Financial Market Basics
When it comes to investing, the common terminology is to say that you're investing in "the market" or Wall Street. But what are you really saying when you use these terms? How is "the market" actually defined?
Simply put, financial markets are where traders and investors buy and sell assets. Markets can be used as a way for some companies to reduce risk and raise capital. Through markets, investors can buy into these businesses in a way that hopefully makes them money. There are many benefits of the financial markets in a capitalist economy, from bringing confidence into the economy and helping to fund an entrepreneur's ventures to providing businesses the liquidity they need.1,2
There are various types of financial markets you can invest in, including but not limited to stocks, bonds, derivatives, and commodities. Let's review and understand the basics of these four types of financial markets.
The Stock Market
The stock market is a financial market where companies can go to raise capital to expand their business. 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 track the averages of a group of companies that are traded publicly.1,2
Mutual funds allow you to buy a group of stocks at once without having to pick them out individually. As an example, you may have seen mutual funds as an option for investing in your 401(k).1,2
The Bond Market
Bonds are used when companies 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 preestablished interest rate. Moreover, unlike stocks, where there is no guarantee of a financial gain, bonds are more like a loan agreement. The bond market sells securities, such as notes and bills issued by the United States Treasury.1,2
Derivatives bring about a more complicated explanation. Essentially, a derivative is a contract between two or more parties where the 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 linked primary security. 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 traded, bought, and sold. While stocks and bonds are more akin to financial contracts, commodities markets deal in physical goods. There are four main types of commodity markets: energy, metals, agricultural products, and livestock.1,2
When it comes to investing, there are many options for you to choose from, which can sometimes feel intimidating. Working closely with a financial advisor can help you decide which investments are right for you, but it's also important to understand the basic concepts of your investments. Don't be afraid to ask your trusted financial advisor about your specific investments. An intelligent investor is worth their weight in gold.