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Sep

2023

Buy Side vs Sell Side

By Kate Ashford | Growing Wealth, invest, Investing | Comments Off

The buy side and sell side are two fundamental aspects of the financial markets. As it sounds the buy side refers to investment companies (including pension funds, hedge funds, money managers) that buy securities for their clients. The sell side is involved in the creation, selling, or issuing of the securities that the buy side then purchases.

Within the buy side and sell side there are different roles and dynamics at play.

Buy Side vs Sell Side: Key Differences

Buy side and sell side are like two faces of the financial and capital markets coin, but there are some key differences between the two.

Buy Side	Sell Side
Buy-siders do their own research, but their reports are proprietary and only available to buy-side clients.	Sell-siders do their own research and reports and make them publicly available.
Buy-side research analysts tend to build a list of sell-side analysts in relevant sectors from which to get reports, technical analysis, and information they rely on.	Sell-side analysts dig deep in their research, get narrow in their focus, and typically develop an area of strong expertise.

What Is the Buy Side?

The buy side is the part of the capital market that buys and invests large quantities of securities as part of money management and/or fund management. On the buy side, professionals and investors invest in securities, including common shares, preferred shares, bonds, derivatives, and other products that are sold — or issued — by the sell side.

Think of the buy side as the firms that purchase investment securities for their own funds or accounts or for investors.

For instance, a fund management or asset management firm might run a fund or set of funds. Naturally, they look for assets that match the fund’s objectives. A buy-side portfolio manager might learn of a new tech product that sounds promising. After doing research on the company and determining whether it was a wise investment, the PM might purchase shares of that company.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

What Is the Role of a Buy-Side Analyst?

Both the buy side and the sell side employ ranks of analysts that in some ways do similar work — but with different aims.

Buy-side analysts do extensive research before recommending whether their firm should purchase a certain security. The goal of a buy-side analyst is to be right as often as possible — because being correct corresponds to profit for their firm and their clients.

In addition to gathering their own information and conducting analysis on a given sector, buy-side analysts get to know the best analysts on the sell side whose research is relevant and reliable.

The relationship between buy-side and sell-side analysts can be seen as mutually beneficial. The more trustworthy a sell-side analyst’s research is, the more likely the buy-sider will be to recommend purchasing securities from the sell-side firm. Thus the buy-side indirectly plays into the sell-side’s compensation.

Buy-Side Goals

The goal of the buy side is to beat their benchmark indexes, and generate financial returns for clients.

Buy-siders put capital to work. They typically have a pool of funds they use to invest in securities. Professionals on the buy side typically work in portfolio management, wealth management, private equity, hedge funds and sometimes venture capital. Buy-side companies work to identify and buy underpriced, undervalued, or high-potential securities for clients in order to make the highest profit on their trades.

Buy-side investors can place large-scale transactions to keep trading costs low. They also have access to a wide variety of trading resources to help them identify, analyze, and quickly make a move on investment opportunities, often in real time. Buy siders must disclose their holdings in a document called a 13F, and this information is available publicly each quarter.

What Happens on the Buy Side

The role of the buy side is to:

• Make decisions about investments (whether to buy, sell, or hold securities)

• Do research on investment opportunities

• Recruit investors and their capital

• Conduct valuations and financial modeling

• Get the best return on capital in order to grow assets under management

What Is the Sell Side?

The sell side of finance deals with creating, promoting, and selling securities that can be traded to the public. The sell side handles all activities related to selling securities to the buy side. That can include underwriting for initial public offerings (IPOs), providing clearing services, and developing research materials and analysis.

Professionals on the sell side represent companies or entities that need to raise money. They do it by selling or issuing securities. The sell side is made up primarily of advisory firms, banks, or other kinds of companies that facilitate selling of securities for their client companies.

What Happens on the Sell Side

The role of the sell side is to:

• Advise corporate clients on large transactions and financial decisions

• Help clients raise capital, be it debt or equity

• Advise clients on corporate mergers and acquisitions

• Market, promote, and sell securities

• Provide research on listed companies (called equity research)

• Conduct valuations and financial modeling

• Create liquidity for securities that are listed

Sell siders keep close track of the performance of specific companies they track, keep track of stocks, and model and project future financial performance and trends. They come up with research recommendations and target prices and sell ideas to clients.

Sell siders spend a lot of time analyzing balance sheets, quarterly results, and any other data they can find on a company. Sell-side analysts aim to give deeper insights into trends and projections; they issue reports and recommendations which are used to make investment decisions for clients.

Professionals focused on the sell side often have jobs in investment banking, sales and trading, equity research, market making, and commercial or corporate banking.

What Is the Role of a Sell-Side Analyst?

The job of a sell-side analyst is to vet different stocks or other assets and sell them to the buy side. In that sense, sell-siders are an essential part of the marketing of different securities.

Typically a sell-side company employs many analysts who help shape the security offerings across sectors and industries. An analyst who covers a certain sector goes deep in that area, talking to a range of people who are knowledgeable about each company and its products — including customers, suppliers, competitors — and building models that help assess a company’s status.

Sell-side analysts are the ones who rate a company’s stock as buy, sell, or hold. It’s generally taken as an evaluation of the stock’s performance rather than the company’s.

