Investing in the 4 Great Categories of Financial Markets
An investor is often confronted with a great number of financial instruments, so it is important to have a clear understanding of the general types of investments there are in order to make the right choices.
Analyzing the securities' greater categories can be very useful when investing. There are four types of investment markets, each of different risk and nature: the money market, the bond market, the ownership market and the derivative market. We will go over their general characteristics, ordered from lowest to highest risk.
The money market is defined to be cash equivalent. It gathers securities issued by governments, banks or companies, who are looking to borrow on a very short term. In this category we can find assets such as Treasury Bills, certificate of deposits from banks, or commercial papers from corporations. These are liquid investments which can be cashed back at any time, just like a checking account. The level of risk is very low, as well as its return, with a rate almost lower than the inflation after taxes.
The bond market is a market where debt securities are issued by governments and companies. When holding a bond, the investor lends money to the issuer at a fixed or variable rate. A coupon attached to the bond dictates the interest rate and periodic payments made until the end of the term, giving a fixed income to the bondholder. The bond is fully reimbursed at its maturity date.
The risk and return can vary, but remain contained since they are debt only, and not shares or stocks. The revenue is principally limited to its interest rate, so there is less speculation. The risk, for its part, is mainly linked to the issuer's credit; a company can be in a good or bad financial situation, and when the government is the issuer, the state's political and financial stability is the indicator. The higher the credit risk, the higher the rate, but when we deal with an industrialized country presenting no risk of default, the risk lies principally on the interest rate.
The Ownership Market
The ownership market involves transactions of property assets. There are two types of investments; the tangible and intangible, or also known as real and financial investments. The real investments include real assets such as land, building, house and other real estate. Financial investments include equity securities such as a company's shares.
When buying a share, you own part of the company's assets and part of its liabilities; therefore, the share represents proportionally the difference between the assets and debts, which is the businesses' equity value. Buying all the shares is buying the company at its market net asset value.
The transactions can be done on a public ground like in the stock exchange, or privately if they are not listed in the stock market. Shares can be common, or preferred. When preferred, this one gives dividends and/or more important voting rights.
The risk and return when investing in shares is mainly based on the company's performance. Its value is directly linked to the business profitability, which naturally elevates its risk from the debt market. A company that records good profits will increase its net asset value, and one with a bad performance will have the opposite effect. Therefore, price fluctuation is very common and can be much wider, because it is not limited to a coupon and the gains and losses are influenced by a greater number of factors.
Investments in real estate have another dynamic but the logic remains the same. If you purchase an income property for example, this one will generate rental income, but also costs. For this reason, it is crucial to know the real value of the property, just like a company, and have the information on hand when negotiating the purchase price. Some real estate investors are looking into making money purely from the property's appreciation, others through flipping, and others through the rental income it can generate. We could assume that real estate investments are a more stable and less risky market than financial investments, however the 2008 crisis proves that the real estate market is not immune to losses.
Derivatives are financial instruments that protect a future transaction between two parties from fluctuations. They are directly linked to underlying entities from which their value derives. They have no value on their own and their main objective is to pass on the fluctuation risk on to another party.
The options for example (an important category of derivatives) give the right, but not the obligation, to sell or purchase shares at a fixed price before a certain date. However, once the delay has passed, the option has zero value as opposed to other securities like bonds and shares which will always keep a certain value unless there is a bankruptcy.
Derivatives are the markets with the highest risk in which we can invest; theoretically, depending on your position, losses can be infinite!
Knowing in which category to invest
When looking at the great markets we can understand each category just by their nature; cash, debt, ownership and derivatives, which tells us right away about their level of risk and potential return.
All financial instruments can be categorized. Investment funds, such as mutual funds, will have a pool of securities from all categories in order to optimize their return. Professionals will invest for you, reflecting the level of risk you are willing to bear, by mixing proportionally the different markets. But keep in mind that even if in most cases professionals manage your investments, it is always important to understand the basics and get a general picture of your portfolio.