how to read the financial market
1 First principles
Write about money, and you cannot entirely avoid technical terms. The simplest terms and concepts need to be dealt with at the outset. They will crop up time and again.
Fundamental to all financial markets is the idea of earning a return on money. Money has to work for its owner. Here-ignoring for the moment some of the tax complications that crop up in practice-are some of the ways it can do so:
You deposit $1,000 with a bank which pays you, say, 5 percent a year interest. In other words, your $1,000 of capital earn your $50 a year, which is the return on your money. When you want your money back you get $1,000, plus any accumulated interest, not more nor less. Provided your bank or building society does not go bust, your $1,000 of capital is not at risk, except from inflation which may reduce its purchasing power each year.
You buy gold bullion to a value of $1,000 because you think the price of gold will rise. If, say, the price of gold has risen by 20 per cent after a year, your can sell your gold for $1,200. you have made a profit or a capital gain of $200 on your capital outlay of $1,000. in other words, you have a return of 20 per cent on your money. If the price of gold fails to move, you’ve earned nothing because commodities like gold do not pay interest.
You use your $1,000 to buy securities that are traded on a stock market. Usually these will be government bonds (known as gilt-edged securities or gilts in the UK) or ordinary shares in a company. The first almost always provide an income; the second normally do. Traditional gilt-edged securities pay a fixed rate of interest. Ordinary shares in companies normally pay a dividend from the profits the company earns. If the company’s profits rise, the dividend is likely to be increased. But there is no guarantee that there will be a dividend at all. If the company makes losses or runs short of cash, it may have to cease paying a dividend.
But when you buy securities that are traded on a stock market, the return on your $1,000 is not limited to the interest or dividends you receive. The prices of these securities in the stock market will also rise and fall, and your original $1,000 investment accordingly becomes worth more or less. So you are taking the risk of capital gains or capital losses.
Suppose you buy $1,000 worth of ordinary shares which pay you an annual dividend of $30 a year on your investment. If after a year the market value of your $1,000of shares has risen to $1,070, you can sell them for a capital gain of $70. thus your overall return over the year consisted of the $30 income and the $70 capital gain: a total of $100, or a 10 per cent overall return on your original $1,000 investment.
Investors are generally prepared to accept much lower initial yield on shares than on fixed-interest stocks because they expect the income to rise in the future. Most investors in ordinary shares are seeking capital gains at least as much as income. Note that if you are buying a security, you are taking the risk that the price may fall, whether it is a government bond or a share. But with the government bond the income is at least guaranteed by the government. With the share there is a second layer of risk: the company may not earn sufficient profits or have sufficient cash to pay a dividend.
Finally, you can put the $1,000 directly to work in a business you run. Since this option does not initially involve the financial markets, we’ll ignore it.
To summarize: money can be deposited to produce an income, it can be used to buy commodities or goods which are expected to rise in value but may not, or it can be invested directly or indirectly in stock market securities which normally produce an income but show capital gains or losses as well. There are many variations on each of these themes. But keep the principles in mind and the variations fall into place.
