Sep
19
2023
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Basics of the Time Value of Money (TVM)

By | Growing Wealth, invest, Investing, Terminology | Comments Off on Basics of the Time Value of Money (TVM)

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.

Recommended: How to Build an Investment Portfolio for Beginners

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.


💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

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.

Recommended: Is Inflation a Good or Bad Thing for Consumers?

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.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


Invest with as little as $5 with a SoFi Active Investing account.

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.

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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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Sep
19
2023
Guide to Investing in Your 30s

Guide to Investing in Your 30s

By | Growing Wealth, invest, Investing | Comments Off on Guide to Investing in Your 30s

Turning 30 can bring a shift in the way you approach your finances. Investing in your 30s can look very different from the way you invest in your 20s or 40s, based on your goals, strategies, and needs.

At this stage in life you may be working on paying off the last of your student loan debt while focusing more on saving. Your financial priorities may revolve around buying a home and starting a family. At the same time, you may be hoping to add investing for retirement into the mix (or increase the amount you’re already investing) as you approach your peak earning years.

Finding ways to make these goals and needs fit together is what financial planning in your 30s is all about. Knowing how to invest your money as a 30-something can help you start building wealth for the decades still to come.

5 Tips for Investing in Your 30s

1. Define Your Investment Goals

Setting clear financial goals in your 30s or at any age matters. Your goals are your end points, the destination that you’re traveling toward.

So as you consider how to invest in your 30s, think about the end result you’re hoping to achieve. Focus on goals that are specific, easy to measure and best of all, actionable.

For example, your goals for investing as a 30-something may include:

•  Contributing 10% of your income to your 401(k) each year

•  Maxing out annual contributions to an Individual Retirement Account

•  Saving three times your salary for retirement by age 40

•  Achieving a net worth of two times your annual salary by age 40

These goals work because you can define them using real numbers. So, say for example, you make $50,000 a year. To meet each of these goals, you’d need to:

•  Contribute $5,000 to your 401(k)

•  Save $6,000 in an IRA

•  Have $150,000 in retirement savings by age 40

•  Grow your net worth to $100,000 by age 40

Setting goals this way may require you to be a little more aggressive in your financial approach. But having hard numbers to work with can help motivate you to move forward.

2. Don’t Be Afraid of Risk

If there’s one important rule to remember about investing in your 30s, it’s that time is on your side.

When retirement is still several decades away, you typically have time to recover from the inevitable bouts of market volatility that you’re likely to experience. The market moves in cycles; sometimes it’s up, others it’s down. But the longer you have to invest, the more risk you can generally afford to take.

The best investments for 30 somethings are the ones that allow you to achieve your goals while taking on a level of risk with which you feel comfortable. That being said, here’s another investing rule to remember: the greater the investment risk, the greater the potential rewards.

Stocks, for example, are riskier than bonds, but of the two, stocks are likely to produce better returns over time. If you’re not sure how to choose your first stock, you may have heard that it’s easiest to buy what you know. But there’s more to investing in stocks than just that. When comparing the best stocks to buy in your 30s, think about things like:

•  How profitable a particular company is and its overall financial health

•  Whether you want to invest in a stock for capital appreciation (i.e. growth) or income (i.e. dividends)

•  How much you’ll need to invest in a particular stock

•  Whether you’re interested in short-term trading or using a buy-and-hold strategy

Past history isn’t an indicator of future performance, so don’t focus on returns alone when choosing stocks. Instead, consider what you want to get from your investments and how each type of investment can help you achieve that.


💡 Quick Tip: When people talk about investment risk, they mean the risk of losing money. Some investments are higher risk, some are lower. Be sure to bear this in mind when investing online.

3. Diversify, Diversify, Diversify

Investing in your 30s can mean taking risk but you don’t necessarily need or want to have 100% of your portfolio committed to just a handful of stocks. A diversified portfolio with multiple investments can spread out the risk associated with each investment.

So why does portfolio diversification matter? It’s simple. A portfolio that’s diversified is better able to balance risk. Say, for example, you have 80% of your investments dedicated to stocks and the remaining 20% split between bonds and cash. If stocks experience increased volatility, your lower risk investments could help smooth out losses.

