Investment Strategy: Financial Market Basics
When it comes to investing, the common terminology says that you're investing in "the markets" or Wall Street. But what do these terms mean, and how are markets defined?
Simply put, financial markets are where traders and investors buy and sell assets. Markets can be used as a way for businesses to reduce risk and raise capital. Through markets, investors can buy into these companies in a way that hopefully makes money. The benefits of financial markets in a capitalist economy are numerous, from bringing confidence to the economy and helping to fund entrepreneurial ventures to providing liquidity to businesses.1,2
Several types of financial markets can be invested in, including but not limited to stocks, bonds, derivatives, and commodities. We review and explain the basics of these four types of financial markets below.
The Stock Market
The stock market is a financial market where companies can go to raise capital to expand. Investors can buy the shares of a company—called stocks—through a broker-dealer. Stocks may be traded on listed exchanges, such as the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotations (Nasdaq) stock market. Indexes such as the Standard and Poor's 500 Index and the Dow Jones tracks the averages of a group of companies that are publicly traded.1,2
Mutual funds allow you to buy a bunch of stocks at once without having to pick them out individually. You may have seen mutual funds as an option for investing in your 401(k), for example.1,2
The Bond Market
Bonds are used when companies or specific projects (such as a municipality building new roads or an airport, for example) need to raise a large amount of money. Unlike stocks, bonds are a security in which an investor loans money for a defined period at a pre-established interest rate. Furthermore, unlike stocks, bonds are more like a loan agreement.
Derivatives entail a more complicated financial market. Essentially, a derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (e.g., a security) or set of assets (e.g., an index). Derivatives are secondary securities whose value is solely derived from the value of the primary security that they are linked to. In and of itself, a derivative is worthless. Rather than trading stocks directly, a derivatives market trades in futures and options contracts, as well as other advanced financial products, which only have as much value as the primary security.1,2
The Commodities Market
Commodities markets involve physical goods that are bought, sold, and traded. Whereas stocks and bonds are more akin to financial contracts, commodities markets deal in physical goods. There are four main types of commodities markets: energy, metals, agricultural products, and livestock.1,2
When it comes to investing, there are many options to choose from, which can seem intimidating. While working closely with a financial planner can help you decide which investments are right for you, it's also important to understand the basic concepts of your investments. Don't be afraid to ask your financial planner about your investments.
This content is developed from sources believed to be providing accurate information. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.