A Fresh Look At The Financial Markets

With the advent of the internet and electronic trading, investors have access to a large number of financial markets and exchanges representing a vast array of financial products. Some of these markets have always been open to private investors; others remained the exclusive domain of major international banks and financial professionals until the very end of the twentieth century. These markets are not all equal; each requires unique skills and knowledge. As such, investors need to identify the market most suitable to their abilities, personality and investment goals, and then gain the specific skills required to profit in that market. Here we'll take a fresh look at the markets available to private investors and let you in on what you need to know to trade them.

Capital Markets
The capital markets generally offer ease of access and encouragement to private investors, limited leverage opportunity and, as a result, limited upside potential. Any government or corporation requires capital (funds) to finance its operations and to engage in its own long-term investments. To do this, a company raises money through the sale of securities - stocks and bonds in the company's name. These are bought and sold in the capital markets.

Private individuals are seizing on the opportunity to invest more than ever before: according to the "Outline of the U.S. Economy" (2001) by Christopher Conte and Albert R. Karr and the U.S. State Department, "the portion of all U.S. households owning stocks, directly or through intermediaries like pension funds, rose from 31% to 41% between 1989 and 1995." Reflecting this increase in private participation, the capital markets are extensively regulated - in the U.S. by the Securities and Exchange Commission (SEC).

The high private investor participation, varied product offerings, limited margin and extensive government regulation all combine to make the capital markets relatively safe for non-professional traders. But with this limited risk comes limited profit potential - this is a classic example of the risk-return tradeoff.  This is partly because there is often a physical limitation as to how fast a company or economy can grow and partly because of the reduced leverage available. For example, most private investors are restricted to borrowing no more than 50% of the face value of their stocks in a margin account. (For background reading, see The Stock Market: A Look Back.)

Stocks
Many private investors' first foray into financial trading in the capital markets is via the stock market. It's relatively easy to understand, offers a wide selection, features many recognizable companies and products, is readily accessible, and its high trading volume creates liquidity that allows investors to "get out" with relatively little hassle. Given these factors, it's not surprising that the New York Stock Exchange's annual trading volume rose almost 15-fold between 1980 and 1998 - from 11,400 million shares to 169,000 million shares ("Outline of the U.S. Economy", 2001).

Bond Markets
A bond is a type of debt security that can be bought and sold by investors on credit markets around the world. This market - alternatively referred to as the debt, credit or fixed-income market - traded $45 trillion worldwide and $25.2 trillion in the U.S. in 2006, according to the Bond Market Association. It is much larger in nominal terms that the world's stock markets. This is considered a passive, low-risk, low-volatility investment. This market also has correspondingly low returns compared to the stock markets when examined over long time periods. (For more on getting into bonds, see the Bond Basics Tutorial.)

Mutual Funds
By the close of the 1990s, the portion of American households holding mutual funds had increased astronomically, from a mere 6% in 1979 to 37% in 1997. Why the dramatic upswing? Mutual funds are an appealing method for individual investors to participate in the outcomes of a large basket of stocks. The money pooled by mutual funds is invested by professional money managers across multiple industries or sectors, and their increased size allows mutual funds to often become active participants in the courses of action their investments take. Mutual fund investors, in turn, are somewhat sheltered from the natural chaos of the stock market through diversification. Returns in equity (stock)-based mutual funds have historically been solid, if not spectacular. Investing in mutual funds removes the need for fundamental security analysis, but asset allocation and sector diversification knowledge will aid investors in maximizing returns for a given level of risk. (For more on this topics, read out Special Feature on Mutual Funds.)

Index Investing
Many private investors are unable to beat the "broad market" as defined by indexes like the Standard & Poor's 500 Index, and consequently believe that simply buying the whole index to be a safer and easier route. Their logic is sound, but investors must also bear in mind that indexes by their nature are susceptible to market fluctuations.

Still, a smaller investor with limited time and capital can achieve a higher degree of sector or market diversification by buying indexes than they could possibly achieve by buying individual stocks. Fortunately for private investors wishing to invest in indexes, there are two simple and low-cost choices: index mutual funds and exchange-traded funds. Both offer low expense ratios and have high trading volumes, allowing for maximum liquidity. Index investing requires little analytical skill. (For more insight, see Index Investing.)

Cash or Spot Market
Investing in the cash or, "spot", market is highly sophisticated, with opportunities for both big losses and big gains. In the cash market, goods are sold for cash and are delivered immediately. By the same token, contracts bought and sold on the spot market are immediately effective. Prices are settled in cash "on the spot" at current market prices. This is notably different from other markets, in which trades are determined at forward prices.

The cash market is complex and delicate, and generally not suitable for inexperienced traders. The cash markets tend to be dominated by so-called institutional market players such as hedge funds, limited partnerships and corporate investors. The very nature of the products traded requires access to far-reaching, detailed information and a high level of macroeconomic analysis and trading skills.

Despite this, an increasing number of private investors are drawn to the massive leverage available and the profit potential. Ironically, it is this high leverage and corresponding high risk that wipes out many new entrants. Professional investors generally do not trade fully leveraged; rather, they operate under disciplined money management rules. It is vital that any private investor wishing to trade within these markets take the time to gain experience and understanding of the market before risking his or her capital. A viable alternative for investors wishing to partake in these opportunities is to invest in a managed account run by an experienced professional. (For more insight, see Hedge Fund Failures Illuminate Leverage Pitfalls.)

Derivatives Markets
The derivative is named so for a reason: its value is derived from its underlying asset or assets. A derivative is a contract, but in this case the contract price is determined by the market price of the core asset. If that sounds complicated, it's because it is. The derivatives market adds yet another layer of complexity and is therefore not ideal for inexperienced traders looking to speculate. However, it can be used quite effectively as part of a risk management program. (To get to know derivatives, read The Barnyard Basics Of Derivatives.)

Leverage can be found in these markets as well, so the chance for  high reward attracts individual investor interest; however many would do better to invest in professionally managed accounts or funds. Complex derivative investing requires a high degree of analytical and mathematical skill as well as a broad macroeconomic understanding.

Examples of common derivatives are forwards, futures, options, swaps and contracts-for-difference (CFDs). Not only are these instruments complex but so too are the strategies deployed by this market's participants.

There have been some spectacular and highly publicized institutional losses in the derivatives market. American political and regulatory bodies have demonstrated their concern about the exploitation of derivative instruments - and, as a result, the exploitation of investors.

There are also many derivatives, structured products and collateralized obligations available, mainly in the over-the-counter (non-exchange) market, that professional investors, institutions and hedge fund managers utilize to varying degrees but play an insignificant role in private investing.

Conclusion
A private investor's foray into various markets is a delicate process, with multiple options and multiple chances for error. Each available market - even those dominated by  individual traders/investors - requires specific information and thorough comprehension of the market's engine. The newfound electronic availability of previously exclusive markets only makes research that much more important; perhaps the single biggest indicator of an investor's potential success is the choice of the most suitable market for his or her skills.