Or say you want to allocate 90% of your portfolio to stocks. Rather than investing in just a few stocks, you could spread out risk by investing and picking one or more low-cost exchange-traded funds (ETFs) instead.

ETFs are similar to mutual funds, but they trade on an exchange like a stock. That means you get the benefit of liquidity and flexibility of a stock along with the exposure to a diversified collection of different assets. Your diversified portfolio might include an index ETF, for example, that tracks the performance of the S&P 500, an ETF that’s focused on growth stocks, a couple of bond ETFs, and some individual stocks.

This type of strategy allows you to be aggressive with your investments in your 30s without putting all of your eggs in one basket, so to speak. That can help with growing wealth without inviting more risk into your portfolio than you’re prepared to handle.


💡 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.

4. Leverage Tax-Advantaged and Taxable Accounts

Asset allocation, or what you decide to invest in, matters for building a diversified portfolio. But asset location is just as important.

Asset location refers to where you keep your investments. This includes tax-advantaged accounts and taxable accounts. Tax-advantaged accounts offer tax benefits to investors, such as tax-deferred growth and/or deductions for contributions. Examples of tax-advantaged accounts include:

•  Workplace retirement plans, such as a 401(k)

•  Traditional and Roth IRAs

•  IRA CDs

•  Health Savings Accounts (HSAs)

•  Flexible Spending Accounts (FSAs)

•  529 College Savings Accounts

If you’re interested in investing for retirement in your 30s, your workplace plan might be the best place to start. You can defer money from your paychecks into your retirement account and may benefit from an employer-matching contribution if your company offers one. That’s free money to help you build wealth for the future.

You could also open an IRA to supplement your 401(k) or in place of one if you don’t have a plan at work. Traditional IRAs can offer a deduction for contributions while Roth IRAs allow for tax-free distributions in retirement. When opening an IRA, think about whether getting a tax break now versus in retirement would be more valuable to you.

If you’re not earning a lot in your 30s but expect to be in a higher tax bracket when you retire, then a Roth IRA could make sense. But if you’re earning more now, then you may prefer the option to deduct what you save in a traditional IRA.

Don’t count out taxable accounts either for investing in your 30s. With a taxable brokerage account, you don’t get any tax breaks. And you’ll owe capital gains tax on any investments you sell at a profit. But taxable accounts can offer access to investments you might not have in a 401(k) or IRA, such as individual stocks, cryptocurrency or the ability to trade fractional shares.

5. Prioritize Other Financial Goals

Retirement is one of the most important financial goals to think about in your 30s but planning for it doesn’t have to sideline your other goals. Financial planning in your 30s should be more comprehensive than that, factoring in things like:

•  Buying a home

•  Marriage and children

•  Saving for emergencies

•  Saving for short-term goals

•  Paying off debt

As you build out your financial plan, consider how you want to prioritize each of your goals. After all, you only have so much income to spread across your goals, so think about which ones need to be funded first.

That might mean creating a comfortable emergency fund, then working on shorter-term goals while also setting aside money for a down payment on a home and contributing to your 401(k). If you’re still paying off student loans or other debts, that may take priority over something like saving for college if you already have children.

Looking at the bigger financial picture can help with balancing investing alongside your other goals.

The Takeaway

Your 30s are a great time to start investing and it’s important to remember that it doesn’t have to be complicated or overwhelming. Taking even small steps toward getting your money in order can help improve your financial security, both now and in the future.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Invest with as little as $5 with a SoFi Active Investing account.

Photo credit: iStock/katleho Seisa

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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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Sep
14
2023
The Monte Carlo Simulation & Its Use in Finance

The Monte Carlo Method & Its Uses in Finance

By | Growing Wealth, invest, Investing | Comments Off on The Monte Carlo Method & Its Uses in Finance

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.


💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

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.


💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

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.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

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

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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14
2023
Pros and Cons of Paper Trading

Pros and Cons of Paper Trading

By | Financial Independence, Growing Wealth, invest, Investing | Comments Off on Pros and Cons of Paper Trading

Paper trading is simulated trading, done for practice without real money. It’s a way to test different trading strategies without the risk of losing money, before an investor starts trading with real capital.

The practice gets its name from how investors would once mark down their hypothetical stock purchases and sales — and track their returns and losses — on paper. But today, investors typically use digital platforms to virtually test out hypothetical investment portfolios, day-trading tactics, and broader investing strategies.

