The Financial System Explained

Financial markets play a critical role in the economy. As the blood for the human body, the Financial markets are responsible for the flow of capital from Savers/Investors that have surplus funds to the Borrowers/Spenders that actually need capital in order to expand, develop or even survive. This transaction might happen in two ways, Directly and Indirectly. There are a number of different types of financial institutions within the Financial System sitting between the lender and the borrower all serving a different purpose. Examples for some include Brokerage Firms and Agencies, Banks, Insurance companies, Pension Funds, Investment Firms, Credit Agencies, Exchanges and other. 

The Financial Markets can be divided into Money Markets and Capital Markets. For now, it is only important to remember that the Money Markers are liquid markets as they facilitate the transactions of short-term securities, usually maturing within less than a year. The Capital Markets, however, imply a long term investment. Companies Shares, for example, are traded on the Capital Markets. Now you can distinguish between both when reading the news. 

Real Assets vs Financial Assets

It is essential for you to understand the difference between Real and Financial Assets. When for example talking about the Gross Domestic Product (GDP) as a measure of economic development, we talk about all goods and services produced in the economy for a certain period of time. The Real Assets are actually the assets used for this production. Real Assets include Land, Buildings, Inventory, Equipment, Human Knowledge, etc. The Financial Assets, in contrast, are nothing more than Claims of Ownership on the Real Assets (or on the income to be generated by the Real Assets in the future). Shares and Bonds, for example, are Financial Assets and are used to determine the distribution of capital generated by Real Assets amongst the investors. You might not be able to buy a factory and start producing iPhone like devices but you could buy shares of Apple and become part of the owners of the company or buy a Corporate Bond and be part of the lenders. Either way, after this transaction you would have the legal right over a fraction of the income generated by the company’s Real Assets. When having a surplus income, it’s your decision to spend it or invest it for the future by buying Financial Assets. I would personally prefer the second option. 

When learning about investing, you will mainly deal with Financial Assets. There are many people nowadays skipping the fundamentals and forgetting that the performance of the Financial Assets is connected to the performance of Real Assets. There will be, however, a dedicated article here about the Behavioural aspect of the Financial Markets and how the mood of the investors affects the economy.

Asset Classes

There are different types of Financial Assets with different characteristics.

Debt

Debt Securities or so-called Fixed income securities give the holder a fixed income in the form of interest in addition to the initial principal amount (the initially invested capital). They are considered to be one of the safest ways to invest your money, however, usually, you cannot expect big returns which is absolutely in line with the Risk-Return tradeoff. If you buy a corporate bond, for example, the company would pay you the interest before distributing profit (if any) as a dividend payments to the shareholders. Another advantage is that your income will not fluctuate influenced by the company’s performance as opposed to if you were investing in shares. 

There is a vast selection of Debt Securities, ranging from very safe as the Government Bonds to a “Junk” Corporate Bonds which are considered very risky. 

Equity

Equity or Common Stocks are a form of ownership of the company. There are two different ways to profit from investing in shares. The first one is buying a stock and assuming that the share price will go up in value and then sell it for profit i.e. Capital Gain. The other way is through Dividend payments. If the performance of the company’s Real Assets is good, then after paying all the expenses, the management has two options. First is to re-invest the profit back in the company and the second is to distribute the profit to the shareholders in the form of Dividends. As you can see, the dividend payments are not guaranteed and the management might stop paying them at any time if they decide that the company needs financial support when going through uncertain times (exactly as we are witnessing at the time of writing this article due to the Coronavirus situation). As opposed to investing in bonds, investing in shares is considered to be riskier but at the same time with a higher expected return, mainly due to the bigger fluctuations in the stock prices. Every business hides risks and by investing in stocks and gaining ownership in the company you get all the related risks and returns up to the amount of your investment. 

Derivatives

Derivatives are financial instruments, the value of which is derived (hence the name) from the value of an underlying asset such as stock, bond, or commodity. Derivatives are used in hedging strategies for reducing risk exposure as well as speculation. The most common derivatives are Options and Futures. This is where the world of Financial Markets gets complicated (and interesting) but nothing to worry about, as we are going to cover those in a separate post. 

Indexes & ETFs

Indexes and ETFs are not exactly separate asset class but I include them as both are very important for you to understand and be able to use. 

Index, simply put, is a basket of stocks from a particular sector of the economy or mixed, which gives us an overall view of the performance of this market. As an example take S&P 500, Russell 2000, DJIA (Dow Jones Industrial Average), FTSE 100, FTSE 250, etc. All of these are baskets of companies, representing the overall performance of the companies included in the index. Dow, for example, represents the performance of 30 big US companies. S&P 500 is considered to be a good representation of the overall US market as it includes 500 of the biggest companies in the US. In the UK we have FTSE 100 and FTSE 250, including the 100 biggest and the 250 mid-sized companies respectively. Both give us a very good overview of the mood in the Financial markets and the current state of the economy. 

For everyone who wants to invest and does not know where to start, investing in indexes is probably the best option that gives you well-diversified exposure to the market. 

So far so good, but how can you invest in an index?

There are a few different ways you can gain exposure to an index. You could use Derivatives, Index Tracking Mutual Funds or Exchange Traded Funds (ETFs). 

The Chicago Mercantile Exchange (CME) offers Futures contracts tracking the value of the index and the Chicago Board Options Exchange (CBOE) offers options on indexes as well as on ETFs. These, however, are, as we mentioned, more complicated methods and not easily accessible for regular investors like you and me.

The simplest and easiest way to invest in an index is through an Index tracking Mutual Fund or an Index tracking Exchange Traded Fund (ETF).

Mutual Fund

is simply a pool of investor’s money, invested in different financial assets. In the case with Tracking Funds, the investments are made in such a way, that enables the fund to track the performance of the index.

ETFs

While with Mutual funds you invest your money in the fund and then the fund use it to invest in stocks, ETFs again invest in a basket of stocks, but they (the ETFs) are traded on the exchanges just like regular stocks. Essentially, Instead of leaving your money in a pool as with the Mutual funds, you buy ETFs the same way you would buy a regular share and that gives you indirect exposure to the performance of the underlying assets the Exchange Traded Fund tracks. 

(As an example you could check SPY which is an ETF tracking S&P 500 index). 

Some good places to start looking for Mutual Funds and ETFs include but not limited to: 

Vanguard

Hargreaves Lansdown

Charles Schwab

Barclays

… and others…

Final Thoughts

I know this all might be confusing but in reality, it all makes sense. Take your time and re-read it if needed. Also, any question you might have, please ask them in the comments below. Remember Finance and Financial Markets affect all of us one way or the other. You will make yourself a big favour, if you try to understand them. 

The sole purpose of this website is to help you make better and informed decisions with your money and spread knowledge. 

Stay tuned for what’s to come from the Investment series.