A Short Guide to the World of Financial Investments. Part Two
An Introduction to the Fundamentals of Investing for Isaac Newton and Other Geniuses
What It Is, Why You Should Do It and Where To Start
In the first part of this short guide we looked at why investing in financial instruments is necessary in principle. Now we will focus on the underlying principles of investing. We will also talk about financial instruments that are available to non-professional investors. Why is it important to know? It is important to know in order to avoid the situation Isaac Newton, one of the greatest scientists of all times found himself in some 300 years ago. Almost everyone knows that he laid the foundations of modern physics and mathematics. Though only a small circle of economic history buffs knows the fact that for many years he served as Warden and Master of the Royal Mint and was directly linked to the world of finance. In that position he had a long and successful career. As for his results as a private investor, however, the situation was not so straightforward.
In general, he was a prudent and savvy investor who initially invested in a diverse portfolio of stocks and government bonds. Gradually he was able to increase his fortune to 32,000 pounds (4.4 million pounds in today’s money) [1]. However, in the early 18th century England was experiencing a financial fever associated with the activities of the South Sea Company. The discoveries of European explorers and the opportunities to get rich quick were stirring the minds of everyone — from peasants to lords — including Isaac Newton, who broke his own rules and made large investments in the shares of this 18th century NFT.
At first, events were developing fantastically well and unnaturally speedy: the company’s stock price rose from 128 pounds in January 1720 to 1,000 pounds in August. But then events began to develop astonishingly badly and breathtakingly fast: by the end of September 1720 the stock price had fallen back to 150 pounds and on September 24 the bank associated with the company declared itself bankrupt. Historians’ estimates vary, but it is likely that Isaac Newton could have lost up to 20,000 pounds (3.54 million pounds in today’s terms). He certainly did not die a poor man. But under the influence of this roller coaster ride he could really say the phrase so frequently attributed to him: “I can predict the movement of heavenly bodies, but not the madness of crowds”. This is not surprising: the world of economics and finance is built not only on mathematical formulas and equations, but is also influenced by human psychology.
So why do financial markets matter if everything may end so badly? They matter because investing in financial market instruments can be both dangerous and beneficial. There is nothing new in this statement: taking medications strictly in accordance with the instructions is useful, while their overdose can be disastrous.
How can financial market investments be beneficial? Let’s take a look at the situation faced by an ordinary citizen who wants to preserve what he/she has accumulated or inherited. He/she can buy a house, a unit in a garage cooperative, or, say, establish a small company if he/she is a self-employed person. He/she can also place money into a deposit account or lend it to his/her relatives or friends. He/she can purchase precious metals, precious stones, or jewelry too. Alternatively, one can invest in antiques and collectibles or just buy scrap metal for storage in the that garage mentioned above. In general, the accumulation of real assets was exactly the approach humanity has used for most of its history because financial markets, in the modern sense of the word, have existed only for about 400 years.
So, what is the role of financial markets? The thing is that by investing all your wealth in real assets only you expose yourself to a fairly high risk. For example, most people have the bulk of their wealth stored as an investment in their apartment or house. This implies that your future financial well-being depends, in fact, on what happens to your place of residence. In addition, if you need financial resources, the process of selling your property can take quite some time and be rather costly. The same can be said about the sale of your unit in a garage cooperative, the sale of your company or the cost of storing jewelry, antiques and even scrap metal.
Financial market instruments provide you with the opportunity to make your savings more diversified and more liquid. Diversification means that you can invest your funds not just in one asset (type of property), but “spread” them across a variety of assets. Liquidity means the speed at which you can buy or sell an asset. In other words, this is the speed of turning your cash into some asset or turning your asset into hard cash. The more “spread” (diversified) your funds are across different assets and the higher the ability to buy or sell them quickly and cheaply (liquidity), the lower the degree of your risk. You can achieve diversification because financial market instruments provide you with the opportunity to acquire very small, uniform fractions (shares) of any assets. You can achieve liquidity because these small, uniform fractions (shares) of assets are traded on special financial trading platforms that are regulated by the government in most cases.
What types of uniform shares of assets are traded on these financial platforms? There you can find shares of almost all types of real assets that we discussed earlier. The real estate industry is represented by shares of real estate investment trusts or REITs that allow their buyers to become the owners of both residential and commercial real estate. You can also purchase shares of funds that invest in physical precious metals or other types of industrial, agricultural or energy commodities. You can certainly buy shares of alternative or exotic assets, for example, crypto assets. Still, the most important asset classes are stocks and bonds.
Stocks give their buyers the opportunity to become the owners or shareholders of a company. In other words, they are an investment in the capital of the company that issued these stocks. In this regard, they are identical to a unit (or a share) in a garage cooperative or shares in your own company (LLC). However, stocks, most often, are traded on trading platforms called exchanges. That is why they can be bought or sold rather quickly and relatively cheaply, unlike your unit in a garage cooperative or your non-traded shares in a small company (LLC).
The purchase of bonds provides their owner with the opportunity to become the creditor of a company. In other words, bonds are loans traded in the financial markets. In this regard, they are identical to your bank deposits or loans made to relatives and friends. In most cases, bonds can also be sold relatively quickly and cheaply, unlike your deposits or loans to family members and friends.
Having said that, we can say (see Picture 1 below) that a shareholder faces a higher risk of losing his/her investment, but also has greater rights to participate in the distribution of profits. On the other hand, a bondholder has a lower risk of losing his investment, since creditors, compared to shareholders, have greater legal rights to the company’s funds in the event of its liquidation. However, they also have less rights to participate in the distribution of the company’s profits. That is, as it usually happens in life, we are faced with the need to make a choice: a potentially higher return on investment is associated with a higher risk of losing this investment, and vice versa. As you know, there is no such thing as a free lunch. In financial theory this is called a trade-off between risk and return.
Nonetheless, miracles still happen from time to time. One of these miracles is the fact that by pursuing a reasonable diversification strategy it is possible to reduce the level of your risk while maintaining the same level of return (see Picture 2 below). Tools for achieving such diversification, for example, exchange-traded funds or ETFs, are widely available and we will discuss them in one of the following articles.
Thus, we have found out that modern financial markets provide non-professional investors with access to a wide range of financial instruments. But how is the value of a stock, bond, or a REIT determined? We will discuss it in the next part of this guide. However, the basic principle is quite simple. As the American investor, professor and writer Joel Greenblatt put it: “The secret of investing is to figure out the value of something — and then pay a lot less.”
References:
[1] “Isaac Newton Learned About the Financial Gravity the Hard Way”, Jason Zweig, The Intelligent Investor, The Wall Street Journal, 8 November 2017.