Back to Basics
A general introduction to main instruments available on financial markets is useful. The purpose in this post is to get a general knowledge to make the most profit of the next chapters of our report. There exist risk less and risky assets. A bank (saving) account is an example of a risk less financial asset, since you are guaranteed to receive a known (usually fixed) interest rate, regardless of the market situation. Roughly speaking, the way banks operate is that they borrow from people who have money to ‘spare’, but are not willing to take risks, and lend (at higher interest rates) to people who ‘need’ money, say, to invest in some risky enterprise. By diversifying their lending, banks can reduce their overall risk, so that even if some of these loans turn bad they can still meet their obligations to the investors from whom they borrowed.
Governments and private companies can also borrow money from investors by issuing bonds. Like a bank account, a bond pays a (fixed or floating) interest rate on a regular basis, the main difference being that the repayment of the loan occurs only at a specified time, called the bond maturity. Another difference is that bonds are not strictly risk free assets because there is always a chance that the bond issuer may default on interest payments or (worse) on the principal. However, since governments have a much lower risk to default than corporations, certain government bonds can be considered to be risk free.
A company can also raise capital by issuing stocks or shares. Basically, a stock represents the ownership of a small piece of the company. By selling many such ‘small pieces’, a company can raise capital at lower costs than if it were to borrow from a bank. As will be discussed shortly, stocks are by definition risky financial assets because their prices are subjected to “unpredictable” fluctuations. In fact, this is what makes stocks attractive to aggressive investors who seek to profit from the price fluctuations. When you buy or sell a stock on the open market, you should keep in mind that you are dealing with real objects, not pieces of paper; you are buying and selling real parts of a particular company, its product, or some other various commodity. Owning a “share” means that you have actually bought into the company or product involved and become a partial owner of that commodity. Of course, you could be one of millions of shareholders, as most companies and products are broken into minute pieces of the whole, but you are still considered an investor in that company or product until you sell your shares.
The buying and selling of stocks are usually done in organized exchanges, such as, the New York Stock Exchange (NYSE). Most stock exchanges have indices or benchmarks that represent some sort of average behaviour of the corresponding market. Each index has its own methodology. For example, the Dow Jones Industrial Average (or Dow Jones) of the NYSE, which is arguably the most famous stock index, corresponds to an average over 30 industrial companies. Others well known US stock indices are the Standard & Poor’s 500 (S&P500) index calculated on the basis of data about 500 companies listed on the NYSE and the NASDAQ index based on major technology companies.