What are Index Funds?

 

Funds that track a market index, such as the S&P 500®, are known as "index funds."

Index funds include both index mutual funds and index exchange-traded funds, or ETFs.

These funds typically use a passive investing strategy, which means their objective is to

deliver returns similar to an index of investments.

However, index funds usually deliver returns that are slightly lower than an index due

to fees associated with these funds.

 

Simply put, index funds are built to have a similar performance to that of a major market

index.

This means they tend to be diversified in securities across that index and include a

number of investments.

There are many market indices, and index funds that follow them.

For example, if you want to invest in U.S. stocks, you might invest in a fund that tracks

an index like the S&P 500, which follows the 500 largest stocks in the market; the Dow

Jones Industrial AverageSM, which includes 30 large-cap industrial stocks; the NASDAQ-100,

which follows 100 large-cap technology stocks; or the Russell 2000®, which tracks 2,000

small-cap stocks.

For international stocks, an example of a widely tracked index is the MSCI EAFE, which

includes large-cap stocks in developed countries across Europe, Australia, and the Far East.

For U.S. bonds, an example of a widely tracked index is the Barclays Capital Aggregate Bond

Index, which includes a mix of government bonds, mortgage-backed securities, and corporate

bonds with different maturities.

As you can see in these examples, index funds can track different assets, including stocks

and bonds.

There are even index funds that follow commodities, currencies, and other assets.

But regardless of which type of asset they track, an index fund still has its risks.

Put simply, index funds are exposed to the same risks as the index they're following.

For instance, if the S&P 500 declines in value, then the index funds which track it will follow

suit.

An index fund that tracks bonds is at risk if interest rates rise and bonds decline in

value.

Some investors are willing to accept these risks and choose to invest in index funds

because of the potential benefits they might offer.

A primary benefit is the typically lower expense ratio—which is the ongoing cost of investing

in the fund—compared to actively managed funds.

As the name implies, actively managed funds use an active investing strategy.

This means that they frequently buy and sell investments.

This typically results in higher costs, or expense ratios, and can be a drag on a portfolio's

performance over time.

Because index funds are passively managed and simply track an index, they generally

have a low portfolio turnover, which means they infrequently buy and sell investments.

Infrequent buying and selling typically translates into low expense ratios.

The low expense ratios of index funds can possibly lead to more growth when compared

to the higher expense ratios of similar actively managed funds.

Let's look at an example.

Suppose an investor purchases $50,000 of two funds that both grow 7% per year - before

expenses - over the next 30 years.

The funds are similar in all respects except expense ratio

Fund A is an actively managed fund with an expense ratio of 1.2%.

This fund would grow to $ $271,356.

Fund B is an index fund with an expense ratio of 0.2%.

This fund would grow to $359,838.

That's a difference of $88,482, and it's all thanks to a low expense ratio.

The low cost of passively managed index funds can make a difference and is a reason index

funds may outperform actively managed funds over long time periods.

This is why some investors take the "if you can't beat 'em, join 'em" approach

and use index funds to simply track market indices.

 

What is Finance? Part 2

 

Assets can be classified into two

types current asset and fixed asset so

the current assets are the assets having

shorter lives usually less than one year

for example cash accounts receivables

and inventories the other type of asset

is the fixed assets which has longer

lives for example equipment, machineries,

building patterns

these acids normally have life more than

one year now if we focus on the right

hand side the first thing is current

liabilities which contain the

liabilities of the firm that must be

repaid within one year period for

example accounts payable among the long

term depths we can give example like

corporate bonds or long term borrowing

from the banks okay so these are the

liabilities that does not have to be

repaid within one year and the owner's

equity are essentially the claims of the

owners okay maybe it is their investment

or maybe the profit generated from their

investments for example common stock or

retained earnings so these are the

components of the balance sheet and. These components can also be related to

different areas of finance for example

the fixed assets are related to capital

budgeting because when the firm decide

in which assets which long-term assets

that form should invest they actually

determine the fixed asset component of

the business organization so this is

related to capital budgeting.

