This lesson will help familiarize you with some common terms and concepts surrounding investments, such as capital, types of investors, equilibrium, risks and diversification.
What is the stock market for?
The role of the stock market is to provide a venue for investors to buy and sell individual company shares, funds or other financial products. The stock market enables those interactions using the mechanism of price discovery based on fundamental and technical analysis. Changes in share prices allow investors to buy or sell financial products they are interested in owning.
What is an exchange?
Stock market exchanges are private businesses that facilitate financial transactions during all or part of the day. Nowadays, most exchanges are fully electronic and receive inbound orders from broker dealers whose clients want to buy and sell shares. An exchange has members and rules about who and how transactions may be made. Upon completion of a transaction, outbound confirmations are sent to broker dealers for their clients. Depending on the broker, investors may choose which exchange venue to send their buy and sell orders to. Each exchange has a certain model of operation that is used to communicate with the brokers. Collectively, exchanges make up the broader stock market.
What is capital?
Capital can come in many forms and is typically associated with asset classes such as cash, real estate, property, stocks, bonds, silver or gold. You may hear people talk about intellectual property as capital , along with human capital or even antiques. All of these are a store of value in one form or another and can be considered forms of capital. Bringing together different forms of capital typically enables investors to grow their capital. For example, forming a company, using capital to acquire raw materials and pay laborers to build a physical product, which can be sold for a profit. Or it could mean investing an amount of capital into another asset class with the expectation of watching its value increase. Often, without capital
investments, even the best ideas cannot be translated into being successful. One way business owners raise capital is by selling off a portion of a company to the public at an agreed upon price in exchange for ownership in the company.
What is an investor?
An investor is someone who puts capital to work in an asset class. If we are describing stock market investors, there are several types, but usually such investors buy and sell shares in companies with a few goals in mind. Investors generally intend to buy something in order to sell it at a higher price. Or, they invest to receive a yield. An example of yield can be in the form of a dividend, which is a flow of cash payments, made by the company, paid out to investors. What types of investors are there?
Some people invest for a living so they use existing capital to buy and sell with the goal of making enough money to earn a living or operate a financial services business. Other investors might act far less frequently and invest for a longer period in a company whose product they are familiar with. Members of the workforce often contribute some of their salary to an investment plan such as an IRA or 401k. Contributions can be directed to a designed company who manages various retirement plans. Often represented by the members of the workforce, major pension funds or asset managers consist of a share of participants operating within the stock market.
Other asset managers such as hedge funds or advisory services may act to invest on behalf of capital contributors who don’t have time or the specific knowledge to make investment decisions. Analysts working on behalf of investment companies spend countless hours trying to find well-run companies to invest clients’ money into.
What is equilibrium?
When two opposing forces are equal, a state of equilibrium exists. And so, when buyers and sellers are content to exchange shares at the prevailing market determined level, prices are said to be in equilibrium. If, over time, there are more buyers than sellers, buyers tend to bid up prices to tempt fresh sellers until equilibrium is restored. Individual share prices may also respond to the overall direction of the stock market. If stock prices correct to the downside by 20%, individual share prices may be dragged down in response to a broad market selloff.
What is risk?
When it comes to investing, risk can be broadly defined as the probability of increasing or decreasing capital. Every investment opportunity carries the inherent chance of improving or worsening the value of the initial capital sum. The implied chance of a profit or loss defines the investment risk. Investments in some companies are said to be riskier than in others. That could be due to how well established the company is, how it is managed, how well it can access debt in order to expand or survive. Or it could be the success of its products or how nimble it is in the face of changes in demand for its products.
What is diversification?
If two investors hold the shares in the same company, an investor holding this single stock may be risking more than an investor holding two stocks. If the lone company becomes insolvent, the first investor loses everything. For the second investor, the loss would represent just half of his entire holdings. A variety of holdings found in a portfolio may allow the investor to achieve greater diversification.
What is an index?
Reporting on the performance of stock markets often uses a benchmark to describe its activity. Common benchmarks are referred to as an index that enables investors to view the performance of the broad market against their own holdings. If the stock being held by an investor rises by 2% while the market index rises by 1%, the investor has outperformed the broad market. Common benchmarks include the S&P 500 index and the Nasdaq Composite index. When comparing performance, investors should be aware of the composition of what they are holding and consider an appropriate benchmark index to compare against.
What is a portfolio?
A portfolio is the collection of investments that one owns. One way to diversify against risk, is for a portfolio to be spread out across a variety of factors. These factors may include asset class, company size, sector, industry, geographical location, yield, valuation or many more. Diversification is one way to help investors considerably reduce risk.
Conclusion – These definitions and starting concepts are just a few pointers that can help novice investors better understand what capital markets and investments are about. In later lessons we will look at industries and economic sectors that neatly define an economy.
We will also introduce you to fundamental concepts involved in a company’s annual statements such as Balance Sheets, cash flows and its income statement.
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