A Fresh Look At The Financial Markets
With the advent of the internet and electronic trading, investors have access to a large number of financial markets and exchanges representing a vast array of financial products. Some of these markets have always been open to private investors; others remained the exclusive domain of major international banks and financial professionals until the very end of the twentieth century. These markets are not all equal; each requires unique skills and knowledge. As such, investors need to identify the market most suitable to their abilities, personality and investment goals, and then gain the specific skills required to profit in that market. Here we'll take a fresh look at the markets available to private investors and let you in on what you need to know to trade them.
* Capital Markets
The capital markets generally offer ease of access and encouragement to private investors, limited leverage opportunity and, as a result, limited upside potential. Any government or corporation requires capital (funds) to finance its operations and to engage in its own long-term investments. To do this, a company raises money through the sale of securities - stocks and bonds in the company's name. These are bought and sold in the capital markets.
The high private investor participation, varied product offerings, limited margin and extensive government regulation all combine to make the capital markets relatively safe for non-professional traders. But with this limited risk comes limited profit potential - this is a classic example of the risk-return tradeoff. This is partly because there is often a physical limitation as to how fast a company or economy can grow and partly because of the reduced leverage available. For example, most private investors are restricted to borrowing no more than 50% of the face value of their stocks in a margin account.
Stocks
Many private investors' first foray into financial trading in the capital markets is via the stock market. It's relatively easy to understand, offers a wide selection, features many recognizable companies and products, is readily accessible, and its high trading volume creates liquidity that allows investors to "get out" with relatively little hassle.
Bond Markets
A bond is a type of debt security that can be bought and sold by investors on credit markets around the world. This market - alternatively referred to as the debt, credit or fixed-income market - traded $45 trillion worldwide and $25.2 trillion in the U.S. in 2006, according to the Bond Market Association. It is much larger in nominal terms that the world's stock markets. This is considered a passive, low-risk, low-volatility investment. This market also has correspondingly low returns compared to the stock markets when examined over long time periods.
Mutual Funds
Mutual funds are an appealing method for individual investors to participate in the outcomes of a large basket of stocks. The money pooled by mutual funds is invested by professional money managers across multiple industries or sectors, and their increased size allows mutual funds to often become active participants in the courses of action their investments take. Investing in mutual funds removes the need for fundamental security analysis, but asset allocation and sector diversification knowledge will aid investors in maximizing returns for a given level of risk.
Index Investing
Many private investors are unable to beat the "broad market" as defined by indexes like the Standard & Poor's 500 Index, and consequently believe that simply buying the whole index to be a safer and easier route. Their logic is sound, but investors must also bear in mind that indexes by their nature are susceptible to market fluctuations.
Still, a smaller investor with limited time and capital can achieve a higher degree of sector or market diversification by buying indexes than they could possibly achieve by buying individual stocks. Fortunately for private investors wishing to invest in indexes, there are two simple and low-cost choices: index mutual funds and exchange-traded funds. Both offer low expense ratios and have high trading volumes, allowing for maximum liquidity. Index investing requires little analytical skill.
Cash or Spot Market
Investing in the cash or, "spot", market is highly sophisticated, with opportunities for both big losses and big gains. In the cash market, goods are sold for cash and are delivered immediately. Prices are settled in cash "on the spot" at current market prices. This is notably different from other markets, in which trades are determined at forward prices.
The cash market is complex and delicate, and generally not suitable for inexperienced traders.Despite this, an increasing number of private investors are drawn to the massive leverage available and the profit potential. A viable alternative for investors wishing to partake in these opportunities is to invest in a managed account run by an experienced professional.
Derivatives Markets
The derivative is named so for a reason: its value is derived from its underlying asset or assets. A derivative is a contract, but in this case the contract price is determined by the market price of the core asset. Leverage can be found in these markets as well, so the chance for high reward attracts individual investor interest; however many would do better to invest in professionally managed accounts or funds.
Examples of common derivatives are forwards, futures, options, swaps and contracts-for-difference (CFDs). Not only are these instruments complex but so too are the strategies deployed by this market's participants.
There have been some spectacular and highly publicized institutional losses in the derivatives market. There are also many derivatives, structured products and collateralized obligations available, mainly in the over-the-counter (non-exchange) market, that professional investors, institutions and hedge fund managers utilize to varying degrees but play an insignificant role in private investing.
Conclusion
A private investor's foray into various markets is a delicate process, with multiple options and multiple chances for error. Each available market - even those dominated by individual traders/investors - requires specific information and thorough comprehension of the market's engine. The newfound electronic availability of previously exclusive markets only makes research that much more important; perhaps the single biggest indicator of an investor's potential success is the choice of the most suitable market for his or her skills.