An analyst’s success hinges to a large degree on their access to the best and most useful information about a stock, its price target, and their estimates about the stock’s performance. Taken together, the estimates of different analyses are sometimes called the consensus estimate. That’s how buy-siders evaluate the merits of different securities and whether to buy.

Sell-Side Goals

Sell-side companies make money through fees and commissions earned when they sell — which means the more deals they make, the more buy-side firms earn. Market making firms are part of the sell side and help provide the liquidity the market needs to make transactions happen.

Investment banks tend to dominate the sell side of the financial markets; they underwrite stock issuances, sell to institutions and individuals and take proprietary positions in securities.

The most high-profile sell side activity is underwriting IPOs, acting as a buffer between companies going public and the investing public set to buy IPO shares.

How Do the Buy Side and Sell Side Earn a Profit?

Because buy-side firms raise money from wealthy investors and institutions and invest on their behalf, buy-siders profit from management and/or performance fees.

Meanwhile, sell-side firms earn money from the commissions they get from facilitating deals, and from marketing, selling and trading securities.

The Takeaway

The capital market is made up of the buy side and the sell side. Whereas the buy side aims to get the best value from investments in order to bring in greater returns for clients, the sell side aims to help clients raise capital through the sale of securities.

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FAQ

Is the buy side more lucrative than the sell side?

Careers on the buy side are generally considered higher paying than on the sell side. This is in part due to the amount of risk a buy sider takes on when selecting securities, and the premium placed on making a profit.

Do people move from the buy side to the sell side?

People do move from one side to another, but the more common transition is from the sell side to the buy side, owing to the allure of higher compensation and in some cases better hours.

Are traders on the buy or sell-side?

Traders are on the sell side. Traders are considered market makers in that they provide liquidity in the markets.

Phot credit: iStock/filadendron

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Sep

2023

Could Hyperinflation Occur in the United States?

What Is Hyperinflation: Can It Happen in the US?

By Brian O'Connell | Growing Wealth, invest, Investing | Comments Off

Hyperinflation occurs when prices for goods and services rise uncontrollably. It is an economic condition that fuels nightmares for consumers and for economists alike.

According to data from Johns Hopkins University professor Steve Hanke, there have been more than 60 documented instances of hyperinflation since the 1700s, and in every instance, economic conditions deteriorated so fast that in all cases, national currencies failed, meaning that they lost nearly all of their purchasing power both domestically and internationally.

That begs a key question: Could hyperinflation come in the United States? And, if so, could hyperinflation take down the U.S. dollar and trigger a recession?

Theoretically, the answer is “possibly.” Realistically, the answer is “not likely.” Let’s take a look at hyperinflation and evaluate the possibility of inflation on steroids taking root in the U.S. economy.

What Is Hyperinflation?

If you’re still not quite clear on what is hyperinflation, economists define the term as when the price of goods and services rises uncontrollably over a specific timeframe, with no short-term economic remedy able to bring those prices back down again.

While figures linked to hyperinflation vary, some economists say hyperinflation occurs when the price of goods and services in a country’s economy rise by 50% over the period of one month.

The causes of hyperinflation typically stem from a skyrocketing boost in a country’s money supply without any accompanying economic growth. That scenario usually occurs when a country’s government essentially prints and spends money in short-term bursts, thus triggering a rise in that country’s money supply.

When a government pursues a high level of short-term economic spending at a rate significantly higher than the country’s gross domestic product (GDP) rate, more money flows through the economy. When that happens, the real value of a nation’s currency declines, the price of goods and services rises, and inflation spikes.

Is Hyperinflation Coming to the United States?

While U.S. inflation rates and the prices of many goods and services are on the upswing, economists dismiss the notion that U.S. hyperinflation is looming for the country for several reasons. First, it’s important to remember that hyperinflation and inflation aren’t the same thing, and the Federal Reserve would likely raise interest rates if inflation concerns grew.

According to data published in September 2023, the annual U.S. inflation rate was 3.7% for the 12 months that ended in August 2023. That’s a significant drop from June of 2022, when the inflation rate was 9.1%, which was led by certain items such as airline tickets, lumber, and hotel rates. Many economists attributed this to ongoing inventory shortages and supply chain issues and the release of post-pandemic pent-up demand.

Even the largest inflation rate in U.S. history — 23% in June, 1920 — wouldn’t come close to approaching hyperinflation levels of 50% in a month. Still, ongoing inflation is something that the U.S. economy hasn’t seen in more than four decades, and it’s a risk that investors may want to consider when devising their portfolio strategy.

How Can Hyperinflation Affect the United States?

Economists have largely downplayed the chances of a hyperinflation in the USA, but with inflation on the rise, it’s helpful for consumers to get a better grip on hyperinflation, in particular, and on inflation in general.

Hyperinflation Causes:

These are some of the typical causes of hyperinflation:

Falling Dollar Value

Like most major global currencies, the dollar trades on foreign currency exchanges. When a country faces inflationary risks, investors grow skittish, and may bypass that country’s currency in favor of more stable currencies. Even without hyperinflation, a weaker dollar can significantly hurt the U.S. economy.

(Hyperinflation is the extreme opposite of what happens during deflation, in which prices for goods and services decline and the value of a currency rises.)

