Investment Basics
Stocks, Bonds and Other Goodies
The stock market used to be separate from the average person's world. But this
distinction between Wall Street and Main Street no longer exists. These days,
every large city has an area housing financial companies, and most small towns
have at least one brokerage office where investment advice can be sought.
Individuals with enough know-how can even buy and sell shares on the Internet.
What's more, virtually every industry is involved in some way in the public capital
market (the market where stocks and bonds are traded). This enormous market has
one purpose -- to raise money. It is used both by the government and by private
enterprise. Without the financial market our economy would have a hard time
surviving.
Still, anybody who invests in the stock and bond markets takes a certain leap of
faith -- that the U.S. economy will continue to grow, profits will continue to be
made and capitalism is worth investing in.
A Sketch of the Financial Asset Classes:
People raise money in the capital markets the same way you would if you wanted
to open an ice cream store: you'd either borrow the money and pay it back with
interest, or convince somebody to invest directly in the business and share the
profits with you. The first case is debt and the second is equity. If you forget
everything else, remember this: bonds are debt, stocks are equity.
In the capital markets there are many lenders,
debtors and investors involved, so the debt and
equity have to be packaged into smaller units to
make trading easier. These units -- stocks, bonds,
and others -- are worth money to the person or
institution that owns them, and are known as
"assets." Different types of assets fall into
different categories, called "asset classes."
The major financial instuments, grouped by asset
class, are the following:
Debt instruments, such as bonds, provide financing through sophisticated loan structures. Both corporate and government bonds are debt instruments. |
 Debt Instruments |
Equity instruments, or stocks, offer shareholders ownership
in a company. A company raises money according to how
many shares it can sell, and at what price. |
Equity and Stocks |
Options, futures and other contract instruments are complex
deals in which you agree to buy or sell stocks and bonds at a
future date, at a set price. |
Other Financial Instruments |
How They're TradedStock and bond prices are determined through trading, which
means the buying or selling of an asset. |
Exchanges and Market Places |
Trading is more efficient when the buyers and sellers know the market's "level,"
that is, approximately what the asset is worth. (This is based on supply and
demand -- how much of it is available, and how many people want to buy it.) To
keep trading efficient, most deals in public assets are done through official
marketplaces where everybody knows the rules and has the latest information.
The vast majority of securities (stocks, bonds and futures) in the U.S. are traded
at three sites: The New York Stock Exchange (NYSE), The American Stock
Exchange (AMEX) and the National Association of Securities Dealers' Automated
Quotation service, generally referred to by its acronym, NASDAQ.
The NYSE and AMEX are actual physical places, located a few blocks away from
each other in New York City. They both function as "auction markets," with
representatives called "specialists" organizing the buying and selling of securities
by floor brokers.
NASDAQ, on the other hand, is a nationwide electronic network in which
securities are traded directly between buyers and sellers, without a middleman.
NASDAQ was originally conceived as an efficient way to store and display
quotations on over-the-counter (OTC) securities, which are those that are not
listed on the national U.S. securities exchanges. It has evolved into an organized
securities market in its own right, and today is separate from the OTC market.
Staying Informed
Both the exchanges and the electronic market make it easy for traders to follow
the quickly changing stock prices -- knowledge that is essential for making good
deals.
Bond trading is similar. The "bond crowd" trades in a special area of the
exchange. Bond traders crave news. They pay close attention to market indicators
such as the indexes published by Lehman Brothers, Salomon Brothers and Merrill
Lynch, as well as a range of statistics and news stories in the daily Bond Buyer
newspaper and other publications.
All this means that the professionals involved in capital markets are extremely well
informed. Something called the "efficient market theory" is worth mentioning here.
This implies that there is no such thing as a "hot stock tip," because all publicly
available knowledge about a stock is already reflected in its price. In other words,
you can't earn abnormal returns simply by reading more information about a
stock. There are arguments for and against this theory. But the logic is sound. Be
wary of people who approach you with tips about stocks, and above all don't ever
imagine you know something that the pros don't.
Wall Street is a very tough, competitive environment and if you want to be active
there, you should have professionals working on your behalf. In our investment
vehicles section, you'll learn how getting professionals to work on your behalf is
easier than it seems.
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