1.1 Overview of Investment Types and Financial Markets
4 min read•july 30, 2024
Investing involves various financial instruments and markets, each with unique characteristics and risks. This overview introduces key investment types, from and to and , 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
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- Financial investments are assets purchased with the expectation of generating income or
- 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 and
- 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
- Ownership investments (stocks)
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 and real-time pricing
- 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
- 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 , (gold, oil), , and alternative investments like and
Primary vs Secondary Markets
Primary Markets
- Primary markets are where new securities are issued and sold to investors for the first time
- Examples of transactions include 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 (, ) and bond markets
- Proceeds from 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 , 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 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
- (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 (balancing portfolio between stocks, bonds, cash based on risk tolerance), with derivatives, and using
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
Key Terms to Review (30)
Asset allocation: Asset allocation is the process of distributing investments across various asset categories, such as stocks, bonds, and cash, to optimize risk and return based on an investor's goals, risk tolerance, and investment time horizon. This strategy is essential in building a diversified portfolio that can withstand market fluctuations while seeking to maximize returns.
Bonds: Bonds are fixed-income securities that represent a loan made by an investor to a borrower, typically a corporation or government. They are essential financial instruments used for raising capital, and their characteristics affect how they fit into various investment strategies, risk assessments, and market dynamics.
Capital Appreciation: Capital appreciation refers to the increase in the value of an investment or asset over time, often measured by the difference between the purchase price and the current market price. This growth in value is a primary objective for many investors, as it signifies a return on their initial investment. Understanding capital appreciation is essential for evaluating investment performance and making informed decisions about asset allocation in various financial markets.
Capital gains: Capital gains refer to the profit that an investor earns when selling an asset for more than its purchase price. This concept is particularly relevant in the context of investments, as it highlights the potential for increasing wealth through buying and selling various assets in financial markets. Understanding capital gains is essential because they influence investment strategies and can impact tax liabilities depending on how long an asset is held.
Commodities: Commodities are basic goods used in commerce that are interchangeable with other goods of the same type. These can include raw materials like oil, gold, and agricultural products such as wheat and corn. Commodities are crucial in the financial markets as they are often traded on exchanges, impacting economic indicators and investment strategies.
Currencies: Currencies are the systems of money in common use, particularly in the context of a specific country or economic region. They serve as a medium of exchange, a unit of account, and a store of value, which are fundamental features for facilitating trade and investment across different financial markets. The value of a currency can fluctuate due to various factors such as economic indicators, interest rates, and geopolitical stability, making it a critical element in global finance.
Derivatives: Derivatives are financial instruments whose value is derived from the performance of an underlying asset, index, or rate. They play a crucial role in risk management and speculative trading, allowing investors to hedge against potential losses or to profit from fluctuations in market prices. Common types of derivatives include options, futures, and swaps, which can be used for various strategies in financial markets.
Dividends: Dividends are payments made by a corporation to its shareholders, typically in the form of cash or additional shares, representing a portion of the company's profits. They serve as a way for companies to distribute earnings back to their investors, providing a return on investment while also signaling financial health and stability. The frequency, amount, and type of dividends can vary greatly among different companies and can influence investor decisions in the financial markets.
Efficient Market Hypothesis: The Efficient Market Hypothesis (EMH) suggests that financial markets are 'informationally efficient,' meaning that asset prices reflect all available information at any given time. This concept has major implications for how investors approach trading strategies, risk assessment, and portfolio management.
Financial Industry Regulatory Authority (FINRA): FINRA is a self-regulatory organization that oversees brokerage firms and exchange markets in the United States, ensuring that they operate fairly and honestly. Its primary mission is to protect investors by maintaining the integrity of the securities industry through regulation and enforcement. FINRA enforces rules that govern trading practices, promotes transparency, and helps to resolve disputes between investors and brokerage firms.
Futures: Futures are standardized contracts that obligate the buyer to purchase, and the seller to sell, a specific asset at a predetermined price at a specified future date. These contracts are traded on exchanges and can involve various assets, including commodities, currencies, and financial instruments, making them a crucial part of financial markets. Futures provide a mechanism for price discovery and risk management, allowing participants to hedge against price fluctuations or speculate on future price movements.
Hedge funds: Hedge funds are investment vehicles that pool capital from accredited investors to pursue a wide range of strategies aimed at maximizing returns while minimizing risk. They typically invest in a diverse array of assets, including stocks, bonds, derivatives, and other securities, and often employ leverage and short selling. Hedge funds are known for their flexibility in investment strategies and can be an essential part of modern financial markets.
Hedging: Hedging is a risk management strategy used to offset potential losses in an investment by taking an opposing position in a related asset. This approach helps investors protect their portfolios from adverse price movements while still allowing for potential gains. By using various financial instruments, such as derivatives, futures, or options, hedging can be integrated into different investment strategies, providing a cushion against the unpredictability of market fluctuations.
Initial Public Offerings (IPOs): An initial public offering (IPO) is the process through which a private company offers its shares to the public for the first time, transitioning into a publicly traded company. This process allows companies to raise capital from public investors, which can be used for various purposes such as expansion, paying off debt, or funding research and development. IPOs play a crucial role in financial markets as they provide liquidity for early investors and set a market price for the company's shares.
