Financial Markets for Dummies: 6 Important Things You Should Know Before Investing
As we all know, finance is a very diverse and deep field of knowledge — one cannot learn about it overnight (trust me, I tried). With the pandemic going around, reality just hits hard. Financial literacy can really prepare you for unexpected events like this one.
The first step to achieving financial literacy (and later on, financial independence) is learning about personal finance. From visualizing your financial goal, to employing budgeting hacks and saving tips, we got you covered! If you haven’t read it yet, check out our first article on personal finance! [Read: Adulting Hacks 101: A Student’s Guide to Personal Finance]
As mentioned in the earlier article, one must invest as early as possible to maximize returns in the future. Scary yet exciting right? If you haven’t started out, fret not because we will guide you on your finance journey.
First things first, ready your money. [Okay, now what?] Now, let’s talk about where you can place and grow your cha-chings. Typical options would be placing your money in a bank and earning a teensy-bit of interest (don’t forget to subtract the withholding tax), or saving it in your cute old piggy bank [Eh, sounds boring].
Before anything else, it’s important to understand the concept of inflation. With the rising prices of basket goods and selected services, the value of your money decreases. Remember the good ol’ year (around 2012) when regular McDonald’s french fries cost only Php 25? Now, you need Php 37 to buy it. This means your purchasing power decreases, and the value of the money you hold is not as much as it was before. By just hiding your money in a savings account or in a piggy bank, you let inflation eat it up. However, by investing your money, you’re able to counter the effect of inflation and much better, earn extra! Now, you can eat more french fries!
To make the best financial decisions, you have to expand your options and choose the best one out there. For aspiring investors and finance savvy people, learning about financial markets is a good place to start.
- What exactly is a financial market, and why is there a need for one?
To put it straight, a financial market is a place (both virtual and physical) where people trade securities. Its main role is to connect lender-savers (people who have excess money) and borrower-spenders (people who need money). This way, both parties may utilize the idle fund efficiently. Wow, sounds easy right?
In this article, let’s assume that you are the lender-saver, the investor. Lender-savers can generally earn money through three ways: (1) from interest when you purchase bonds, (2) from dividends when you purchase stocks, and (3) from fluctuations in market value when you trade securities.
Through following our budgeting tips and saving hacks, you may save enough money for yourself and have an extra fund. You may grow this idle fund by investing it and helping out borrower-spenders. [How do I grow my extra fund by lending it?] In exchange for the extra fund you lend, the borrower-spenders may pay you interest periodically, or give you a part of their income through dividends. Aww, how grateful!
Now, you have to know, there are two ways of financing borrower-spenders. The first one is by purchasing securities directly from them (the borrower-spenders) which we call Direct Financing. An example of this is when you purchase a treasury bond (government-issued) from the Bureau of the Treasury. The second one is through Indirect Financing, wherein you commission a financial intermediary to manage and invest your money for you. An example of this is when you invest in financial products offered by banks like mutual funds and equity funds. [What happens to my money?] The banks lend your money to borrower-spenders in the form of a loan, and help them achieve their financial goals like starting a business or buying a house. Time to phone your local banks and check out different financial products tailored just for you!
2. What are securities?
As of now, you might be wondering what securities are (no, they’re not guards stationed at the entrances of buildings). Well, they are defined as negotiable financial instruments that hold some type of monetary value. In simple words, securities are the exchangeable items you buy and sell in the financial market. They are claims on a borrower-spenders future income or assets and come in the form of a stock or a bond. This means, you are legally entitled to their future money or other properties since they owe you.
There are many kinds of financial markets selling different types of securities. Each one of them has their own specs, their pros and cons. Now, buckle up as I tour you around the common classifications of financial markets.
3. What is the difference between the money and capital market?
The first classification: the money and the capital market — is based on tenure and maturity. These two big words refer to how long lender-savers plan to hold a security. It’s basically the duration of investing, the life expectancy of a security. For example, a standard treasury bill (T-bill) matures in 45 days. This means, you get your money back, plus your earnings at the end of 45 days. The money market is where you can buy and trade short-term securities like T-bills. These short-term securities are held for a maximum of one year. Due to its duration, short-term securities have less price fluctuations with low returns. Other examples of short-term securities are certificates of deposits and commercial papers.
