Updated: Jan 4, 2021
In the next few blog posts, we will be diving into some of the basic and most important fundamental concepts of investing. Below is part 1 of our series on investing fundamentals. We will be looking at the market from 30,000 feet.
The terms “market” and “investing” can be ambiguous and confusing when trying to navigate the nuances and complexities of how to put your money to work. This only becomes increasingly so as new technologies, industries, and investing products emerge in our rapidly-changing culture. Today we will take a brief crash course on the market, the foundation on which all the components of investing rest.
The "market" generally refers to the massive conglomeration of businesses, industries, and sectors that make up the economy, both in the U.S. and internationally. A business can be individual-owned sole proprietorship, partnership, limited liability corporation (LLC), non-profit organization (NPO), or corporation. Generally speaking, the primary differences between these types of business are organizational in nature, attributed to various tax and legal structures.
When it comes to investing, we are generally concerned the most with corporations. Corporations are public entities, meaning they are owned by their shareholders and registered to sell shares of the company on a stock exchange (e.g. the New York Stock Exchange, NASDAQ, etc.). These exchanges facilitate the trading of stocks (also known as “securities”). Stocks are a monetary representation of the tangible and intangible value of a company and are bought and sold much like any other good. The stock price of a company’s shares rise and fall based on internal and external factors that affect the business, cash flows, and financial health of the company. An important concept to keep in mind regarding the movement of a stock’s price is market efficiency, which refers to the nearly instant speed at which the stock price reflects new information about the company. Because the stock price is so reactive to new information, it is nearly impossible for a single investor to act upon brand new information before anyone else, unless that person has insider information. There are different economic theories on market efficiency, but the takeaway is that it is very difficult to predict or anticipate the direction a stock price will go, thereby making stock-trading a risky business.
The buying and selling of stocks on the major stock exchanges makes up what is known as the stock market. Investments in corporations earn returns by either capital appreciation (i.e. the stock price goes up), or by the payment of dividends to shareholders. A dividend is a payment a corporation makes to its shareholders from its earning of profits. A dividend is usually expressed as a percentage (dividend yield) of the company’s stock price, and is most often paid quarterly. Many investors seek to invest in companies with a high dividend yield, focusing on a steady stream of income versus the capital appreciation of the stock price. Investment using this dividend strategy is commonly referred to as a passive income investing approach.
Bonds are another type of security that is exchanged on the stock market. Bonds are a form of debt that companies and governments issue to raise capital. While they can be traded similar to stocks, bonds are more complex, as they involve interest yields over time until the bond is paid back to the party that issued the bond. Bonds are generally considered a less risky and volatile investment than stocks. Bond investing is another form of a passive income investment approach
Less important to our discussion are private entities, companies which do not have publicly-traded shares. This class of organizations is essentially composed of companies that are not public corporations. Because of the capital structure of most private entities, it is not always as easy to invest in a private entity as it is in public corporations.
Before considering ways to invest, one should consider the impact of inflation on returns. Inflation, in simple terms, is the percent change in prices of goods and services in the U.S. from year to year (read more from the website “The Balance” here). Generally, the annual inflation rate is between 2-3%, but it can swing wildly from year to year and decade to decade, depending on a number of economic factors. We won’t get into the weeds right now, but just remember that if the prices of goods and services go up, the spending power of your money goes down. Inflation can eat into your investments’ returns and should be a factor to consider when you are looking at investment strategies.
Wherever you are in your journey to financial success, it's always important to stop and understand the market as a backdrop to your path of investing. The market can be constantly changing, but thankfully the basic principles of investing are universal and timeless. Check out our next post in this series, where we discuss some of the most popular investment accounts around and how they apply to you. Stay tuned!
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