If you do this often, the costs may add up to affect your returns.
Returns
As with an index fund, don’t aim to beat the market with an ETF. Most ETFs track an index. So, they may not offer high returns.
Scores
SavingsROI Ease of AccessibilityRisk
LowHigh (<= Index funds)High (> Index funds)Low (< Index funds)
Savings – LowROI – High (<= Index funds)Ease of Accessibility – High (> Index funds)Risk – Low (< Index funds)
6. Peer-to-Peer Lending
As the name suggests, Peer-to-Peer Lending makes it possible for individuals to avail loans from other individuals directly. It eliminates the need for a middleman, normally a financial institution. It has only been in existence since 2005.
Borrowers
For borrowers, it offers lower interest rates and flexible terms when compared to banks. Peer-to-Peer lending companies don’t need collateral for issuing a loan. Instead, they assign a credit grade to the borrower.
The credit grade depends on the borrower’s credit score, income, loan amount, and term. The interest rate for the loan depends on the credit grade. The entire process, from applying for the loan and getting a loan, could finish within a few hours.
Lenders
As a lender, you can open an account with a Peer-to-Peer lending company and deposit an amount. You can choose whom to lend your money to, depending on his/her credit score, income-to-debt ratio, loan type, loan amount, loan term, etc. You don’t even have to loan the entire amount a borrower needs.
Instead, you can break your whole investment into small chunks called notes. You can then invest your notes in multiple loans. For example, if you have $1000 to invest, you can break it into 20 notes ($50 each) and loan it to 20 people. This offers the advantages of a mutual fund at a lower price.
You can diversify your investment by distributing your notes between high-risk, high-interest-rate loans, and secure loans. Thus, you can get higher returns while ensuring that you don’t lose all your money if some loans default. Indeed, some people who invested in Peer-to-Peer lending have reported double-digit returns every year.
What to know before you invest in Peer-to-Peer lending?
Risk
No investment is without risk. Peer-to-Peer lending is also risky. The average rate of default is higher in Peer-to-Peer lending than some other investments. Hence, if you invest all your money in a high-risk loan, hoping for high returns, you may lose everything. However, if you have diversified your investment, the probability of all the loans defaulting is very low.
Not tested –
Peer-to-Peer lending has been gaining traction for only a decade. Hence, it is not tested for recession. If the borrowers will repay the loan in a recession is a big question. This brings us to the next issue.
Not insured
Any investments you make in a Peer-to-Peer lending is not insured. So, making wise decisions on when to invest in Peer-to-Peer lending and which loans to pick lies entirely upon your shoulders.
Reinvest
In a government bond and a Certificate of Deposit, you invest a huge amount at the beginning. In return, you get regular interest payments until the expiry of the maturity period. Once the maturity period expires, you get your original investment back. But Peer-to-Peer lending works on the concept of loaning money.
At the end of the loan period, you won’t get your original investment back. Instead, you receive a part of your investment plus the interest every month. So, it is entirely upon you to reinvest this amount. If you keep spending the amount you receive every month, you won’t have any investment left when the loan period expires.
Costs
Before investing in a Peer-to-Peer lending company, find out who pays the commissions – You or the Borrower? If you have to pay the commissions, what percentage of your investment should you pay? Are there any hidden costs?
Taxes
How will you be taxed on your returns? Depending on your country, it may vary.
Transfer
Can you set up a retirement account and transfer your returns to it?
The credibility of the company
Before investing in a Peer-to-Peer lending company, find out how long it has been in existence. What do its customers say about it? Research properly because your investment is not insured.
Liquidity
Unlike bonds, notes are not traded in an exchange. So, early withdrawal is only possible if another investor takes over your loan. However, if interest rates rise during this period, nobody would be willing to take over your loan, which has a lower interest rate.
No fund manager
In a mutual fund, a fund manager takes care of all your investments. Even though it makes a mutual fund costly, at least you don’t have to worry about making the right choices. In Peer-to-Peer lending, however, you have to build your own portfolio. So, depending on the loans you choose, it can either be a boon or bane to you.
Scores
SavingsROI Ease of AccessibilityRisk
HighHighLowMedium to High
Savings – HighROI – HighEase of Accessibility – LowRisk – Medium to High
Even though a lecture on saving money can be a boring topic for many people, it is life-skill worth learning. By saving today, you will be protected tomorrow from unforeseen emergencies and financial burdens. Whether you are saving for your retirement, your children’s studies, or your own marriage, choosing the right saving method is important.