How do Paper Trades Work?

What is paper trading? In its most basic form, paper trading involves selecting a stock, group of stocks, or a sector, then writing down the ticker or tickers and choosing a time to buy the stock. The paper trader then writes down the purchase price or prices.

When they sell the stock or stocks, they write down that price as well, and tally up their return.


💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Pros and Cons of Paper Trading

Paper trading has both benefits and drawbacks. Here are a few factors to consider before you try paper trading.

The Pros of Paper Trading

Build skills: Paper trading is a way to learn and build trading skills in either a bear or a bull market. For new traders, a virtual trading platform offers a way to make rookie mistakes without risking real money. It’s a method to get comfortable with the process of buying and selling stocks, and making sure you don’t enter a limit order when you mean to place a market order.

Test out strategies: Paper stock trading allows for experimentation. For example, an investor might hear about shorting a stock. But they may not know how the process works, and what it actually pays out. Paper trading permits investors to learn how these trades work in practical terms. Or, they might want to try out other strategies, such as swing trading.

Learn about strengths and weaknesses: Paper trading is also a way for investors to learn about their own strengths and weaknesses. Traders lose money in the markets for a number of personal reasons. Some stick to their guns too long, while others give up too soon when the market is down. Some lose money because they panic, while others lose money because they ignore clear warning signs. Paper trading is a way for investors to learn their own tendencies and weaknesses without paying for the lesson.

Keep emotions out of it: Finally, paper trading can help teach investors to keep their emotions in check while the markets are going up and down. Investing with hypothetical dollars can be good practice in the valuable art of making rational decisions in stressful situations and allow investors to find risk management techniques that work best for them.

The Cons of Paper Trading

It’s not real: The biggest drawback of paper trading is that it’s not real. An investor can’t keep the returns they earn paper trading. And those paper returns can lead the investor to have an unrealistic sense of confidence, and a false sense of security. Paper trading also doesn’t account for real-life situations that might require an investor to withdraw money from the market for personal reasons or the impact of an unexpected recession.

The emotional impact is hard to gauge: Paper trading does limit the impact of emotions, but once an investor’s real, actual money is in play, it may be more difficult to reign in emotions. That money represents a month’s salary, or a semester’s tuition, or a house payment, and so forth, so it can be hard to remain calm and keep perspective when the market plunges over the course of a trading day.

Could be misleading: While paper trading offers important lessons, it can also mislead investors in other ways. If a paper trading strategy focuses on just a few stocks, or using one trading strategy, they can easily lose sight of how broader market conditions actually drive the performance of those stocks, including stock volatility, or their strategy, or have an inflated confidence in their ability to time the markets. They need to realize their holdings or strategy may offer very different results in a real-world scenario.

Doesn’t involve the true costs of trading: Another danger with paper-trading is that traders may overlook the cost of slippage and commissions. These two factors are a reality of actual trading, and they erode an investor’s returns. Slippage is the difference between the price of a trade at the time the trader decides to execute it and the price they actually pay or receive for a given stock.

Especially during periods of high volatility, slippage can make a significant impact on the profitability of a trade. Any difference, up or down, counts as slippage, so slippage can be good news at times. Since brokerage commissions and other fees always come out of a trader’s bottom line, paper traders should include them in their model.


💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

Live Trading vs Paper Money

When an investor uses live trading, they are using real money to buy and/or sell stocks or other securities. They will confront market fluctuations and need to make decisions, sometimes quickly, about what to do. Live trading can be very stressful, but it does offer the opportunity for an investor to earn money. However, it also comes with the very real risk of losing money.

With paper trading, there is no money involved to lose. But once again, it’s not “real,” so while it may teach you some basics, paper trading does have limits and drawbacks, as detailed above.

Paper Trading in the Digital Age

Wondering how to paper trade? There are different ways to do it. Some investors swear by a tangible notebook-and-paper approach to paper trading, others keep a spreadsheet, which allows them to track other factors involved in the investment, including the exact time of the purchase and sale, volume, holding period, index direction, overall market volatility, and other factors they may be studying.