Fewer Major Purchases

As inflation seeps into an economy, high prices may prompt individuals and businesses to defer or cancel large purchases. Consumers, for example, could hold off buying new homes, new vehicles, or major household appliances. Businesses might postpone big-ticket purchases like heavy machinery, office buildings, and commercial vehicles.

Some investors may hesitate to put money into stocks in a down market. All of those decisions could stall economic growth, as fewer dollars are circulating through the economy.

Monetary Policy

When inflation occurs, banks and financial institutions may not lend money or extend credit to consumers and businesses, as confidence in the overall economy wanes.

The economic fix for skyrocketing inflation typically comes from a country’s central bank. In the United States, that would be the Federal Reserve. When necessary, the Federal Reserve uses monetary policy to slow rising inflation by curbing the U.S. money supply, often by raising interest rates. Higher interest rates give consumers and businesses more incentive to save and less incentive to spend. That, in turn, slows rising inflation.

Recommended: What Is Monetary Policy?

Lower Investment Returns

Inflation eats into real investment returns. As the value of a dollar declines, investors need to earn more than their average return on investment in order to generate the same purchasing power.

How to Combat Hyperinflation

Individuals can’t do much to combat hyperinflation on their own. In fact, during hyperinflation, economies and societies can break down or collapse. Fortunately, periods of hyperinflation are rare. And remember, the 3.7% inflation rate as of August 2023 in the U.S. is nowhere near the levels of 50% in a month, which is when many economists believe hyperinflation occurs.

That said, there are things that might help individuals lessen the impact regular or high inflation might have on their investments. These actions include having a balanced and diversified portfolio, and investing in Treasury Inflation-Protected Securities (TIPS), in which the principal amount invested adjusts with inflation.

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Real-World Examples of Hyperinflation

Zimbabwe offers a relatively recent example of hyperinflation. Just over a decade ago, Zimbabwe’s inflation rate stood at a staggering 98% daily inflation rate as the country’s economy went into free fall. That means consumer prices doubled on a daily basis.

Today, the Zimbabwe dollar is very weak, as the country continues to struggle with the issues that often lead to hyperinflation, such as an increased money supply, political corruption, and a major decline in economic activity.

Even historically stable country economies have experienced hyperinflation.

In the immediate aftermath of World War I, the Weimer Republic of Germany fell into economic decline due to war reparation debts and significantly reduced economic activity. The German government printed too much money in an effort to handle its economic obligations and to ignite a stagnant economy. The country faced an inflation rate of 323% per month by November, 1923 — that’s an annual inflation rate of three billion percent.

In today’s dollars, the consumer impact of hyperinflation is particularly onerous. For example, a small cup of coffee that normally would cost $3 would cost $22 at a 1,000% inflation rate. Similarly, a rental payment for an apartment in a major U.S. city might normally cost $2,000. With a 1,000% inflation rate, that rent would cost $22,000.

Hyperinflation also exists on the world’s economic stage in 2023. Venezuela, for example, has an estimated inflation rate of about 400%.

The Takeaway

While hyperinflation is certainly an economic condition any country would strive to avoid, there’s no compelling evidence suggesting it’s on the U.S. economic horizon — now or anytime in the near future. Still, the country has been in an inflationary period since 2022, so investors may consider using some inflation-hedging strategies to reduce its impact.

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FAQ

How does hyperinflation differ from regular inflation?

Inflation is the rate at which prices for goods and services are rising in a given economy. Hyperinflation is considered out-of-control inflation, at levels of about 50% in one month, and it can be a sign that a severe economic crisis is on the horizon.

Has the United States ever experienced hyperinflation in its history?

No. The closest the U.S. has come to hyperinflation is when annual inflation peaked at almost 30% during the Revolutionary War in 1778.

Are there any warning signs or indicators that could suggest the onset of hyperinflation?

Signs that might suggest that hyperinflation could happen include significant price increases of goods and services (such as increases of 50% in one month), the value of a country’s currency plummets, and economic activity slows or stops.

How can individuals protect their assets and finances during periods of hyperinflation?

Hyperinflation is quite rare, especially in countries with a central bank, like the Federal Reserve, that works to control inflation. However, there are things an investor might do to help limit the impact regular inflation might have. This includes having a balanced and diversified portfolio, and investing in Treasury Inflation-Protected Securities (TIPS), in which the principal invested adjusts with inflation.

Photo credit: iStock/milindri

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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Sep

2023

What Is Operating Leverage?

By Brian O'Connell | Growing Wealth, invest, Investing, Terminology | Comments Off

Operating leverage looks at the relationship between a company’s fixed costs (e.g. rent), its variable costs (e.g. shipping), and revenue. The higher a company’s fixed costs relative to its variable costs indicates a high operating leverage.

Knowing whether a company’s operating leverage is high or low is important because those two factors, when taken into account with revenue, have an impact on profitability. A company with higher fixed costs has a higher degree of operating leverage (DOL), which then determines how much revenue is needed after costs are met — i.e. after the break-even point — to make a profit.

Operating Leverage Definition

The definition of operating leverage is fairly straightforward: It’s the amount of a company’s fixed costs relative to its variable costs. But the impact of operating leverage is best understood in relation to revenue.