Since there are a lot of options available to choose from, choosing one can easily become stressful. This blog post lists some of the ways in which you can save your money and compares them so that you can make a decision easily.
1. Savings account
A savings account is the most common method of investment. It is risk-free since the savings account is insured by the government in most countries. Since the risk involved is low, the interest rate is also lower than most other investments.
Banks use the money in your savings account to lend loans to other people. So, the bank profits from the money you deposit in your savings account.
A savings account can help you to reduce your spending. In many countries, the number of times you can withdraw money from your savings account free of cost is limited.
A savings account is intended as a method of long-term investment. It helps you save money for planned and unplanned events in the future.
Nowadays, you can open a savings account with online banks as well. Online banks offer better interest rates when compared to traditional banks.
What should you look for in a savings account?
Depending on your needs, prioritize the following factors before finding a bank to open a savings account.
i. Interest rates
Obviously, you want to save money. So, it goes without saying that you need to find a bank that offers higher interest rates.
ii. Monthly fees
Depending on the country you live in, most banks might charge you a monthly fee for opening a savings account. Some banks might waive these fees if you have a minimum balance. Try to find a bank that suits your needs and read their terms of service before you sign up.
iii. Ease of withdrawal
Does the bank have an extensive network of ATMs? It is crucial if you want to tackle an unexpected emergency in the middle of the night.
iv. Automatic transfers
Does the bank let you transfer money from your checking account to your savings account automatically? That way, you will be saving money even in months when you have zero motivation to save.
v. Opening balance
This is not a deal-breaker. However, depending on your situation, you might need a bank that permits you to have an opening balance as small as possible.
vi. Insurance
In some countries, the savings account is insured by the government. Is it available in your country as well?
Scores
Ability to saveROIEase of AccessibilityRisk
MediumLowHighLow
Ability to save – MediumROI – LowEase of Accessibility- HighRisk – Low
2. Money Market Account
A money market account is not to be confused with a money market fund, which is a type of mutual fund. A money market account is a savings account that offers higher interest rates. Like savings accounts, it only permits a fixed number of free withdrawals per month. But, unlike a savings account, it comes with debit cards and the ability to write checks. But there’s a catch when it comes to money market accounts. They have higher minimum balance requirements. That’s why they offer better interest rates than a normal savings account.
What should you look for in a money market account?
i. Interest rates
This should obviously be the most important criteria in choosing a money market fund. Does it offer higher interest rates than traditional savings accounts? Does it offer higher interest rates than online savings accounts?
ii. Minimum balance
Is the minimum balance required to open an account too high for you? If not, you can invest in a money market account if it offers higher interest rates.
iii. Fees
Do they have any monthly fees? If yes, how high is it? Do you have to pay any penalties if your balance is less than the minimum balance required? If so, then how much is it?
iv. Insurance
In some countries, money market accounts are insured by the government. Is it available in your country as well?
v. Ease of withdrawal
Debit cards and the ability to write checks can make withdrawal easy. But they can also increase spending. So, depending on whether you want the flexibility or better savings, you can decide between getting a debit card, and not getting one.
Ability to save – Low (< Savings account)ROI – Medium (>= savings account)Ease of Accessibility – High (> savings account)Risk – Low (= savings account)
3. Term (Fixed) deposit account
A Term deposit account is also known as a fixed deposit account in some countries. It offers a fixed interest rate for a designated time (called the maturity period). Regardless of how the market varies and how the bank changes its interest, a fixed interest rate is assured. Hence, if the market performs poorly and the bank reduces its interest rates, your interest rate doesn’t drop. On the other hand, if the market performs better, and the bank increases its interest rates, your interest rate doesn’t rise either. The interest rate offered here is usually higher than the interest rate offered for a savings account. However, withdrawing money from a Term deposit account before the maturity period leads to penalties. In addition to that, adding more money to the term deposit account is not possible. You have to open a new term deposit account instead.
Hence, a term deposit account doesn’t provide as much flexibility as a savings account. But it helps you to save your money more than a traditional savings account.