But while paper or spreadsheets are valuable tools, most investors testing out their trading chops or portfolio-construction skills now prefer virtual trading platforms, which pit a hypothetical portfolio or strategy against real markets. These platforms mimic the look and feel of an actual trading platform, but deal only in hypothetical assets. Understanding a platform can make it easier to transition to real-life trading in the future.

On these platforms, an investor will start with fake money and begin trading. As they do, they can track the fluctuations in an account’s value, along with profit and loss, and other key metrics. Many trading simulators offered by online brokerages allow investors to virtually trade in real-time during live markets without risking their money. For some investors, this can be a valuable experience before they dive in with real money–and the potential for real losses.

Recommended: Managing the Common Risks of Day Trading

How to start paper trading

If you’d like to try paper trading, be sure to research your investments, just like you would if you were investing for real, and use the same amount of paper money you would use in real life. This will help mimic the actual experience.

If you choose to paper trade with a pencil and paper, you can simply choose a stock or group of stocks, write down the ticker, and pick a time to buy the stock. You then write down the purchase price, or prices. When you sell the stock you record that price and then figure out your up their return.

If you decide to use a virtual trading platform, you’ll need to choose a platform. There are many free platforms available. You may want to look for one that has live market feeds so that you can practice trading without delays.

Setting up a Paper Trading Account

Once you’ve selected a virtual trading platform, you’ll set up an account. Simply log onto the platform and follow the prompts to set up an account. Once you’ve done that, there should be a “paper trading” option you can click on.You’ll need to select a balance and then you should be able to start simulating trading.

The Takeaway

Paper trading can be a way to learn about investing. By keeping track of all trades, and the losses or gains they generate, it creates a low-stress practice for examining why certain stocks, and certain trades, perform the way they do. That can be invaluable later, when there’s real money on the line.

However, remember that paper trading isn’t real. In real-life trading with an investment account, you’ll have the potential for gains, but also for losses. Make sure you are comfortable taking that risk.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


Invest with as little as $5 with a SoFi Active Investing account.

FAQ

Do you make money from paper trading?

No. With paper trading, there is no real money involved, so there is no opportunity to make (or lose) money. Paper trading is a way to learn about trading without risking money.

How realistic is paper trading?

Paper trading involves using real trading strategies and simulates a real market experience. However there are no real losses or gains since no real money is involved. Because of that, it doesn’t convey a fully realistic experience.

Is paper trading good for beginners?

Paper trading can be a way to learn the basics of investing. A beginner could build their skills and test different strategies without risking loss. However, paper trading can be misleading because there is no real risk involved. An investor might be tempted to take more risks than they would in a real life investing scenario, for instance.

Why is paper trading important?

Paper trading could be important because it allows beginning investors to practice trades, build their skills, and test different market strategies, without the risk of losing money. However, it can’t replicate the experience of real trading with actual money and the potential to possibly lose money, which someone who tries paper trading should keep in mind.

Photo credit: iStock/fizkes

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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.

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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Sep
14
2023

What Is a Direct Stock Purchase Plan (DSPP)?

By | Growing Wealth, invest, Investing | Comments Off on What Is a Direct Stock Purchase Plan (DSPP)?

A direct stock purchase plan (DSPP) is a plan that allows investors to purchase stock in a company without a broker and get it directly from the company instead.

With DSSPs, there are often no brokerage fees. Meanwhile, discounts to the share prices may be available for larger purchases. With shares purchased through a DSPP, investors have the same profit and loss opportunities, access to dividends, as well as stockholder voting rights.

However, direct stock purchase plans may not be right for every investor. Learn more about buying stock direct from companies through a DSPP, including the pros and cons.

Direct Stock Purchase Plan, Explained

What is a direct stock purchase plan? Typically, many investors use a broker to buy shares of stock. But you can sometimes purchase stocks directly from companies, no broker required. This is what it means to participate in a direct stock purchase plan.

Many blue-chip stocks tend to offer DSPPs. For example, let’s say Company X offers a plan that allows investors to buy $500 or more worth of company stock directly from it, up to $250,000 a year, with some service and transaction fees.

With a DSPP, investors directly purchase shares, sometimes at a small discount. Discounts can range from 1% to 10% to encourage investors to buy more shares.

However, because many brokerage accounts now waive fees and commissions entirely for many investors, the savings difference is smaller than it used to be.


💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

Pros and Cons of a DSPP

Direct stock purchase plans have benefits and drawbacks. These include:

Pros:

•   No broker needed. Investors can purchase shares of stock directly from the company.

•   Very little money is required to get started, and the process is typically simple to do.
Good for long-term investing.

•   Some DSPP programs offer dividend reinvestment plans.

Cons:

•   An investor may not achieve portfolio diversification because not all stocks offer DSPPs.

•   Companies may put maximum limits on how much an individual investor can purchase.

•   When selling DSPP stocks, multiple types of fees can sometimes be charged.

How To Invest in a DSPP

Armed with information about how to buy directly from companies, investors may want to explore what specific opportunities exist. Perhaps they already have a publicly traded company in mind. In that case, they can go to that company’s investor relations website to see if the company offers this type of investment opportunity.

They can also search on the Internet to see which direct stock purchase plans are available.

More specifically, if someone wants to buy stocks in this way, they typically open an account and make deposits into it. Usually, these deposits are automatically made monthly through an ACH funds transfer from the investor’s bank account. In some cases you can write checks as well.

Then, that dollar amount is applied toward purchasing shares in that company’s stock, which can include fractional shares. For example, let’s say that one share of a company’s stock currently costs $20. If an investor sets up an ACH withdrawal of $50 monthly, then, each month they have purchased 2.5 shares of that company’s stock.

One of the benefits of investing through a direct stock purchase plan is the ability to incrementally invest in an inexpensive way. This might make it a good choice for some first-time investors with smaller amounts of money to invest, with initial deposits ranging from $100 to $500. In some cases, initial deposit minimums can be waived if you purchase a certain dollar value of stock every month. But again, it may be difficult to achieve portfolio diversification with DSPP.

Companies With DSPPs

A number of large, well-established companies offer DSPPs. Companies with direct stock purchase plans include Walmart, The Coca-Cola Company, Starbucks, and Home Depot, and Best Buy, among others.


💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

What to Consider Before Buying DSPPs

When online investing was new, people typically needed to pay significant fees to brokers to buy stock. In that era, direct stock purchase plans could be money-savers for investors. Over time, though, fees for online investing have lessened, making this less distinctive of a benefit.

In addition, many DSPPs charge initial setup fees, and may have other investment fees, including ones for each purchase transaction or sale. Although they may be small, these fees can build up over time. And it may be challenging to re-sell shares without the use of a broker, which makes this investment strategy more of a long-term one.

Plus, any time a share is purchased, some degree of stock volatility comes along with it — how much depends upon what is happening with that specific company and the overall levels of turbulence in the market.

Here’s something else to consider: When owning stock in just one company, or only a couple of them, portfolios aren’t diversified. When you diversify your investment assets, it helps to spread out the degree of risk. That’s because, if one stock’s value decreases, others may rise to balance out that portfolio.

The Takeaway

Direct stock purchase plans are when individual investors can directly purchase shares of that company’s stock without the need for broker involvement. The benefits of DSPPs potentially include purchasing company shares at a discount, and not needing a broker to make the transaction.

The downside of DSPPs is that a limited number of companies offer them, which means that an investor who invests solely through DSPPs may not have the best portfolio diversification. Plus, with brokerage commissions and fees rapidly shrinking, in many cases to zero, DSPPs have become a less essential way of cutting down trading costs for investors.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


Invest with as little as $5 with a SoFi Active Investing account.

FAQ

What is the difference between a brokerage and a direct stock purchase?

The main difference between a brokerage and a direct stock purchase is this: With a direct stock purchase, an investor buys shares of one company. A brokerage, on the other hand, offers multitudes of different stock options an investor may choose from.

What is direct stock vs portfolio stock?

With direct stock, an investor purchases shares of stock directly from a company. A portfolio refers to a collection of different types of investments an investor may have, including stocks, bonds, or stock funds, to name a few.

What is the difference between DSPP and DRIP?

By using a DRIP (dividend reinvestment plan), investors can buy more stock in companies whose shares they own by reinvesting what they earn from dividends. With a DSPP, an investor can purchase stock directly from a company. Unlike a DRIP, they don’t have to use dividends to purchase shares.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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.

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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