That’s because a company with lower fixed costs has a lower break-even point before revenue begins to generate a profit. A company with higher fixed costs, i.e. higher operating leverage, has to work harder to cover its fixed costs and reach that break-even point. What are some of those costs?

Fixed Costs and Variable Costs

Many people are familiar with the idea of a fixed expense vs. a variable expense, as these apply to everyday life as they do in business.

• Fixed expenses. These are certain business expenses that rarely vary, like commercial rent, for example. It doesn’t matter how much a company earns or loses in a given month, the amount of rent owed on their lease is set at a fixed rate until the contract expires.

Fixed expenses tend to be related to time: e.g. X salaries per year for X employees, the cost of liability insurance, loan payments.

• Variable expenses. These expenses are related to the selling of a product or service, e.g. inventory and shipping costs, or marketing and sales. Another would be a “work for hire” employee who may or may not stay with the company.

Examples of Hybrid Semi-variable and Semi-fixed Costs

Sometimes costs blend together to create semi-fixed or semi-variable costs. For instance, a business may promise a plant supervisor a weekly salary of $1,500, plus 1% of the cost price for every widget produced under that manager’s supervision.

The fixed cost is the manager’s weekly salary of $1,500. That remains the same from pay period to pay period.

The variable cost is the 1% unit production percentage paid to the manager as an income incentive. That 1% payout is largely unknowable when the promise is made, making it a variable cost.

In another example, a company may pay its corporate finance manager a salary, which represents a fixed cost. Yet that same company may also pay its line workers on a production basis, based on a per-product wage formula. In that scenario, the same company may have dual fixed and variable costs in the same cost pipeline (i.e., salaries and wages), making those costs semi-variable and semi-fixed costs.

When trying to understand a business’s profitability and scalability, combining different metrics with operating leverage, like the asset turnover ratio, may also be helpful.

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Understanding the Degree of Operating Leverage (DOL)

Since every business deals with a combination of fixed and variable expenses, understanding the degree of operating leverage is the next step in gauging a company’s path to profitability.

When a company has higher fixed costs, the break-even point is also higher. But once that point is reached, every additional dollar in revenue has the potential to generate more profit because fixed costs stay the same, regardless of changes in production (volume).

When a company’s variable costs are higher the break-even point may be lower, but additional revenue also potentially drives up the variable costs (because those costs rise as volume rises). This impacts profitability.

High Operating Leverage and Low Operating Leverage: A Comparison

Some industries tend to have a higher DOL and some tend to have a lower DOL. Those with higher fixed costs often include leases for land or buildings, or heavy R&D. Retailers are among those with lower fixed costs vs. their much higher variable costs (merchandise is pretty variable).

High Degree of Operating Leverage	Low Degree of Operating Leverage
Airlines and automotive	Food services (e.g. restaurants)
Energy	Retailers (e.g. fashion)
Telecommunications	Professional services
Pharmaceuticals	Ecommerce

For example an airline has high fixed costs: It has to maintain a fleet of aircraft, pay fuel, salaries, insurance, and so on. A consulting firm has higher variable costs — i.e. the salaries and commissions of its consultant staff.

Operating Leverage Formula

The operating leverage formula is a useful way to compare companies within the same industry.

Mathematically, the formula for operating leverage looks like this:

Operating Leverage = [Quantity (Price – Variable Cost per Unit)] / Quantity (Price – Variable Cost per Unit) – Fixed Operating Cost

Example Scenario and Calculation

For example, say Firm ABC has sold 1,000,000 hammers for $12 each. Firm ABC also has $10,000,000 worth of fixed costs, for expenses for machinery, office equipment, employees, among other costs. With unit sales at $12 each and $10 million in fixed costs, Firm ABC pays $0.10 per unit to make each hammer.

Here’s what that equation looks like in mathematical terms, and what the operational leverage outcome winds up being:

Operating Leverage = [1,000,000 x ($12 – $0.10)] / 1,000,000 x ($12 – $0.10) – $10,000,000 = $11,900,000/$1,900,000 = 6.26 or 626%

Based on that calculation, a 10% increase in revenue will result in a 62.6% operating income (i.e. profit) increase for Firm ABC.

But if you ran the numbers for Company XYZ, another hammer manufacturer, with different fixed costs and different variable costs, the amount of profit generated by an increase in revenue would also be different — and this could provide an important point of comparison for investing in one company vs. another.

💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.

How to Use Operating Leverage

Operating leverage helps to determine a few things. First, it’s used to measure the break-even point for a company. That’s the point at which expenses are covered and profit is zero — knowing this can help set appropriate per-unit prices.

That’s because changes in revenue naturally impact operating income, but calculating the DOL can reveal what that means for individual companies: i.e. how much will a 10% change in revenue affect profit? A high DOL company might see higher profits once fixed costs are covered. But if revenue decreases, there would be downward pressure on its margins.

Knowing the DOL can also help assess whether a company is getting the most out of its fixed-cost assets (e.g. the cost of the factory, machinery, maintenance), or are there efficiencies that might help generate higher operating income (profit)? By managing fixed cost items better, a company might increase profits without needing to move other levers like price or number of units sold.