What should you look for in a term deposit account?
i. Interest rate
This is obviously the most crucial factor. Your goal is to find the bank with the highest interest rate.
ii. Maturity period
Does the bank offer different maturity periods for you to choose from? Depositing a huge sum for an extended period will give you higher returns. However, shorter periods are sensible if you don’t have a separate emergency fund. Hence, having different options can help you make a better choice.
iii. SMS maturity reminders
Most term deposit accounts renew automatically upon the expiry of the maturity period. The interest rate that the bank offers at the time of expiry will be automatically chosen for the next term.
An SMS reminder on the expiry of the maturity period can help prevent such an automatic renewal with lower interest rates. You can then decide if you want to close the account or negotiate a better interest rate for the next term.
iv. Withdrawal penalties
How much does the bank charge for early withdrawal. Not everyone can keep depositing money regularly for a long time. For those cases, choosing a bank that charges a minimal premature withdrawal penalty is a wise choice.
v. Interest payout frequency
How often do you want the interest to be paid to you? Monthly, yearly, or only at the expiry of the maturity period? Choose the bank according to that.
vi. Interest payment between banks
You may have your savings or checking account in one bank and a term deposit account in another bank. In that case, does the bank deposit the interest from the term deposit account in your savings account in another bank? Choose a bank that does offer such an option.
vii. Collateral for a loan
Most banks allow the option of taking a loan against a fixed deposit account. Instead of breaking a term deposit account, you can use this option in an emergency.
The loan offered is usually a percentage of the term deposit account. It has to be repaid before the maturity period expires. The interest rate is lower than that of a personal loan, but higher than the interest rate on the term deposit account. You can compare banks based on these details too.
Ability to save – High (> savings account)ROI – High (>= Money market account)Ease of Accessibility – Low (< Money market account)Risk – Low
4. Recurring deposit account
A recurring deposit account is a type of term deposit account. In a recurring deposit account, you can deposit fixed sums of money every month. If you don’t have a huge amount of money already saved, you can opt for a recurring deposit account. It is a boon for everyone who cannot stop themselves from spending all the money they have. Just like a term deposit account, the interest rate is fixed. This ensures that you are not affected by market fluctuations. Also, you have to pay high penalties if you withdraw money before the maturity period expires.
What should you look for in a recurring deposit account?
All the factors that apply to a term deposit account affect the recurring deposit account as well. However, the maturity period plays an increased significance in a recurring deposit account.
i. Maturity period
This one is also important. In a term deposit account, you deposit a considerable amount early on and forget about it.
But, in a recurring deposit account, you deposit small sums of money at regular intervals until the maturity period expires. The period should be long enough to earn you a higher interest rate. At the same time, it shouldn’t be too long that you end up withdrawing money early.
ii. Collateral for a loan
Most banks allow the option of taking a loan against a recurring deposit account. Check the same details (as in a term deposit account), before choosing a bank.
Recurring deposit account vs. term deposit account
Consider the following cases:
You invest a huge amount in a term deposit account.
You invest the same amount split into smaller sums at regular intervals in a recurring deposit account.
They have the same interest rate. At the expiry of the maturity period, which of the two accounts will earn you a higher interest?
A term deposit account will earn you a higher interest because you invest the entire sum upfront. So, the interest rate applies to the entire sum for the entire period. However, this doesn’t hold true if the interest rate is compounded yearly, and both accounts mature in a year.
Scores
Ability to saveROIEase of AccessibilityRisk
High (> Term deposit account)High (< Term deposit account)Low (= Term deposit account)Low
Ability to save – High (> Term deposit account)ROI – High (< Term deposit account)Ease of Accessibility – Low (= Term deposit account)Risk – Low
5. Certificate of Deposit
A Certificate of Deposit (CD) is an excellent option for impulsive spenders to save money. It is an option offered by banks and credit unions. It offers customers fixed interest rates for depositing a considerable amount and leave it untouched for a specified time. There is a penalty for early withdrawal, but the interest rate offered is higher than a savings account. Since the interest rate is fixed, you are protected from market fluctuations until the maturity period expires. Hence, you won’t suffer any losses if the market suffers a downfall suddenly. But, in case the market performs better, you won’t be able to make any profits from it either. The early withdrawal penalty can help you save money. If you have a lump of money and are afraid of spending it, you can invest it in a CD. This ensures that your money is protected from your impulsive spending habit while earning a little interest.
