Investment Basics

Stocks, Bonds and Other Goodies

The stock market used to be separate from the average person's world. But this distinction between Wall Street and Main Street no longer exists. These days, every large city has an area housing financial companies, and most small towns have at least one brokerage office where investment advice can be sought. Individuals with enough know-how can even buy and sell shares on the Internet.

What's more, virtually every industry is involved in some way in the public capital market (the market where stocks and bonds are traded). This enormous market has one purpose -- to raise money. It is used both by the government and by private enterprise. Without the financial market our economy would have a hard time surviving.

Still, anybody who invests in the stock and bond markets takes a certain leap of faith -- that the U.S. economy will continue to grow, profits will continue to be made and capitalism is worth investing in.

A Sketch of the Financial Asset Classes:

People raise money in the capital markets the same way you would if you wanted to open an ice cream store: you'd either borrow the money and pay it back with interest, or convince somebody to invest directly in the business and share the profits with you. The first case is debt and the second is equity. If you forget everything else, remember this: bonds are debt, stocks are equity.

In the capital markets there are many lenders, debtors and investors involved, so the debt and equity have to be packaged into smaller units to make trading easier. These units -- stocks, bonds, and others -- are worth money to the person or institution that owns them, and are known as "assets." Different types of assets fall into different categories, called "asset classes."

The major financial instuments, grouped by asset class, are the following:

Trading is more efficient when the buyers and sellers know the market's "level," that is, approximately what the asset is worth. (This is based on supply and demand -- how much of it is available, and how many people want to buy it.) To keep trading efficient, most deals in public assets are done through official marketplaces where everybody knows the rules and has the latest information.

The vast majority of securities (stocks, bonds and futures) in the U.S. are traded at three sites: The New York Stock Exchange (NYSE), The American Stock Exchange (AMEX) and the National Association of Securities Dealers' Automated Quotation service, generally referred to by its acronym, NASDAQ.

The NYSE and AMEX are actual physical places, located a few blocks away from each other in New York City. They both function as "auction markets," with representatives called "specialists" organizing the buying and selling of securities by floor brokers.

NASDAQ, on the other hand, is a nationwide electronic network in which securities are traded directly between buyers and sellers, without a middleman. NASDAQ was originally conceived as an efficient way to store and display quotations on over-the-counter (OTC) securities, which are those that are not listed on the national U.S. securities exchanges. It has evolved into an organized securities market in its own right, and today is separate from the OTC market.

Staying Informed

Both the exchanges and the electronic market make it easy for traders to follow the quickly changing stock prices -- knowledge that is essential for making good deals.

Bond trading is similar. The "bond crowd" trades in a special area of the exchange. Bond traders crave news. They pay close attention to market indicators such as the indexes published by Lehman Brothers, Salomon Brothers and Merrill Lynch, as well as a range of statistics and news stories in the daily Bond Buyer newspaper and other publications.

All this means that the professionals involved in capital markets are extremely well informed. Something called the "efficient market theory" is worth mentioning here. This implies that there is no such thing as a "hot stock tip," because all publicly available knowledge about a stock is already reflected in its price. In other words, you can't earn abnormal returns simply by reading more information about a stock. There are arguments for and against this theory. But the logic is sound. Be wary of people who approach you with tips about stocks, and above all don't ever imagine you know something that the pros don't.

Wall Street is a very tough, competitive environment and if you want to be active there, you should have professionals working on your behalf. In our investment vehicles section, you'll learn how getting professionals to work on your behalf is easier than it seems.