On the other hand, the capital market is where you can buy and trade long-term securities. As the name suggests, long-term securities take more than a year to mature and experience more price fluctuations due to changes over time. In fact, one may reach five years, ten years, or even 100 years (woah, real story). Common examples of long-term securities are bonds, stocks, mutual funds, real estates and many more.
4. What is the difference between the debt market and equity market?
Breathe in, we’re halfway there! Under the capital market, we have a subclassification based on the types of long-term securities issued and traded in these markets. Here, we have the debt and the equity market. The debt market, also known as bond market, is where fixed income securities are issued by firms and governments. Through this market, borrower-spenders loan money from the lender-savers. They issue bonds (fixed income securities) signifying their indebtedness to you. [Hmm, why do they call it fixed income?] Bonds are called fixed income securities because borrower-spenders are obliged to make fixed interest payments on a fixed schedule. This way, you know when and how much you’ll earn as a bondholder. Scared of losing your money? Worry not! Institutions that offer bonds are usually well-established and well-funded.
On the other hand, the equity market is where you buy and trade shares of stock. In this market, instead of loaning, borrower-spenders sell a portion of their ownership to lender-savers. As a stockholder, you own a percentage of the corporation proportionate to the shares you own. Popular companies that issue stocks include Jollibee Food Corporation (JFC), Petron Corporation and Ayala Land, Inc. [So, how do I earn?] One way of earning through stocks is when a corporation declares dividends. Through dividends, you get a share of the corporation’s net income. Another way of earning is through trading. This is when you sell your shares when the market price rises. Unlike the debt market, you don’t get fixed payments on a fixed schedule when investing in an equity market. It is more risky because you depend on the corporation’s performance and net income. If they don’t do well, your shares may suffer and you may not get dividends. However, if they do exceptionally good, you get higher rewards compared to fixed income investments.
6. What is the difference between the primary and secondary market?
Let’s move on to the next classification of financial markets — the primary and the secondary market. This classification is based on the issuance of securities. Starting with the primary market, this is where new stocks and bonds are sold for the first time. Here, companies launch IPOs (initial public offering) to sell their newly issued securities. On the other hand, the secondary market is where previously-issued securities are exchanged. Basically, all the trades happen here. A common example of this market is the New York Stock Exchange (NYSE). Sounds easy! [Do we have any here in the Philippines?] Here in the Philippines, we have the Philippine Stock Exchange (PSE) which is both a primary and a secondary market. You can buy newly-issued securities and trade old ones in the PSE.
Again, just to recap, you buy newly-issued securities in the primary market and trade previously-owned securities in the secondary market. Just think of National Book Store as the Primary Market and Booksale as the Secondary Market. Makes sense, right?
7. What is the difference between exchange and OTC markets?
Wow, I never knew financial markets can be classified into so many categories! Finally down to the last classification — the exchange and over-the-counter (OTC) market. Both under the secondary market, this subclassification is based on the trading location of securities. Let’s get it! An exchange market provides a centralized trading location which allows for more transparency and regulation. This means everyone gets the same standard information about the securities they trade therefore, allowing them to accurately apply economic and financial concepts. The American Stock Exchange (AMEX), NYSE, and our very own PSE are examples of exchange markets. Mostly large corporations have their stocks traded here, which we call listed stocks.
[What about the small corporations?] For small corporations, the best option is an OTC market which requires less capital and requirements. Here, trades occur despite the absence of a centralized location. Instead, they have a broker-dealer network with no access to the same standard information. This set-up has less transparency and regulation meaning everyone may trade securities at different rates. Due to this, OTC markets tend to be more competitive. Stocks traded here are called unlisted stocks. However, it is important to know that OTC markets are not popular in the Philippines.
Are you still there? I know it’s a lot of technical terms and hard definitions but don’t be scared. You’ll get a hang of it. Trust me. I’ll cut this short and let you rest (for now). The grind never stops. You’re one step closer to becoming a true investor, young learner.
Watch out for our next article as we dive deeper into risk management. Don’t forget to comment below if you have any additional must-know facts, insights, or questions.
Adios, fellow student. Level up your investment plan with UP JFA’s Pisopedia. See you next Saturday! 💚