Certificate of Deposit vs. Term deposit account
While a Term deposit account and a Certificate of Deposit may appear the same, there are some minor differences. A CD is generally used to save money for the short-term. A term deposit account, on the other hand, is used to save money for the long-run (10+ years). In some countries, you can take a loan against a Term deposit account. But, a CD doesn’t offer such an option. You can start a term deposit account with a minimal amount of money. A CD, in comparison, requires a huger deposit.
What should you enquire about, before opening a CD?
i. Duration
How long is the Certificate of Deposit for? This depends on your financial situation and the amount of money you wish to save. Longer durations typically offer higher interest rates because you can’t access your money for longer durations.
ii. Renewal
What happens when the duration expires? Does the CD get automatically renewed? If so, how will you be intimidated about it?
iii. Withdrawal penalty
How high is the penalty for early withdrawal of your money? Some banks might even offer a no-penalty CD.
iv. Insurance
Who is the issuer of the CD – A bank, a credit union, or a brokerage firm? Is your investment covered by insurance? One of the primary reasons why people invest in a CD is for the safety of their money. So, if your investment is not backed by insurance, what happens if the issuing agency goes bankrupt?
v. Interest payment
Will the interests be paid every month, every quarter, half-yearly, yearly, or only at the end of the maturity period? Are the interest payments taxable?
vi. Inflation
CDs are meant to park your money for shorter periods. If you invest in a CD for longer periods (> 5 years) and if the inflation increases during this period, the value of your money may depreciate. So, a CD with a longer maturity period is only worthwhile if the interest rate is more than the inflation rate.
Scores
Ability to saveROIEase of AccessibilityRisk
High (<= Term deposit account)High (>= Money market account)Low (<= Term deposit account)Low
Ability to save – High (<= Term deposit account)ROI – High (>= Money market account)Ease of Accessibility – Low (<= Term deposit account)Risk – Low
This blog post will help you find out what the worst financial crises in history are, what started them, and how they affected the world. Most of us are aware of the financial crisis of 2008 and the global economic recession (large-scale job cuts, a decline in the wealth and assets of people) that followed. Even though a decade has already passed, the world has still not recovered from it.
A financial crisis can cripple a country by destroying it from the inside. Let’s look at the four most devastating financial crisis that destroyed people’s lives and reduced their lif-time savings to ash.
Financial crises in history
A financial crisis is a situation in which the values of assets fall steeply. As the costs of assets decline, fearing further depreciation of these assets, most investors (both people and companies) who invested in these assets try to sell them at the same time, leading to a reduction in demand for these assets.
Due to the decline in demand, the values of these assets fall further. The investors, who end up selling them, now have a shortage of assets. Due to the loss incurred by selling the assets at lower prices, they have less money to pay their debts.
When this transforms into a large scale problem, the government intervenes to rescue the financial institutions.
1. The Great Recession of 2007-2008
On 15th September 2008, Lehman Brothers, one of the oldest, largest investment banks in the world, filed for bankruptcy. This is considered to be the official start of the financial crisis of 2007-2008.
How did it happen? – The sequence of events
1. At the beginning of the 21st century, real estate booms in the US. Investors borrow credit from banks to invest in real estate. Banks provide cheap loans in the hopes that they will get them back.
2. However, from 2005, due to the rising global energy prices, the (negative) gap between people’s incomes and their debts widens.
3. Therefore, people are not able to repay their mortgages to the banks.
4. This leads to a decline in demand for real estate properties. Due to the fall in demand, the values of real estate properties (including those that were mortgaged by people) and other assets held by banks and other financial institutions fall as well.
5. Many influential banks in the USA and the UK come to the brink of collapse.
6. The government pumps in billions of dollars to rescue these financial institutions from collapsing.
The European sovereign debt crisis – The sequence of events
8. Due to the financial crisis of 2007-2008 and the economic recession that follows, the banking system of Iceland completely breaks down.
9. In 2009, this spreads to Spain, Portugal, Greece, Italy, and Ireland.
10. The other European countries, fearing the collapse of the European Union, agree to bailout (providing vast amounts of money) the affected countries. In exchange, they demand austerity measures like temporarily increasing the tax rate and reducing public spending.
11. The collapse of the financial system of these countries reduces the FDI (Foreign Direct Investment) in these countries, whereas the adopted austerity measures lead to public turmoil.
Some of these countries (for example, Greece) still haven’t recovered from this crisis.