 Now the long-term depth and owner's equity these

part of the balance sheet is related to

capital structure decision because if

the firm decide how much to borrow and

how much to get from the owner okay that

is essentially the capital structure of

the firm now the remaining portion

current assets and current liabilities

,both of these two have shorter

lives less than one year one year or

less,  so the management of current

assets and current liabilities this is

related to the working capital

management area of business finance.

 

 

What is Finance? Part 1

 

Finance can be defined as the science and art of managing money in order to achieve the appropriate objective you can see that there are two components two important components in the definition one is managing money therefore finance involved with managing money and the other component is appropriate objective that means finance involve managing money with an appropriate objective in mind.

Finance is a wide area and it can be it can be thought in different contexts like from personal context government, context or business context from personal context if you think about finance it is the management of money for personal objective for example if you are thinking about personal finance perhaps you will think about how to earn adequate amount of money how much money to spend and save how much to borrow if necessary how much money to invest if you have extra and if you want to increase your consumption in future where the in where to invest the money when to invest the money so these are the these are some examples of questions that you answer if you are dealing with personal finance.

 

Government context in government context the finance will be dealing with a generating government revenue for example by deciding how much to tax public spending the amount of public spending budgeting government depth production distribution of public goods and if we think about business context of finance then it will be dealing with for example in what fixed assets should we invest our money how to raise money for the investment of the business how to manage the short-term cash flows how much to reinvest in the business if you want to expand the business so these are the different context of finance but now we are going to focus on business finance and learning about business finance can also help you to understand the finance in other context so what are the areas of business finance.

One is capital budgeting capital budgeting answers in what fixed asset and when a forum should invest the other relative related area is dividend policy when a firm makes profit the firm will normally distribute the profit to the owners but if the firm decides to reinvest how much of the profit should be reinvested so if the firm reinvest the dividend will be lower so these kind of decisions are the area of dividend policy then again the area of capital structure which deals with raising money how to raise money for the investment and it also involved deciding when to raise the money from which sources the firm should raise money should it should the firm raise money more from the owners or more from the creditors and the other area of finance is working capital management which is related to the management of short-term assets more particularly short-term cash flows so it involved for example cash budgeting, managing of current assets, managing up current liabilities etc so these are the areas of Finance which can be related with the balance sheet of a business organization you know that the balance sheet of a business organization has two sides the left-hand side contains the assets and the right-hand side contains the liabilities and owner's equity.

In other words we can say that liabilities and owner's equity x' are the sources of fun because when you are liable to someone that means you are supposed to pay that means you have other people's money borrowed from them and equity is also other people's money but it is the owners money that you have in your business.  so we can say that the right-hand side of the balance sheet actually indicate the sources of money the business organization has and the left-hand side of the balance sheet contains the assets which are essentially the uses of money because how do you use the money normally you buy different types of assets so this type of assets are contained in the left hand side so a business organization can have assets only if the business organization has money in the first place then the organization then the firm can use the money to buy assets. This is why the sources of money and the users of money should be equal and this is why the left hand side and the right hand side of the balance sheets balance sheet are equal if we focus on the left hand side of the balance sheet we have assets.

Behavioral Economics (Part 3)

 

continue from the part 2,

Fighting childhood obesity is a priority in many countries and policy makers have suggested a whole range of solutions. Everything from banning soda in schools to running media campaigns promoting healthy eating. Behavioral economists approached the problem a little differently.

They wanted to see if they could get children to eat healthier by rearranging school cafeterias.

They put healthier food like fruits and vegetables on eye-level shelves and less healthy foods, like desserts, in less convenient places. Classical economic theory suggests that this idea wouldn’t work since rational people would pick the brownie.

But it turns out, students choose the healthier foods. Nudge theory works and it’s changing how we implement public policy. There are some issues that can be addressed best with the right type of nudge.

Let’s talk about something else behavioral economists look at: risk. Let’s say someone offered you two sealed envelopes. One has a hundred dollars, and one has no dollars.

