Investing in the 4 Great Categories of Financial Markets
An investor is confronted to a great number of financial instruments, so it is important to have an understanding of the general types of investments there are in order to make better choices. To do so, 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 by lowest to highest risk.
The money market is defined to be cash equivalent. It gathers securities issued by governments, banks or companies, looking to borrow on a very short term. We can find, in this category, assets such as Treasury Bills, certificate of deposit from banks or commercial paper from corporations. These are very liquid investments, because we can cash it back at any times, 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, which gives fixed income to the bondholder. The bond is fully reimbursed at the maturity date, because like any other loan, there is a time limit in borrowing money.
The risk and return can vary, but remains contained since we are dealing with debt only. 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 investment; the tangible and intangible, or also known as real and financial investment. The real investments include real assets such as land, building, house and other real estate. Financial investments, for its part, include equity securities such as 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, which in the preferred case gives dividend and/or more important voting right. The risk and return when investing in shares are mainly based on the company's performance. Its value is directly linked to the businesses profitability, which naturally elevates its risk from the debt market. A company that record good profits will increase its net asset value, and a bad performance will have the opposite effect. Therefore the price fluctuation is very common and much wider, because it is not limited to a coupon, and the gains and losses are influences by a greater number of factors.
As for investment in real estate, it is another dynamic but the logic remains the same. In the case of purchasing an income property for example, it will generates rental income, but also costs, so there is room for negotiation when going through the act of sale in order to know the value of the real property, just like a company. In fact, some investors are actually looking to make money mainly out of the propriety appreciation, also known as property flipping. We could assume it is a more stable and less risky market than the financial investments, but the 2008 crisis showed that the real estate market is not completely immune to losses.
The derivatives are financial instruments that protect a future transaction between two parties from any fluctuations. Derivatives are directly linked to underlying entities in which their value derives; they have no value on their own. Its main objective is to pass on the fluctuation risk to another party.
The options for example, an important category of derivatives, gives 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 equity like bonds and shares which will always keep a certain value unless there is a bankruptcy. The derivatives are the market 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 the return. Professionals will invest for you reflecting on the level of risk you are willing to bear by mixing proportionally the different markets. 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.