1. From 1985 to 1996, Thailand has the highest economic growth rate (9% p.a.) in the world. Its currency, Baht, is pegged (fixed at a specific rate so that it cannot vary) to the US Dollar. This high economic growth rate is mostly due to its exports, and also due to the high interest-rate offered by Thailand’s banks attracting foreign investors to deposit more dollars in Thailand’s banks.
3. At the same time (beginning of the 1990s), the US is slowly recovering from a recession. To counter the high inflation rates in the country, US banks increase the interest rates. Simultaneously, the cost of the US dollar rises in the global market.
4. Both these developments in the US affect Thailand adversely. Since the cost of the US dollar has increased in the global market, the prices of Thai products increase as well (since Baht is pegged to the US dollar). Now, Japanese and German products become cheaper to their Thai counterparts.
5. As a result, exports in Thailand decline sharply. Simultaneously, foreign investors choose to invest in US banks instead of Thailand’s banks due to the increased interest rates in the US.
6. Left with no other choice, Thailand unpegs the Baht to opt for a floating exchange rate (the value of the currency is no more fixed to the US dollar, it can change) and devalues the Baht (For example, if one dollar was 50 Bahts before, now it will be 70 Bahts).
7. The intended results are simple: Exports in Thailand will increase. However, imports will become extremely costly. Hence, people will buy domestic products instead of foreign products.
8. However, due to the steep increase in exports, all wealth flows out of the country. As a result, capital flight (disappearance of wealth) ensues, reducing the purchasing power of Thailand tremendously. This makes several services dependent on imports very costly (for example, some medical surgeries become too expensive because the devices needed become too costly to import).
9. At the same time, the Thailand government is unable to repay all the foreign debt, because, now, Thailand has to pay more Bahts for the same amount of dollars.
10. Thus, the Asian financial crisis begins. Within a few years, it spreads to the neighboring Southeast Asian and other Asian countries and eventually to Russia and Brazil.
11. The IMF (International Monetary Fund) steps in to rescue the sinking economies. It pumps in billions of dollars. In exchange, the borrowing nations are forced to implement austerity measures.
12. By the end of 1999, the economies of several affected countries have stabilized.
3. The OPEC Oil Embargo of 1973
Organization of Petroleum Exporting Countries or OPEC, in short, is a group of 14 countries that are the world’s major oil exporters. The oil crisis began in October 1973, when members of the OPEC issued an oil embargo against the US and other allies of Israel.
Food for thought:
What is an embargo?
An embargo is a penalty (commercial or financial) issued by a country against another country or an individual. An embargo can also prohibit partial/complete trade with that country or group of countries.
How did it happen? – The sequence of events
1. Till 1971, the US followed the Gold standard, and other countries traded in US dollars. However, in 1971, President (of the US) Nixon takes the US off the Gold standard. Hence, countries that hold reserves of American dollars cannot exchange it for gold anymore.
2. Since the value of the American dollar is not tied to any fixed asset anymore, the value of the American dollar depreciates.
3. Oil is sold in US dollars. Hence, with the decline in the value of the American dollar, the revenue of OPEC falls as well.
4. At the same time, the US supports Israel in the war against Egypt.
5. Both these factors aggravate the OPEC and push it to stop oil exports to the US and other allies of Israel.
6. In a single year, oil prices quadruple.
7. Now, people have to spend more money on oil. As a result, they have less money to spend on other goods. At the same time, the prices of common goods increase, leading to inflation, unemployment, and, ultimately, recession.
8. The oil embargo finally comes to an end in March 1974.
4. The Great Depression (1929 – 1939)
The Great Depression is the worst financial crisis of all time. It began on 29th October 1929 with the stock market crash, costing the jobs of 15 million Americans (25% unemployment rate) and reducing the GDP of the world by 15% (During the Wall Street crash of 2007 – 2008, the GDP fell only by 1%).
How did it happen? – The sequence of events
1. During the 1920s, the economy of the US develops at a fast rate. The wealth of the US doubles during this period, and this period would later come to be known as the ‘Roaring Twenties.’
2. Even though the prices of most items remain stable, the stock prices soar to the sky, increasing four-fold during this period.
3. This increase in stock prices encourages people, ranging from prince to pauper, to invest in stocks. Those who don’t have enough money, lend money from banks to invest in stocks.