The Takeaway

Operating leverage is an important metric in business. It can help analysts or investors better understand a company’s fixed costs relative to its variable costs, and how revenue will impact profit owing to the difference in break-even points.

For example, a company with higher fixed costs has higher operating leverage than a company with higher variable costs. So the higher DOL company will see a substantive change in profits as sales increase past the break-even point.

A company with higher variable costs (and lower operating leverage) will see a smaller profit on each sale — but because it has lower fixed costs, it likely won’t need to increase sales as much to cover those items.

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FAQ

What does it mean to have high operating leverage?

When a company has higher fixed costs it’s said to have a higher degree of operating leverage. This means the break-even point for that company is also higher. After that point, every additional dollar in revenue has the potential to generate more profit because fixed costs stay the same, regardless of changes in production (volume).

What does it mean to have low operating leverage?

When a company’s variable costs are higher, it has lower operating leverage (i.e. lower fixed costs). In that case the break-even point for that company is lower, and a lower proportion of additional revenue will go toward profit, because variable costs go up as sales rise.

How do you improve operating leverage?

One way to improve operating leverage is to reduce fixed costs where possible. This will lower the break-even point for a company and potentially increase profits. That said, different companies are structured differently, and improving operating leverage may require changes in variable costs versus a company that will benefit by lowering its fixed costs.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Sep

2023

Basics of the Time Value of Money (TVM)

By Amanda Holden | Growing Wealth, invest, Investing, Terminology | Comments Off

If you’ve ever heard the expression, “A dollar today is worth more than a dollar tomorrow,” then you know the basic definition of the time value of money. Essentially, having $1,000 today is more valuable than having $1,000 a year from now because of the potential for growth over that time period.

Other factors can also influence the time value of money, or TVM. For example, inflation naturally increases over time, and that can lower the purchasing power of future dollars. In short: Money you can put to work now is usually worth more than the same amount down the line.

Investors and business owners use TVM as a way to compare values of certain sums of money over different time periods.

What Is the Time Value of Money?

The time value of money is the relationship between a dollar at one point in time and the value of that same dollar at another point in time. For example, $50 today likely won’t have the same value as $50 a year from now, just as $1 million now is not the same as $1 million 20 years ago (when a million dollars bought more than it does now).

You don’t need to know the formula for time value of money to understand the basic forces at play here. First, there is the potential for a present sum of money to earn a profit (if you invest it) or to gain interest (if you save it or buy debt instruments like bonds) over time.

Inflation is also an important consideration when calculating the time value of money. As goods get more expensive, each dollar will purchase less than it did the year before. For example, the historic rate of inflation is about 2% per year. If you consider how much $10,000 can buy today, it would buy roughly 2% less in a year — about $9,800 worth of goods.

So the time value of money is a framework for comparing lump sums of money and/or payments across different time periods. Dollars can be future, present, or past — almost like different currencies.

The definition of the time value of money may seem like a purely academic concept, but has many real-world applications. Time value of money is used in personal finance, real estate, and investing decisions.

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How Does Time Value Work?

The time value of money can look at both the present and future value of money and the value of cash flows. It allows both institutional and retail investors to compare payments or sums of money over different time frames.

Within a business context, calculating the time value of money using a TVM formula is important because it can help with decision making, e.g. about acquiring a new business or developing a new product. If you put $X amount of cash into a new line of business, what is the future value of that amount? And would the new investment equal or exceed it — or not (in which case it might not be a good use of your capital)?

To determine the value of money over periods of time, investors can use a formula that takes into account the present value and future value of a specific amount, and how it will change over time.

How to Calculate TVM for a Future Value

Quite often, investors are called upon to evaluate the future value (FV) of a present dollar amount. That formula is:

FV = PV x [1 + (i / n)]^{(n x t)}

Where:

• PV – Present value of money

• FV – Future value of money

• i – interest rate or other amount that can be earned on the money

• t – number of years being considered

• n – number of compounding periods of interest per year

Let’s say you have $2,000 that’s earning 5% per year in interest payments. You could keep your money where it is, or you could consider another investment opportunity. In order to decide, it helps to know what the future value of your cash will be, given current parameters.

In this case, the calculation would look like this, employing the FV formula above:

FV = $2,000 x [1 + (5% / 1) ]^{(1 x 2)}

FV = $2,000 x [1 + 0.05]⁽²⁾

FV = $2,205

This calculation tells you that your money is likely to be worth $2,205 in two years, assuming nothing changes. This could help you gauge whether the new opportunity would be likely to deliver a higher or a lower return.

How to Calculate TVM for a Present Value

It’s also possible to consider a future sum that’s being offered, and what that translates to in present dollars. Let’s say you could earn $2,000 now or be given $2,200 in a year. You’d need to calculate what the present value of $2,200 is.

To determine whether it makes sense to wait one year for an extra $200, here’s how to calculate the present value of that future amount, assuming you could earn 5% in the coming year.

PV = FV / (1 + (i / n)^{(n x t)}

PV = $2,200 / 1 + ( 5% / 1)^{(1 x 1)}

PV = $2,095

In this case, the present value of the $2,200 being offered in one year is higher than taking just $2,000 now ($2,095). Which suggests that waiting to take the $2,200 payment might be a better move.

