INVESTING IN FINANCIAL MARKETS

INTRODUCTION

There is a moment in every human’s life when he thinks that why not invest in the financial market but then he thinks that it’s not his cup of tea as he doesn’t know how to go about it. In today’s world, there are so many consultancies firms, dealing with such kinds of problems in return for a payment. So, for people to understand it better, there are few basic things that I think everyone should know about them before stepping into the financial market.

SECURITY AND PORTFOLIO

Security is a financial asset that contains an economic value, which can be purchased and traded by an individual, group of individuals with an expectation (check out my previous article on expectations to know more about it) that it will provide future benefits to them. There are different types of securities available in the market but we keep our focus mainly on Equity(stocks) and Debt(bonds).

A portfolio is a collection of a wide range of securities owned by an individual or a group of individuals.

RETURN AND RISK

Our discussion starts with one big question: Why people want to invest in the financial market? People invest in the stock market to gain money like buying today at a low price and selling tomorrow at a high price. But this gain is not certain as it will happen in the future, so for that people form expectations about the gains at the time of purchasing securities i.e., Return = (Selling price - Purchasing price)/Purchasing price.

People not only want these expected returns to be as high as possible but also want them to be more certain as possible. What if someone is expecting to get the twenty percent return on the purchased security but end up with only two percent return, so there is a deviation of about negative eighteen percent, which is considered as a Risk. But securities with high expected returns come with high risks while securities with low expected returns come with low risks. To solve such risks or uncertainty problems, one should consider investing in the portfolio or one should diversify by purchasing more than one security. This approach was developed by a very famous economist “Harry Max Markowitz” in his work popularly known as “Modern Portfolio Theory”.

DIVERSIFICATION

It involves purchasing more than one security and create a portfolio to get high returns and low risks simultaneously. Portfolio risk consists of two risk-

Market Risk: It represents those economy-wide factors that are out of our control like inflation, government spending, interest rates, etc, which can affect our portfolio’s return and risk. Diversification can’t reduce the market risk, it just led to an averaging of market risk. As when prospects for the economy turn sour (or rosy), most securities will fall (or rise) in price, regardless of the amount of diversification in the portfolio.

Unique Risk: For this to understand, let me give you an example, suppose you made a portfolio of hundred securities of different companies and due to some unexpected bad events in the few companies, the price of some securities goes down while due to some unexpected good events in the few companies, the price of some securities goes up. Hence, on average there is a little expected risk or deviation on the return of a well-diversified portfolio. Hence, diversification can substantially reduce unique risk.

RISK-FREE SECURITY

To reduce portfolio risk, sometimes people consider investing in risk-free securities or adding risk-free security in the portfolio. The return on risk-free security is fixed as investors at the time of purchasing security know the exact amount they will get at the time of maturity. In other words, it can be called “fixed income securities”. Since corporate securities have some chances of default, the risk-free securities are issued by the government. For example Treasury Bonds.

One thing to note here is that not all bonds issued by the government are riskfree but only those bonds whose maturities match with the time for which investors wants to keep or hold the securities, like if an investor wants to hold the security for one year, then only securities maturing in one year will do the job i.e., the maturity period is equal to the holding period. Otherwise, there will be the chances of interest-rate risk and reinvestment risk.

CONCLUSION

Investors should consider the expected returns and deviations (risk) of the securities before investing in them. One best way to reduce such risks is to develop a portfolio consisting of various securities after checking the covariances between each security as diversification helps in reducing the unique risk of a portfolio. Moreover, one can include risk-free security in the portfolio to make it more risk-free. After knowing all the above basic things, now I think people can make some wise decisions about how to go after investing in the financial market.

LINKS:

Modern Portfolio Theory by Harry Max Markowitz https://www.investopedia.com/terms/m/modernportfoliotheory.asp