4. Since the rise in stock prices is irrational, it instills fear in people’s minds. They start believing that if irrational growth is possible, an irrational decline is also likely.
5. Since the rise in prices is irrational, the government tries to regulate it by increasing the interests of banks. The government hopes it will encourage people to borrow less and invest less in stocks.
6. However, this severely affects investments in sectors like construction and automobile, for which people heavily depend on loans from banks. This reduces production (since people buy less, companies start producing less), and people have less work (not necessarily fewer jobs).
7. At the same time, the prices of stocks fall slightly. Since people had less confidence in stocks, many of them sell their stocks at this point. As a result, the prices of stocks fall further (due to lower demand), and people start selling more, triggering a chain reaction.
8. Since many people have already lost a lot of money in stocks, they reduce their spending in other areas, probably to preserve wealth for an uncertain future.
9. Consequently, the production in the US (because demand has reduced) and its wealth start declining steeply by the end of 1929. This ultimately leads to the loss of jobs.
10. During the Autumn of 1930, people, fearing that banks might close down, demand that their money-deposits be paid in cash. Since most banks only hold a portion of their assets as liquid cash, this leads to banking panics throughout the US. A banking panic arises when a lot of people demand that their deposits in banks be paid in cash, at the same time. As a result, banks try to liquidate most of their loans hastily. This causes several banks to fail.
11. This continues until 1933. By that time, 20% of the banks that existed in 1931 have already failed.
12. Due to the Gold standard, the economic downfall of the US also perpetuates to the countries in Europe. The Gold standard is an agreement that many countries signed to make international trade easier. The participating countries fixed the values of their currencies with respect to the cost of gold. As a result, the values of these currencies were fixed against each other.
Food for thought:
What are the advantages of Gold standard?
In the Gold standard, the value of a country’s currency is dependent on the amount of gold it owns. Anyone who has that currency can submit it to the government to get gold equivalent to that value. Since the country can only print as much money as the amount of gold it possesses, it helps prevent inflation and stabilize the economy.
13. The banking catastrophe ends only in 1933 when President Roosevelt issues a four-day banking holiday. During this time, Congress passes reform legislation. After the holiday, only the banks that are found not to fail are reopened.
14. He also sets up several organizations to protect the citizens’ deposits in banks and to regulate the stock market.
15. At the same time, nations around the world (including the US) abandon the gold standard and devalue their currency. This gives them more freedom because they can fix the value of their currencies without worrying about the exchange rates (and gold standard).
16. As a result, the economies of several nations start recovering slowly. In the US, the economy recovers steadily between 1933 and 1937, and the money supply grows by 42% in this period.
Recession within the depression – The Recession of 1937 – 1938
17. Even though the economy has started to grow, the government still has huge budget deficits. So, the government starts reducing government spending and increasing taxes.
How can an increase in the money supply lead to inflation in the country?
Increased money supply means more money in people’s wallets. More money in people’s wallets means they are willing to pay more to purchase goods. Thus, the prices of consumer goods increase due to an increase in demand, leading to inflation.
19. The government doubles the reserve requirement ratios (Amount of liquid cash / Total amount of customers’ deposits) for banks and sterilizes all the gold in the system by storing them away in federal reserves and not allowing them to enter into circulation.
20. These two improvements strongly limit the expansion of money. Very soon, the supply of money starts to decline; people have less money to purchase; production declines; and unemployment increases, leading to another recession in 1937- 1938.
Recovery
21. To push the country out of recession, President Roosevelt rolls out a major spending program to increase people’s purchasing power and requests that the Federal Reserve Board reduces its reserve requirements.
22. As a result, the country starts to come out of recession slowly. However, the economy is still not back to pre-depression levels.
23. At the same time, the US increases its military spending, due to the fears of the Second world war. This, in turn, increases the government’s budget deficits. To save the economy, the Federal Reserve uses its reserve cash and gold to increase the money supply. This boosts the economy by providing more jobs.
24. Finally, the second world war brings the Great Depression to an end. Second world war is not the direct reason for the end of the Great Depression. However, the jobs (military, navy, air force, arms production, etc.) it created and the push it gave to the Federal Reserve, to push its cash and gold reserves into the monetary system, ends the Great Depression.
We hope that you liked this blog post about the worst financial crises in history. If you liked this blog post, also check out the following blog posts:
