Investing involves various financial instruments and markets, each with unique characteristics and risks. This overview introduces key investment types, from stocks and bonds to mutual funds and derivatives, highlighting their roles in portfolio building and wealth creation.
Understanding financial markets is crucial for successful investing. We'll explore primary and secondary markets, stock exchanges, and over-the-counter trading, examining how these systems facilitate capital flow and price discovery for different assets.
Financial Investment Characteristics
Types of Financial Investments
- Financial investments are assets purchased with the expectation of generating income or capital appreciation
- The three main types of financial investments are:
- Ownership investments (stocks)
- Stocks represent equity or ownership stake in a company
- Investors are entitled to a share of company profits through capital gains and dividends
- Lending investments (bonds)
- Bonds are debt securities where the investor lends money to the issuer (government or corporation) in return for periodic interest payments and return of principal at maturity
- Key characteristics of bonds include par value, coupon rate, maturity date, and credit rating
- Cash equivalents
- Cash equivalents are short-term, highly liquid investments (money market funds, Treasury bills) that provide stability and easy access to funds
Other Investment Types
- Mutual funds are professionally managed portfolios that pool money from many investors to invest in a diversified range of securities
- Exchange-traded funds (ETFs) are similar to mutual funds but trade on exchanges like stocks, offering greater liquidity and real-time pricing
- Options are contracts giving the buyer the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a predetermined price and date
- Futures are standardized contracts obligating the buyer to purchase an asset (or the seller to sell an asset) at a predetermined future date and price
- Investors can also invest directly in currencies, commodities (gold, oil), real estate, and alternative investments like private equity and hedge funds
Primary vs Secondary Markets
Primary Markets
- Primary markets are where new securities are issued and sold to investors for the first time
- Examples of primary market transactions include initial public offerings (IPOs) of stocks or bond issuances
- Proceeds from primary market sales go directly to the issuing company, allowing them to raise capital
- Primary markets are critical for capital formation, enabling companies and governments to finance operations and growth
Secondary Markets
- Secondary markets provide liquidity by allowing investors to trade previously issued securities with each other
- Examples of secondary markets are stock exchanges (NYSE, NASDAQ) and bond markets
- Proceeds from secondary market transactions go to the selling investor, not the underlying company
- Secondary markets determine the real-time value of assets through supply and demand and enable investors to readily convert investments to cash
- Financial markets as a whole facilitate the transfer of funds between suppliers of capital (savers/investors) and demanders of capital (businesses, governments), determining asset prices and yields through market forces
Risk and Return in Investments
Defining Risk and Return
- Risk refers to the variability or uncertainty of investment returns
- Sources of risk include market volatility, company-specific events, economic conditions, interest rate changes, and liquidity
- Return is the gain or loss on an investment over time, including income (dividends, interest) and capital appreciation (increase in value)
- There is a positive relationship between risk and expected return
- Investments with higher risk (more volatility) must compensate investors with potentially higher returns
- The risk-free rate of return is the theoretical return on an investment with zero risk, often benchmarked to short-term government securities like Treasury bills
- All other investments have additional risk premiums above the risk-free rate to compensate for their level of risk
Managing Risk in Investing
- Investors have different risk tolerances based on their goals, time horizon, and personal preferences
- Risk aversion describes most investors' preference for the lowest level of risk possible to achieve their targeted expected return
- Diversification is a key risk management strategy that involves combining uncorrelated assets in a portfolio to reduce overall risk while maintaining a desired return level
- Specific risk (company or industry risk) can be diversified away by holding many different securities
- Market or systematic risk affects the entire market and cannot be diversified away, only hedged
- Other ways to control risk include asset allocation (balancing portfolio between stocks, bonds, cash based on risk tolerance), hedging with derivatives, and using stop-loss orders
Stock Exchanges and OTC Markets
Functions of Stock Exchanges
- Stock exchanges are secondary markets that provide a centralized and regulated platform to facilitate transactions between buyers and sellers of equity securities
- Major functions of exchanges include:
- Efficient price discovery through an auction process matching buy and sell orders
- Providing liquidity for shares, allowing investors to easily trade securities
- Enabling companies to raise capital by listing shares for sale to the public
- Serving as an economic indicator reflecting investor sentiment and corporate valuations
- Exchanges have listing requirements for firms (size, financials, governance) and enforce reporting rules to protect investors
- They also oversee trading practices, monitor for manipulation, and can suspend trading in securities
Over-the-Counter (OTC) Markets
- Over-the-counter (OTC) markets are decentralized networks of dealers connected electronically to provide liquidity in securities not listed on formal exchanges
- Securities traded OTC include certain stocks (penny stocks, ADRs), bonds, and derivatives
- OTC trading involves dealers posting bid prices (what they're willing to buy for) and ask prices (what they're willing to sell for)
- Investors trade directly with dealers, often with less transparency and regulation compared to exchanges
- OTC markets are less liquid and have wider bid-ask spreads than exchanges, but provide an important source of liquidity for niche securities