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 will hopefully make money. The benefits of financial markets in a capitalist economy are numerous, from bringing confidence to the economy and helping 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 in order 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 track the averages of groups of companies that are publicly traded.^1,2

Mutual funds allow you to buy a lot of stocks at once without having to pick them out individually. You might 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 need to raise large amounts of money. Unlike stocks, bonds are securities in which investors loan money for a defined period at a pre-established interest rate. Furthermore, while stocks carry no guarantee of financial gain, bonds are more like loan agreements. The bond market sells securities, such as notes and bills issued by the United States Treasury.^1,2

Derivatives

Derivatives entail a more complicated financial market. Essentially, a derivative is a contract between two or more parties with value based on an agreed-upon underlying financial asset (e.g., a security) or set of assets (e.g., an index). Derivatives are secondary securities with values solely derived from the value of the primary security to which they are linked. In and of itself, a derivative is worthless. Rather than trading stocks directly, a derivatives market trades in futures and options contracts and other advanced financial products, which have only as much value as the primary security.^1,2

The Commodities Market

Commodities markets involve physical goods that are bought, sold, and traded. While 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 advisor 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 advisor about your investments. An intelligent investor is worth their weight in gold.