You can choose an envelope, or you can take $50 cash right now.

So do you take the fifty bucks? Or what about $49?

Now, this is unlikely to happen to you in real life, but the exercise is about your attitude towards risk. Since there’s a 50/50 chance of getting $100 or nothing, the expected return, or the average of the possible outcomes is $50. If you’re willing to accept $50 cash to abandon the envelopes, then you’re risk neutral. But if you accept less than $50, just to avoid walking away with nothing, then you’re risk-averse. Behavioral economists have done lots of studies about risk and in particular loss aversion, the idea that people strongly want to avoid losing. Studies show that, in general, losses are more painful than gains are pleasurable. So people might choose a safe course of action even if it’s not the most logical choice. Let’s say we flip a coin and if it’s heads I give you $100 but if it’s tails, you have to give me $50. Now, mathematically you should go for it. But many people won’t because they want to avoid losing. Understanding of loss aversion can help businesses and policymakers influence decisions. For example, some grocery stores in the Washington DC tried to decrease the use of disposable plastic bags by offering five cent bonuses if customers brought reusable bags. The policy didn’t do that much. Later they tried a five-cent tax on plastic bags, and, this time, people used fewer disposable bags. This is loss aversion at work. The pain of having to pay 5 cents per bag was greater than the benefit of receiving 5 cents per bag.

Another study analyzed how loss aversion can help incentivize employees. Researchers divided workers into three groups. The first was a control group that wasn’t given a bonus.

The second group was promised a bonus at the end of the year based on meeting specific goals.

Participants in third group were given the bonus at the beginning of the year and were told that they would have to pay it back if they didn’t meet specific goals.

The workers in the first and second groups performed about the same.

But those in the third group performed significantly better. We just hate losing so, behavioral economics has a lot to tell us. Accounting for emotion gives us a realistic view of how people actually behave.

We might not always be the rational actors classical economists believe us to be.

For years, economics has had a blind spot. But behavioral economics helps us get a better look at how we make decisions.

 

 

Behavioral Economics (Part 2)

 

Many economists used to believe that assets, like stocks and real estate, would stay at or near their real value because cold, calculating investors would buy undervalued assets and sell overvalued assets. But that doesn’t explain bubbles:

In real life, investors aren’t always cold and calculating. They can get worked up and irrational sometimes.

This helps explain bubbles. From the Dutch Tulip Mania of the 17th century, to the 2008 financial crisis.

Investors became irrationally exuberant, and were driven not by logic, but by what economist John Maynard Keynes once called, “Animal Spirits.”

So behavioral economics doesn’t blow up traditional economic theory, it just seeks to understand when and why people behave differently than economic models suggest. Let’s go the Thought Bubble:

One of the most popular experiments in behavioral economics is called the ultimatum game.

In this experiment, two players decide how to share a specific sum of money, let’s say $100.

The first player is given all the money and then is asked to propose a way of splitting it with the second player.

Now if the second player accepts the deal both players get to keep the money.

But, if the second player refuses, nobody gets to keep the money.

When the first player offers to split the money 50/50 the second player almost always accepts.

But what happens when the first player offers an unequal split, like 80/20?

Would you accept that offer? Well, It turns out that less equal offers are often rejected.

Now that doesn’t seem surprising, but it directly contradicts classical economic theory. It’s irrational.

The rational choice would be for the second player to accept any offer, even if it's only a dollar.

After all, a dollar is better than nothing. But human behavior is not motivated solely by gain; it’s also shaped by complex ideas like fairness, injustice, and even revenge.

The ultimatum game shows that people aren’t always as predictable as many economists like to suggest. If people were entirely rational then they would consistently make the same decision given identical options, but sometimes people's preferences are dependent on how the options are presented. Psychologists call this type of cognitive bias the Framing Effect.

I mean, would you rather eat beef that's 75% fat free or 25% fat? Would you rather enter a raffle that claims that 1 out of every 1000 players is a winner or a raffle that points out that there will be 999 losers. Would you support a law named the “Improve our Schools Act” or one named the “Raise our Taxes Act”?