If there are multiple times per year when interest compounds, the result can be quite different. If interest compounds daily, monthly, quarterly or yearly can have a big effect on the TMV calculation (see below for more on compounding).

Why Is the Time Value of Money Important?

Time changes the value of money. Being able to calculate the present vs. the future value of money enables you to make better choices about how to invest and spend your money.

Therefore, TVM is inherently important in both an investing and a business context because it can help you gauge the value of different opportunities, and assess which makes the most sense financially.

Time Value of Money and Compound Returns

For the individual investor, there is perhaps no way in which the time value of money is more important than with the potential for earning compound returns.

To earn compound returns is to earn a rate of return on both the initial principal invested and all subsequent profits. As profits grow, so does the potential to earn more — and all that this exponential growth requires is that you stay invested.

The key to harnessing the raw power of compound returns is to spend as much time invested as possible — another example of the time value of money. Each year of positive returns is fuel for greater future returns.

This can be hard for investors to wrap their heads around because the results can take decades to reveal themselves. To understand compound returns, and the phenomenon of compounding in general, it helps to start with a comparison of simple and compound interest.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

Comparing Simple Interest to Compound Interest

With simple returns, a rate of return is produced on the principal investment in each period. An example is a basic Treasury note or bond that pays a 5% rate of return on $1,000 each year for five years. Each year the bondholder receives a $50 payment ($1,000 x 5%). The amount is not reinvested (i.e. there is no compounding), and at the end of five years the investor gets back the principal, and makes a profit of $250 (5 x $50) for a total of $1,250.

The time value of money has a bigger impact when you have a savings bond that pays 5% that compounds semi-annually. At the end of the five years, the investor’s initial $1,000 investment has grown to approximately $1,276. This is a total profit of $276, compared to simple interest’s $250. While this might not seem like much, this gap will continue to grow as compound return growth increases.

Likewise, the more frequent the compounding is, the greater the potential for growth would be. Thus compounding is an important factor in the time value of money as well.

Factors Affecting Compound Returns

There are four variables at play when calculating compound returns: the rate of return, the principal invested, the duration, and the frequency of compounding (e.g. monthly, quarterly, annually).

Check out a compound returns calculator for a better understanding of how these variables interplay. What you’ll find is that all factors can have a powerful impact on the time value of money.

Investors should also consider inflation. Inflation, or rising prices over time, also has a compounding effect. Investors can consider using a time value of money formula for inflation, and think about ways to hedge against inflation.

How Does Inflation Impact the Time Value of Money?

Inflation is another reason that money is typically worth more in the present than in the future. As time goes on, inflation erodes the purchasing power of money. So the same amount of money can’t buy as many goods in the future as it can today.

This is sometimes called inflation risk, and it refers to the need for investors to factor in the potential gains of an investment over time vs the impact of inflation, so they can protect their money. Invested money that gains more than the rate of inflation won’t lose value over time.

Working With the Time Value of Money

Investors use the time value of money to understand the worth of money in relation to time, which helps them understand the value of their funds in the present and the future and how to invest them.

As noted above, factors such as interest rates, inflation, and risk all affect investments over time, so having formulas to help make decisions is a useful tool. Here are some other factors to consider.

Discount Rate

To decide whether the future cash flows from an investment will be worth more than the money required to fund the project now, in the present, you can use something called the discount rate. The discount rate is the rate of interest used to assess the present value (PV) of those future dollars.

For example, if you put $1,000 into an account or investment with a guaranteed 5% annual return, the future value of that money will be $1,050 in a year. So the discount rate in this case is 5%; you would discount $1,050 by 5% to arrive at its PV.

Sinking Funds

There is also the option to use the TVM calculation for so-called sinking funds, which is actually a savings strategy.

If you’re saving up for something in the future and know how much you need to save, you can figure out how much you need to save each month or year to reach that goal if you are earning interest on those savings.

Real Estate Investments

An investor might look at a property in a high-growth neighborhood and predict that it will be worth a certain amount in five years, but they want to calculate whether it is actually a good investment. They can use the TVM calculation to discount that estimated future value to find out the current value and see how the two compare.

Investing With SoFi

The time value of money (TVM) is an important concept for investors. It underscores the notion that time affects the value of money, along with other factors, and being able to calculate TVM in different scenarios, from investing to business, can help you decide whether one choice is likely to be more profitable over time.

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FAQ

Why use the time value of money concept?

A dollar now is almost always worth more than that same dollar in the future, owing to that dollar’s potential for growth (and the diminishing effect of inflation) over time. Using TVM formulas, it’s possible to gauge the long-term impact of different choices so you can make the more profitable one.

Is the time value of money concept always true?

Yes, for the simple reason that it’s always possible to invest your money now and gain some interest over time, even a minor amount.

What are some factors that may affect the time value of money?

The main factors that can impact the time value of money are the rate of interest, the number of years the money will earn that rate, and how often interest compounds.

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Sep

2023

The Monte Carlo Simulation & Its Use in Finance

The Monte Carlo Method & Its Uses in Finance

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

A Monte Carlo simulation is a mathematical technique used by investors and others to estimate the probability of different outcomes given a situation where multiple variables may come into play.