Liquidity: Liquidity refers to the ease with which an asset can be quickly converted into cash without significantly affecting its market price. It is a crucial concept in finance, as it determines how easily individuals or institutions can access cash for transactions or investments. High liquidity means that assets can be sold rapidly with minimal price impact, while low liquidity may require longer selling times or concessions on price, affecting overall financial stability and decision-making.
Market volatility: Market volatility refers to the degree of variation in the price of a financial asset over time, often measured by the standard deviation of returns. It is an essential concept as it reflects the level of risk and uncertainty in the market, influencing investor behavior and investment strategies. High volatility can indicate market instability, while low volatility suggests a more stable environment, affecting how various investment types are perceived and their performance in both domestic and international contexts.
Mutual funds: Mutual funds are investment vehicles that pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. They offer individual investors the ability to access a diversified investment strategy without needing to select individual securities themselves.
Nasdaq: NASDAQ is an electronic stock exchange based in the United States, known for being the first electronic market and for listing a high concentration of technology and internet-based companies. It operates as a dealer network, allowing buyers and sellers to trade securities through a computerized system rather than a physical trading floor, which connects to its unique market structure and the diverse types of equity securities it accommodates.
NYSE: The New York Stock Exchange (NYSE) is one of the largest and most well-known stock exchanges in the world, where stocks, bonds, and other securities are bought and sold. It serves as a vital marketplace for investors, allowing companies to raise capital by issuing shares to the public and providing a platform for trading those shares among investors. The NYSE plays a key role in the financial markets by providing transparency, liquidity, and a regulated environment for trading.
Options: Options are financial derivatives that give investors the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific timeframe. They are used to manage risk and enhance returns in investment portfolios, allowing for strategic positioning based on market expectations. By providing flexibility, options can be applied in various trading strategies and portfolio management techniques, impacting the overall performance of investments.
Primary market: The primary market is the financial market where new securities are created and sold for the first time. This market allows companies to raise capital by issuing stocks and bonds directly to investors, making it essential for funding new projects or business expansion. It connects businesses in need of funds with investors looking to purchase new equity or debt instruments.
Private equity: Private equity refers to investment funds that acquire ownership in private companies or take public companies private, typically through buyouts. These investments are often made with the goal of improving the company's operations and increasing its value over time, before eventually selling it for a profit. Private equity plays a significant role in financial markets by providing capital and expertise to businesses that may not have access to traditional public funding sources.
Real Estate: Real estate refers to land and any physical properties or structures attached to it, such as buildings, homes, and natural resources. It plays a vital role in investment portfolios, offering both potential income through rental opportunities and appreciation in value over time. Real estate can also serve as a hedge against inflation and adds diversification to investment strategies due to its low correlation with traditional asset classes like stocks and bonds.
Return on Investment (ROI): Return on Investment (ROI) is a financial metric used to evaluate the profitability of an investment relative to its cost. It helps investors measure how much profit they make on an investment compared to what they initially invested, typically expressed as a percentage. Understanding ROI is essential for comparing different investment opportunities and assessing their potential returns in various financial markets, influencing decisions on asset allocation and investment strategies.
Risk-free rate of return: The risk-free rate of return is the theoretical return on an investment with zero risk, typically represented by government securities like U.S. Treasury bills. This rate serves as a baseline for evaluating the potential return of riskier investments, allowing investors to gauge whether the additional risks are worth taking compared to a secure investment. It's a crucial concept in finance as it reflects the time value of money and helps in determining discount rates for various investment decisions.
Secondary market: The secondary market is where previously issued securities, such as stocks and bonds, are bought and sold among investors. Unlike the primary market, where securities are created and sold for the first time, the secondary market provides liquidity and allows investors to trade these securities, impacting their prices based on supply and demand dynamics. This market is crucial for price discovery and enables investors to adjust their portfolios after the initial purchase.
Securities and Exchange Commission (SEC): The Securities and Exchange Commission (SEC) is a U.S. government agency responsible for regulating the securities industry, enforcing federal securities laws, and protecting investors. The SEC plays a critical role in ensuring transparency and fairness in financial markets, which influences various investment types, market structures, and ethical practices within investment management.
Specific Risk: Specific risk, also known as unsystematic risk, refers to the potential for an individual investment's value to decline due to factors specific to that particular asset. This type of risk is different from systemic risk, which affects the entire market or a significant segment of it. Specific risk can arise from company-specific events such as management changes, product recalls, or regulatory impacts that can dramatically influence the performance of a single investment without affecting the broader market.
Stocks: Stocks represent ownership shares in a company, allowing investors to claim a portion of the company's assets and earnings. When individuals purchase stocks, they become shareholders and can benefit from the company's growth through capital appreciation and dividends, while also facing the risks of market fluctuations.
Stop-loss orders: A stop-loss order is an instruction given by an investor to a broker to sell a security when it reaches a specified price, aimed at limiting potential losses on an investment. This strategy helps investors manage risk by automatically triggering a sale to prevent further losses, especially in volatile markets. Stop-loss orders are essential tools for risk management in various financial markets, providing a safety net for investors as they navigate price fluctuations.