Financial Literacy 101:  The Anatomy of the Investment Markets

I have a great group of girlfriends from all walks of life, but my nearest and dearest are my gal pals from high school.  We have been thick as thieves since middle school and have talked almost everyday since the beginning of the pandemic.  These girls are so smart and I am so lucky to call them my friends.  The one thing they have in common that I do not is that they are all educators.  As we swap stories about life and kids and work I follow along with all of the trials and tribulations they face in their schools, but then I talk about the events of the economy and investment markets and challenges I face in my work and they all almost say in unison, “Iris – we have no idea what you are talking about.”

It’s not just my friends, though, that I hear this from.  I cannot tell you how many clients I work with say things such as “this is why I hire you – I have no idea what that means – just tell me how I am doing – what is the outlook going forward?”  The thought occurred to me that although people who don’t understand the markets keep me gainfully employed, everyone should have a fundamental understanding of what makes up the investment markets and how do we earn money over time.   We all need to save for retirement and we are giving up our disposable income for the potential to meet these goals over the long term.  I never buy a new pair of shoes without knowing the size and how they feel, and the purchase of securities should be treated the same.  Here are the basics about the investment markets that everyone should know:

How Do I Invest My Money?

There are two ways you can make investments.  The first way is to purchase ownership in an asset where you have the potential to participate in the future growth of that asset.  This is also called an equity investment.  The second way is to lend your money to someone for a stated period of time with their promise to return your principal at the end of the agreed upon term along with interest payments over the same time.  These types of investments are known as fixed return investments. 

Equity vs. Fixed Return?

When you purchases equities there is no guarantee that you will make money on your investment.  Your profitability is dependent of the earnings of the company that you have purchased a stake in.  This ownership stake is also referred to as stock.  All publicly traded companies can be bought and sold in a variety of investment markets, but the most commonly known ones are the Dow Jones Industrial Average (DJIA) and the Standard & Poor’s 500 (S&P 500).  The DJIA is made up of the 30 largest publicly traded companies in the United States.  The S&P 500 is a market-capitalization weighted index comprised of 500 leading publicly treaded companies in the US.  Market-capitalization refers to the size of a company so in the US we use the performance of the S&P 500 as a gauge to determine the overall health and viability of the performance of the companies and the overall stock market in general.

Contrary to popular belief, fixed return investments have as much risk as equities because, again, there is no guarantee that you will be repaid on time for the money that you lended to someone.  The most common fixed return investments include bank depository accounts, certificate of deposits, and bonds.  When you make a fixed return investment you want to be sure that the company or entity that you are lending money to is strong and will have the cash flow over time to support paying you back.  There is much less risk in these types of investments versus equities, but you want to be sure the credit worthiness of the borrower meets your overall standards.  Because there is less risk in these markets, fixed return investments typically earn less over time than the broader returns of the stock market.

What Is a Stock Versus A Fund?

While you can own stock in one or several companies, one practice that you want to avoid while investing is concentration risk, or having too much money invested in any particular holding.  To mitigate this investors can purchase mutual funds or exchange traded funds.  Funds are essentially a basket of hundreds of stock that are professionally managed.  The idea with using funds is that you can eliminate concentration risk by buying baskets of securities.  This works similarly for bond funds as well.  If you own a basket of companies or fixed return investments in a fund, or own several funds in your portfolio, your performance will not suffer drastically if any particular holding does not perform well.  In most situations for the average investor using funds in your portfolio for investments is much more prudent that owning individual stocks and bonds.

 No matter what you own, the key to having the potential for long term, positive performance is to have a highly diversified portfolio that is aligned with a level of risk you are comfortable with.  You want to invest your money in different parts of the markets and own a combination of equity and fixed return investments.  How you are invested today will change over time as your goals change.  Make sure you are asking your financial professional about not only what you own, but what that means and how it fits into your overall strategy.  I tell my clients all of the time, no question is a silly question, and armed with these basic concepts you can feel more comfortable in approaching the professionals you work with to  take a deeper dive. 

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