Monte Carlo simulations are used in such a wide range of industries — e.g., physics, engineering, meteorology, finance, and more — that the term doesn’t refer to a single formula, but rather a type of multivariate modeling technique. Multivariate modeling is a statistical method that uses multiple variables to forecast outcomes. A Monte Carlo simulation is an example of this type of calculation, which provides a range of potential outcomes using a probability distribution.

What Is the Monte Carlo Method?

A Monte Carlo simulation calculates a probability distribution for any variable that has inherent uncertainty. It then recalculates the results thousands of times over, each time using a different set of random numbers pertaining to each variable, to produce a vast array of outcomes that are then averaged together. In this way, a Monte Carlo analysis enables researchers from many industries to run multiple trials, and thus to define the potential outcome or risk of an event or a decision.

Applying mathematics to investment or business scenarios is difficult precisely because there are so many random variables involved in any single decision or any single investment or portfolio of investments. That’s why a Monte Carlo analysis can be more informative compared with predictive models that use fixed inputs.

The ability to apply mathematics to situations where many elements are probable, and then rank the likelihood of possible outcomes in order to gauge the potential for risk, is a chief advantage of Monte Carlo simulations.

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Monte Carlo Method History

Using simulations to solve problems dates back to the 19th century, and perhaps even earlier, when simulations were an experimental way to test theories, analyze data, or support scientific intuition using statistics. But these simulations typically dealt with established deterministic problems. A modern Monte Carlo analysis, however, inverts that structure by using probabilities to solve the problem.

One of the first known uses of a modern Monte Carlo simulation dates back to the 1930s, when physicist Enrico Fermi experimented with an early form of the method to understand the diffusion of neutrons.

Physicists Stanislaw Ulam and John von Neumann are credited with developing and refining the current Monte Carlo method while working at the Los Alamos National Laboratory on nuclear weapons in the 1940s. Of course, the technique needed a code name, and Monte Carlo was chosen because the element of chance also drives the games at a casino (the Monte Carlo region of Monaco is well-known as a gambling hub).

Soon, the simulation method gained traction in the fields of physics, chemistry, and operations research, thanks to its adoption by the Rand Corporation and the U.S. Air Force. From there, it spread to many of the natural sciences, and eventually found its way to finance.

How the Monte Carlo Method is Used in Finance

In terms of practicality in the financial space, the Monte Carlo method has numerous potential uses.

For instance, money managers might use a Monte Carlo analysis to estimate risk levels for different investments when constructing a portfolio. Corporate finance managers might use a Monte Carlo simulation to assess the impact of variables like future sales, commodities prices, interest rates, currency fluctuations, and so on. Brokers might use a Monte Carlo analysis to calculate the risks of stock options.

Monte Carlo Simulation Method

The Monte Carlo simulation works by constructing a model of possible outcomes based on an estimated range of possible conditions. It does this by creating a curve of different variables for each unknown variable, and inserting random numbers between the minimum and maximum value for each variable, and running the calculation over and over again.

A Monte Carlo experiment will run the calculation thousands upon thousands of times. Along the way, it will produce a large number of possible outcomes.

But even for a simple investment, there are a host of factors that will affect its outcome. There are interest rates, regulations, market swings, as well as factors innate to that investment, such as the sales and revenue of the underlying business, or its competitive landscape, or disruptive technology, and so on.

And as an investor seeks to peer further into the future, more possible variables emerge. Using a Monte Carlo simulation to understand those potential investment risks requires using a growing number of inputs as the time horizon grows longer.

After an investor runs a Monte Carlo simulation, the calculation will deliver a range of possible outcomes, with a probability score assigned to each outcome. By weighing the probability scores of different outcomes, an investor can proceed with a better sense of the risks and possible rewards of a given investment decision.

Monte Carlo Simulation Steps

Using a Monte Carlo simulation is a complicated process that requires a background in mathematics, though some investors have created Monte-Carlo-like models using spreadsheet software. Some of those homespun programs can be used to try to project possible price trajectories of a given asset.

If you wanted to get an idea of how the Monte Carlo method could be used to estimate potential stock movements, the steps to do so would look something like the following — but note that this is a very simplistic, pared down model.

• Step 1: Use historical price data of a stock to generate a set of daily returns data

• Step 2: Use that data set to determine further variables, such as standard deviations and variance

• Step 3: Define a random input or variable

• Step 4: Run a simulation (again, this will require software or a program) and analyze the results

In Monte Carlo fashion, the user will repeatedly run the equation an arbitrary number of times, to see how often each outcome occurs. The frequency of each outcome will reflect the likelihood of each outcome.

The results will most likely form a bell curve, with the most likely result in the middle of the curve. But as with any bell curve, those results also indicate that there is an equal chance that the actual result will be either higher or lower than the number in the middle.

Estimating Risk Using the Monte Carlo Method

The Monte Carlo method can be used to determine the likelihood of certain risks when investing, but there are some important things to take into consideration.

For one, a Monte Carlo simulation is only as good as the data that’s programmed into it. No matter how well the simulation is run, its predictive powers can easily be undone by factors that haven’t been added into the equation. For example, when using a Monte Carlo simulation to decide whether or not to buy a given stock, the model could seem to deliver a clear picture of the risks and rewards of the investment.

