Financial Literacy – Markets – Basics

Markets are and always have been a group of buyers and a group of sellers coming together to conduct business through trade. There are exchanges in all parts of the world. For example, there’s the NYSE or New York Stock Exchange, there’s the Nikkei or Japan’s stock exchange, the LSE or London Stock Exchange and many more. On these markets one can find assets for sale much like in a grocery store. There is a price that the seller wants to sell at and a price that buyers offer and negotiations take place back and forth. The price listed on the exchanges, are in fact thousands and often times, millions of these types of negotiations that eventually settle around a range of prices. The prices you see on the edges of the television screen or in financial papers are generally agreed on prices of common assets and stocks, like oil, gold, and stocks like FaceBook and Google.

Access to the markets are often done by brokerages. Brokerages like Charles Shwab, E-Trade, and TD Ameritrade provide the platforms and structures needed to place orders in the markets. It is much simpler than it sounds but some knowledge is needed to understand the nuances of one order over another. That type of information we will cover in another section, but for now, we will broadly speak of the markets and information that will be important on a broad scale.

There are big players in the markets. Entities that have a much larger and more important presence than others. The primary one being the Federal Reserve. This entity sets forth the Federal Funds Rate and is a rough measure of the cost of credit, or the cost of borrowing money. This is a vitally important entity because not only does it control interests rates in the economy, but it is also the central bank with the power of controlling the money supply in its respective economy. The job of the Federal Reserve is to control the interest rates and the money supply in the Unites States and it does this by dealing directly with the United States government rather than with everyday individuals, but sets baseline interests rates for the banks in the Unites States to constrict or expand the money supply in the economy. This is important for a few reasons we will get to shortly.

In the markets there are, very generally, 4 major asset classes. There are Equities (Stocks), Fixed Income (Bonds), Cash and Cash Equivalents, and Alternative Investments. Many people include other assets like real estate but we are going to limit the discussion to these 4 for the sake of simplicity. Understanding the fundamentals of asset classes will allow you to decipher if an alternative investment, like real estate is right for you.

The important concept to understand about the markets is that there is always a risk vs. reward curve. The more risk you take, the higher the reward should theoretically be. The less risk you take, the lower the reward, generally speaking. Equities have historically offered the highest returns. This is because there is inherit risk in investing in companies, and prices are often volatile. One day a stock may be doing well, and the next something may happen that will send the price down. Overall, however, over the long run stocks tend to average out at higher gains than other investments.

Fixed income is exactly as it sounds, fixed income. These assets usually take the form of bonds, an I.O.U. from an entity. The safest perceived investment one can make is to lend money to the United States Government. The Unites States government issues Treasury Bonds and this is seen as the default “safe” rate of return. This is usually an agreement to lend the government money for a set period of time. During this time, the government or entity will make interest payments and when the agreed set period of time is up, they will pay back the principal to the Bond holder. This is seen as safer because the probability that the Unites States government will not pay you is seen as low. Even if you lend a corporation your money, bondholders are paid first in case of bankruptcy. Now, do not make the mistake of thinking that any bond is safe. Corporations, governments and municipalities have credit ratings just like you and I. A financially risky entity must issue a bond with a higher rate of interest, because investors demand more compensation for the increased risk and that is exactly why the interest rate is higher, it is because it is riskier and the probability of losing all your principal is higher.

Cash and cash equivalents are investments that are used to maintain liquidity and to earn very modest returns. The reason is because these investments can be liquidated or turned into cash very very quickly and are very safe to hold. A cash equivalent can be something like a savings account with a modest rate of return. The chances of you losing the money you have in the bank are very very low, especially if you keep less cash than is federally insured. The risk that you will not have that principal is so low that you make very low rates of return because of it.

Alternative investments are everything else that is left. These include things like commodities, Exchange Traded Notes, Derivatives, real estate, futures contracts and many more. These types of investments are more geared towards those who have a working understanding of their value and why one would choose to own these investments over others. Options trading, for example, is a way to hedge risk or leverage your position. It is relatively complicated and unless you understand what you are trying to accomplish and why, I would strongly recommend staying away from this asset class until you understand not only the way in which they function, but also why they function in the manner they do.

All this information is briefly covered to illustrate a general concept, some asset classes function differently than others and some function closely to each other. This is called asset class correlation. This is a fancy way to say that when one investment asset moves in performance, another asset moves in the same direction. This is known as a positive asset correlation. Negative asset correlation means that the relationship is inversely related so that when one asset does poorly, the negatively correlated asset well do well and vice versa. The reason this concept is important is to balance risk as much as possible while maintaining a good return on your investments. If allocated properly, no matter what happens in the markets, your portfolio of investments will do well relative to the market conditions.

This is going to conclude the basics of the markets. In the coming lessons, we will cover more on each asset class so that the important fundamentals are understood and how some of the information here ties in with each asset class. This will paint a big picture and give you  

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