Do You Truly Understand The Financial Markets?

Understanding the Financial Markets

Bob French, CFA, Director of Investment Analysis with Retirement Researcher, does a great job explaining financial markets. The post below summarizes a piece of his lecture series in a blog post.

With stock and bond market volatility, it’s important to keep financial markets in perspective.

What are the financial markets?

We see them on a daily basis — hear about on them on the drive home, read about them online or in the paper. Markets are the center of people’s retirement plans. Markets are how most of us will create retirement income so it makes sense we care what happens. But most people don’t really understand them. More likely, they only have a vague idea of what’s going on.

The key to making the most out of financial markets is to know what they are there to do and why they exist.

Why do companies come to the market?

The markets are there to raise money. Companies actively raise money or want to have the option to actively raise money. Companies have two options — sell stocks claims on future cash-flows (little slivers of ownership of the company) or sell bonds (highly structured loans of the company).

Markets would not exist without companies doing this. The financial markets are all about efficiently and effectively allocating capital across different companies. Markets are not there to help us with retirement or any of the other purposes we give to the market. They are there to allocate capital and help companies raise money. Companies are active participants in the market.

This is easy to forget and causes a serious disconnect that leads to investing mistakes and opportunities for speculators.

Why do investors come to the market?

There are all sorts of different investors — people looking at retirement, high-frequency traders, insurance companies, market timers. They all want to make money. We all want to invest and grow to a larger number in the future.

There are two types of market participants:

  1. Investors
  2. Speculators

Investing is about risk and return. It’s about identifying how best to allocate your capital based on long term expected rates of return and then managing it to stay comfortable and meet objectives. Speculating is not investing; it’s betting something will go up or down.

Why do real investors get involved?

Because capitalism works, there is a positive return on capital. This doesn’t mean every year, every two years, or every decade that things are going to work out well. They may not.

All investing is about taking risk. The market pays us for taking certain types of risk.

Markets don’t owe you anything. Any benefit to your retirement is secondary. Markets aren’t designed to help us; they’re design to help companies allocate capital. We’re just trying to piggy back off capitalism.

Why are you investing?

Invest with a purpose. Investments are a lot like power tools. They are really useful but you can also hurt yourself if you don’t know how to use them. The smart choice is to invest with a plan, and consider how everything fits together.

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