Each of these scenarios can be framed in ways that influence your decision. Classical economics argues that framing should have relatively little effect on decision making because most people are rational and intelligent, but in the real world, people can be pretty irrational. So, Businesses have known about the psychology of decision making for a long time. For example, a gym might break down its membership fee and advertise it only costs only $1 a day, which seems way more affordable than $365 a year.

And a TV priced at $499.99 seems like a better deal than one priced at $500.

This is called psychological pricing. It can make people feel like they’re getting a good deal.

Interestingly, high-end retailers sometimes do the opposite. They set their prices at whole dollars, basically signaling their goods are of a higher quality than you might see at a discount store. Behavioral economists also like to talk about nudge theory. Nudges encourage people to act a certain way, without actually changing the choices that are available to them.

Behavioral Economics (Part 1)

 

When economists make their models, they generally assume that people are rational and predictable. But when we look at actual human beings, it turns out that people are impulsive, shortsighted, and, a lot of times, just plain irrational. Look! Balloons!

Today we’re talking about Behavioral Economics and how people actually make decisions.

Behavioral economics is a subfield of economics that focuses on the psychological, social, and emotional factors that influence decision-making. That's not necessarily new. In fact, our old buddy Adam Smith, discussed it in The Theory of Moral Sentiments in 1759. But generations of economists chose to ignore many irrational elements of decision making since it makes it harder to predict human behavior. But in the last few decades, behavioral economics has made a comeback. Several Nobel Prizes have been awarded to researchers that blend economics and psychology and behavioral economics is being applied to more and more fields like marketing, finance, political science, and public policy. Now it’s important to mention that irrational human behavior doesn’t negate everything you’ve learned here at Crash Course Economics. It just adds another layer of complexity, which is exactly what we love at Crash Course

Now in most cases, people are rational. When the price falls for a product, people have a tendency to buy more of that product, so the law of demand holds true. But economists also accept that there is bounded rationality. Limits on information, time, and abilities might prevent people from seeking out the best possible outcome.

For example, if the price for ice cream is really low consumers might not buy more.

In fact, they might buy less if they think that that low price means that ice cream tastes horrible.

Now if that happens, then the law of demand doesn’t hold true, which creates a serious problem in classical economics. I mean it is the LAW of demand. You can’t have a situation that breaks the law and still call it a law. That doesn’t happen in other disciplines like physics…except it does.

 

The Newtonian laws of physics, like gravity, hold true most of the time but they breakdown at the quantum level. They explain the orbits of planets, but they have a harder time explaining the orbits of electrons And It’s the same in economics. Classical economic theories explain the big picture stuff pretty well, but there are still a lot of things about individual decision-making that we just don’t fully understand. In ice cream example one of the problems is lack of information. Classical economics assumes that consumers have perfect information when making choices. That is, they know or at least can quickly access information about prices and quality, but, in reality, they often don’t. Sure, the consumer could ask around or call their friends to see if they’ve tried that type of ice cream but they're probably not going to do that. In this situation, consumers may act on the limited information they have, a suspiciously low price, which means either the ice cream is a great deal or it tastes like mayonnaise. They just don’t know.

Prices do send a lot of signals, and there’s even science on how prices change perception.

A study in California analyzed the brains of people taste testing a variety of red wines.

The researchers gave participants fake prices and scanned their brains to determine the level of enjoyment.

The results were surprising. When they thought the price was higher, they actually liked the wine more. This held true even when the subjects were given the exact same type of wine but were told it was a different higher-priced wine. The researchers said "Contrary to the basic assumptions of economics…marketing actions can successfully affect experienced pleasantness by manipulating non-intrinsic attributes of goods.” So, once you’ve got a palatable Pinot Noir, you might be able to raise the price, and actually raise the demand. All you have to do is change perceptions.

 The idea that perceptions and passions influence our actions also applies in finance.