In that example, the problems arise if the programmer or investor leaves out one single factor, such as macro trends, the effectiveness of company leadership, cyclical factors, political changes, and so on.

There’s a chance that factor could be the one that completely subverts the simulation. And those variables are potentially without limit.

Who Uses Monte Carlo Simulations, and How

Nonetheless, large institutional investors might use Monte Carlo simulations as a tool in their projections and decision making. And its use for investors isn’t limited to hedge fund managers and spreadsheet wizards. There are even online Monte Carlo simulators that can help people save for retirement.

Those tools are designed for the average investor to input some basic information like their savings, and years until retirement to help them understand the likelihood that they will be able to reach their financial goals, and whether they will have enough income in retirement. Those calculators use a generic set of parameters for their calculations, with inputs such as interest rates, and a generic portfolio allocation.

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The Takeaway

A Monte Carlo simulation is a mathematical technique used to estimate possible outcomes of an uncertain event, such as the movement of securities.

The basis of this analysis is that the probability of different outcomes cannot be determined because random variables cannot be predicted. Therefore, a Monte Carlo simulation will constantly repeat random samples to achieve certain results that can be used to gauge the likelihood of various outcomes, and therefore different risk levels associated with different choices.

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FAQ

What are the advantages of using the Monte Carlo method compared to other numerical techniques?

Though many other numerical techniques have the same goal as the Monte Carlo method, it may be advantageous in that it tests out numerous random variables and then works to an average, rather than starting from an average — which is not to say that it’ll always provide a superior result than another technique.

How is randomness or probability incorporated into the Monte Carlo method?

The Monte Carlo method incorporates randomness or probability into the mix by using random numbers and distributions of probability, which could include formulas or data sets associated with random variables.

Are there any techniques to improve the efficiency or speed of Monte Carlo simulations?

There are potential techniques and strategies to improve upon the base Monte Carlo method model, and they’re all fairly high-level and abstract (remember, it was developed by physicists at Los Alamos!). For the typical investor, it may not be worth looking too far into.

What are some historical origins and applications of the Monte Carlo method?

The Monte Carlo method’s origins can be traced back to the 1930s and the experiments of physicist Enrico Fermi, and later, others during the 1940s working on nuclear weapon development. It can be used to determine the probability of different outcomes or results that may not easily be predicted.

Photo credit: iStock/PeopleImages

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Buy Side vs Sell Side

Buy Side vs Sell Side: Key Differences

What Is the Buy Side?

What Is the Role of a Buy-Side Analyst?

Buy-Side Goals

What Happens on the Buy Side

What Is the Sell Side?

What Happens on the Sell Side

What Is the Role of a Sell-Side Analyst?

Sell-Side Goals

How Do the Buy Side and Sell Side Earn a Profit?

The Takeaway

FAQ

Is the buy side more lucrative than the sell side?

Do people move from the buy side to the sell side?

Are traders on the buy or sell-side?

What Is Hyperinflation: Can It Happen in the US?

What Is Hyperinflation?

Is Hyperinflation Coming to the United States?

How Can Hyperinflation Affect the United States?

Hyperinflation Causes:

Falling Dollar Value

Fewer Major Purchases

Monetary Policy

Lower Investment Returns

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How to Combat Hyperinflation

Real-World Examples of Hyperinflation

The Takeaway

FAQ

How does hyperinflation differ from regular inflation?

Has the United States ever experienced hyperinflation in its history?

Are there any warning signs or indicators that could suggest the onset of hyperinflation?

How can individuals protect their assets and finances during periods of hyperinflation?

What Is Operating Leverage?

Operating Leverage Definition

Fixed Costs and Variable Costs

Examples of Hybrid Semi-variable and Semi-fixed Costs

Understanding the Degree of Operating Leverage (DOL)

High Operating Leverage and Low Operating Leverage: A Comparison

Operating Leverage Formula

How to Use Operating Leverage

The Takeaway

FAQ

What does it mean to have high operating leverage?

What does it mean to have low operating leverage?

How do you improve operating leverage?

Basics of the Time Value of Money (TVM)

What Is the Time Value of Money?

How Does Time Value Work?

How to Calculate TVM for a Future Value

How to Calculate TVM for a Present Value

Why Is the Time Value of Money Important?

Time Value of Money and Compound Returns

Comparing Simple Interest to Compound Interest

Factors Affecting Compound Returns

How Does Inflation Impact the Time Value of Money?

Working With the Time Value of Money

Discount Rate

Sinking Funds

Real Estate Investments

Investing With SoFi

FAQ

Why use the time value of money concept?

Is the time value of money concept always true?

What are some factors that may affect the time value of money?

The Monte Carlo Method & Its Uses in Finance

What Is the Monte Carlo Method?

Monte Carlo Method History

How the Monte Carlo Method is Used in Finance

Monte Carlo Simulation Method

Monte Carlo Simulation Steps

Estimating Risk Using the Monte Carlo Method

Who Uses Monte Carlo Simulations, and How

The Takeaway

FAQ

What are the advantages of using the Monte Carlo method compared to other numerical techniques?

How is randomness or probability incorporated into the Monte Carlo method?

Are there any techniques to improve the efficiency or speed of Monte Carlo simulations?

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