Investment, Asset Classes and Financial Markets

When you talk to someone about “investing”, two words that you will come across frequently are “Investment” and “Market”. So what is an investment and what’s a market?

What is an Investment
People have been confusing the word investment with a lot of things which have nothing to do with investment. Now a days you see people “investing” in their big houses, cars, TVs, education and the word investing is replacing so many other words just to justify an “investment”.

Investment means “a purchase” which is supposed to generate a profit or an income. In broad category, we can categorize investment into three categories:

1. Ownership e.g. Business, Real Estate, Stocks, Precious metals (like gold, silver)
2. Lending e.g Peer-to-peer lending, Bonds, Certificate of deposits (CDs), Treasury inflation protected securities (TIPS)
3. Cash Equivalent e.g savings account, money market funds

But investment companies categorize it into four groups known as Asset Classes - 

1. Equity e.g Stocks, 
2. Fixed Income e.g. Bonds 
3. Cash Equivalent e.g. Money Market Instruments such as Treasury bills, Certificates of deposit, Bills of exchange, Asset backed securities and Repurchase agreements
4. Alternative Investments e.g Real Estate, Commodities, Derivatives, Hedge Funds, Index Funds, Funds of Funds, Mutual Funds, Exchange Traded Funds (ETFs), Private Equity, Venture Capital, Options, Futures, Forex, Annuities

So basically an asset class is a group of financial assets / securities that are behaviorally and characteristically similar and are subject to the same laws and regulations.

Investopedia defines security as “A security is a financial instrument that represents an ownership position in a publicly-traded corporation (stock), a creditor relationship with governmental body or a corporation (bond), or rights to ownership as represented by an option. A security is a fungible, negotiable financial instrument that represents some type of financial value. The company or entity that issues the security is known as the issuer”.

Here I am just giving you an overview of everything and later we will get into the details of each of these to see what exactly they are.

What is a Market
The yield of every investment depends on how the “market” is doing. When you invest your money with investment companies, they further invest that money in the market through various investment vehicles to generate profits. These investment vehicles may have different level of risk associated with them. High risk investment vehicles such as stocks, options and futures usually yield high returns and low risk investment vehicles such as CDs and Bonds yield comparatively low returns.

Market, also called financial market, is a place where these securities are traded i.e. Where they are bought and sold. The funniest fact of the market is there are two sides (buyer and seller) of this trade and both sides expect to make profit with their respective transactions.

Financial market is further categorized as- Capital Market and Money Market.

Capital Market
Capital market primarily provides a platform for trading of securities in order to raise long term funds for corporations, government, banks or any other issuing group. Let’s take a look how it works-

First time when a company seeks to raise funds through public investments in its shares it goes through investment banks and underwriters to issue the shares, distributes prospectus, and conducts road show (marketing). Investment banks advise the company about the best way to raise funds, pricing financial instruments and how to meet the regulatory requirements. Investment banks have to outbid other institutions who also want to handle the transaction on behalf of the issuer but if the market demand for the securities is weaker than expected, investment ban may not be able to make a nice spread (spread is the profit margin) or may even end up in loss.

Underwriter is the company that works with the issuing company to determine the “right price” of the security offerings and manages the issuance and distribution of securities, buys securities at a predetermined price from the issuer and re-sells them to the public through its distribution network at an exchange. Underwriter received underwriting fee and makes some profit in the re-selling the stocks to public that is also called initial public offering (IPO).

In the above scenario, investment bank operates in Primary Market while initial public offering is made in the Secondary Market, if the company meets the conditions of Size, Liquidity and Ownership (public float) . Stock exchanges are characterized by a summary index called stock index or stock market index which is typically computed as a weighted average price of the selected stocks being traded in that exchange. NASDAQ composite, Dow Jones Industrial Average, and S&P500 are he examples of stock indices.

An exchange can be used by the companies to seek new capital, additional equity capital for expansion or new projects, buy back shares if funds can not be invested more productively and take over or merger with other companies.

Just like corporations need money to expand into new markets, governments also need funds for things like building new infrastructure and improvement of old infrastructure but governments do not issue stocks (remember stocks are the ownership equities) . Governments issue various bonds to borrow money from the public for a certain time.

Depending on the type of security being traded, capital market is further categorized into:

1. Equity Market
2. Debt Market
3. Derivatives Market
4. Commodity Market
5. Forex Market (also currency market)

Money Market
Money market is used to raise short term funds, usually for one year or less. From the investors’ point of view money market is a good place to “park” funds. Money market ensures corporations and governments maintain adequate level of liquidity on daily basis. Companies may even borrow short term funds from the money market for things like running payrolls.

Money market instruments include Treasury Notes, Bank Accepted Bills, Commercial Papers, Certificates of Deposit.

But remember regardless of the term (long term or the short term) and the type of market (capital market or money market), all types of investments have some inherent risks involved. No investment is safe and even money market investments may also experience negative returns.