This article on investments is the first of a series of three, introducing you to financial instruments that could make your money work for you.
If all your money is either stuck in a savings account or a transactional account, this article is for YOU. However, even if you are familiar with stocks, bonds and ETFs, I highly recommend a read of this article so you may understand your stocks and bonds more.
I am also publishing my article for intermediate investors to introduce options, futures and swaps not too long from now, and I’m planning an advanced article on CFDs, MBSs, and REITs as well (you know it gets complicated when you start reading random letters).
But for now, let me introduce you to the most basic, most invested financial instruments.
Table of Contents
1. Stocks
To introduce you to stocks, let me start with a little story-telling.
Long long time ago, the Dutch people went on voyages in order to trade silk, coffee, spices, and wine. In order to help fund their growing expeditions, they decided to sell coupons to the public with the terms that the people who bought the coupons would be investors of the voyages, and the profit made from the expeditions would be distributed to the owners of the coupons accordingly. As the expeditions grew and the news spread, the buying and selling of the coupons amongst the public became unavoidable, the prices of the coupons fluctuated depending on supply and demand.
The people who went on voyages were all under the historical Dutch East India Company, and the selling of coupons became the first ever IPO (initial public offering). The coupons released by Dutch East India became the first ever publicly traded stock, and the profits that they distributed at the end of their voyages were what we now call “dividends”.
Despite all these happening back in the 1600s, the stock market we have now still works in exactly the same way. Companies try to raise more money by issuing stocks (coupons) to the public, and after this initial offering (the IPO), the owners of the newly issued stocks then enter the stock market in order to buy and sell these stocks to other interested investors. Hence, stocks are also called “shares”, because owning stocks entitles you to “shares” of a company’s profit when they distribute them to the stockholders.
Nowadays, most people trade stocks in order to profit from the movement of the stock’s price rather than for the dividends the companies give out. The company who originally issued the stock does not earn or lose from the movement of their stock price, as they only get the amount they raised from their IPO, but events surrounding the company may affect their stock price significantly. Seasoned investors thus tend to put their money into stocks that have good potential and high earnings in order to profit from a good dividend return and a higher stock price for when they sell off their shares.
If you want to know about Warren Buffett’s highly successful investing style, I highly recommend reading my article on the 3 steps to Warren Buffett’s value investing.
2. Bonds
Similar to stocks, bonds are also used by major companies and the government to raise funds. Like stocks, they are released through a public offering and may also be traded on a market (a secondhand bond market).
However, the main difference lies in ownership: owning a stock means a person partially owns a company while owning a bond means the person is lending money to the company or the government.
Interesting, hey? Now you just have to think whether you want to say “I OWN APPLE”, or, “I LEND MONEY TO APPLE”. I personally think both are pretty cool.
When one puts money in a savings account, that person actually loans money to the bank – this is the reason why banks pay interest. In the case of a bond, you receive a set rate of interest as well, but unlike the banks, you have to hold the bond until the maturity date in order to get your entire investment back. This is the reason why bonds tend to pay more interest than banks do, as bonds can range from a year of holding to 10, and maybe 20 years.
As an investor, the most important things you need to know about bonds are the interest rate, the length of time till maturity of the bond, and the credit rating of the bond.
Bonds are a complex subject, so if you think they’re a good idea (I highly support that!), then YOU MUST visit my painfully-written article explaining more about how they work and where to buy them here.
3. ETFs
ETFs are the last in this beginner article, but one all financial experts would recommend to beginners. ETF is short for “exchange-traded fund”. Funds are essentially a basket of several financial instruments. In noob terms, if you went shopping and put 10 different meat items into your basket, finance people would call that a “meat fund”.
As such in finance, we have funds that focus on stocks, corporate bonds, government bonds, and many more. Stock funds can even be broken down into “Tech funds”, “Consumer goods funds”, “Banking funds” and countless others. Bond funds can be broken down into long-term and short-term bonds, high-interest bonds, etc. “Exchange-traded” just means that you are able to buy and sell these funds on the stock market.
ETFs are highly recommended due to the fact that they lessen your risk. In Finance, risk is described as the volatility of a stock, or how much a stock goes up or down. It has been mathematically proven that by diversifying the stocks you own, you lessen your exposure to risks such as industry-specific risks, management risks, location risks, and all other types of risk. As such, by investing in a fund of stocks rather than just one specific stock, you get the highest return for the least amount of risk.
Now you may ask, “but but… you said there that risk is volatility and it means how much a stock moves. I want to go for higher returns!”
My friend, this is why financial experts recommend ETFs mostly to beginners – if you think you are ready to take on more risk for the chance of higher returns, then by all means, you are free to do so! Just remember the famous words of wisdom… don’t put all your eggs in one basket.
It is important to note that all ETFs are funds – but not all funds are ETFs. You will come across the terms mutual funds and hedge funds regularly while investing. These are funds you apply for directly with the institution that manages the funds, and they manage your money by distributing it proportionately to their own basket of financial instruments. ETFs only consist of funds that you can buy on the secondary market. This article introduces you to the different other types of funds.
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