For anyone new to investing it can take a moment to get your bearings, but, its important to cut through the finance jargon before putting together any sort of investing strategy.
An important early step is to begin to understand the different types of investments one can make.
So, collectively, the type of investments that we’re about to look at are referred to as ‘securities’.
In finance, the term 'securities' encompasses a wide range of financial instruments, including stocks, bonds, options, futures, and other tradable financial assets.
Each type of security carries different risks and rewards, making them suitable for different investor types and investment strategies.
Generally speaking, securities comprise a set of financial instruments that represent an ownership position, a creditor relationship, or some other legally defined right to an asset or debt.
Securities can be bought, sold, or traded on financial markets. These are the basis for practically all formalised investing, from a financial services point of view.
Notably, you’ll see that cryptocurrencies and digital assets are not mentioned in the list above. That is because their definition and status are currently very much up for debate – whether or not they’re classified as securities will in the near future have significant ramifications in terms of regulation and taxation, but, we’re getting ahead of ourselves.
Here, we'll explore the differences between debt instruments, equities, and derivatives.
We’ll shed light on why certain investors may favour each and discuss their suitability for beginners and inexperienced investors.
Bonds (debt investing):
Debt instruments, commonly referred to as bonds, are fixed-income investments where investors lend money to an entity (typically a company or government) for a predetermined period.
In return, the bond investors receive interest payments at fixed intervals and are owed the principal investment back upon maturity.
There are a number of different types of bonds, depending upon who the funds are being lent to, these are government bonds (in the UK known as ‘gilts’), municipal bonds (like a government bond, but issued by a local or regional authority rather than a state), and corporate bonds (which are issued by companies).
Traditionally, bonds are favoured by conservative investors due to their relatively lower risk compared to equities.
They provide a steady stream of income and a higher level of capital preservation.
But, ordinarily, their returns are usually lower than equities, and they can be susceptible to interest rate fluctuations and inflation risk.
Higher return bond investment strategies exist, where investors buy riskier debt (sometimes called ‘junk bonds’) where the bonds may be priced lower than the debt’s face value or where the issuer is prepared to pay higher interest rates.
Nevertheless, as demonstrated in the recent collapse of the Silicon Valley Bank, bond investing is only as ‘safe’ as institutional risk management can be ‘reliable’.
Stocks and shares (equities):
Equity, more commonly known as shares or stocks, represents ownership in a company.
By purchasing equity (a share or shares) in a company, investors gain a proportional stake in the company's assets and earnings.
As a shareholder, an investor can make money from equities through capital appreciation, if the stock price goes up.
An investor also sees returns from dividend payments, if the company is profitable enough to pay them to shareholders.
Equities, theoretically, can offer higher returns than bonds (on the basis that the upside to an equity price is ‘uncapped’ whereas bonds return a fixed interest and a defined principal repayment).
But, holding shares also comes with a higher level of risk compared to bonds. This is a point that’s generally true, but, is also explicitly defined when a company goes bust – as creditors, bondholders will receive monies from administrators long before anything is left for those holding equity.
Moreover, the performance of bonds are more tangibly linked to a company’s current financial situation - so long as it remains liquid and can repay its debt – whereas equity valuations can be swayed by a much broader set of stimuli.
Share prices are influenced by many factors, some as abstract and ethereal as market sentiment, or as rooted in the real world as financial performance, future forecasting, and a plethora of special circumstances.
Some investors prefer equities for the supposed long-term growth potential, and, importantly they are typically preferred in an inflationary environment (unlike bonds, given that the underlying value of the loan principal erodes with inflation).
Nonetheless, it remains that equities are more suitable for investors with a higher risk tolerances and longer-term investment horizons.
Derivatives (Options, CFDs, and Futures):
Derivatives are much more exotic in comparison to either debt or equity.
This would be the so-called casino of the financial markets.
Here, often complex financial instruments are constructed to represent the value of underlying assets.
At their most exotic, they may essentially be represented a set of bets upon future financial events.
In the broadest and simple description, meanwhile, they are instruments that derive a value from other underlying assets like stocks, bonds, commodities, or currencies.
Among the most common types of derivatives are options, contracts for difference (CFDs), and futures contracts.
Options: these instruments give investors the right, but not the obligation, to buy or sell an underlying asset at a specific price before a predetermined date.
CFD: These instruments are contracted agreements between two parties to exchange the difference in the value of an asset, from the opening and closing of the contract.
Futures: Like CFDs, these are contracts, though futures are standardized and are available only in predetermined markets and are operated on organised exchanges. Basically, futures contracts allow investors to buy or sell a specific amount of a specific asset at a predetermined price on a set date in the future.
In the textbook definition of derivatives, it will explain that they exist to allow sophisticated and professional investors to hedge their portfolios.
It also will say, in the case of commodity markets, that they allow producers to balance and hedge their inventory, thus providing greater financial planning and stability for those industrial customers.
On the more exotic side, meanwhile, derivative trading creates a market in which professional (and even ‘hardy’ private investors) to speculate on price movements and/or access leverage (borrowing money to invest).
For good reason, derivatives are deemed to be much higher risk. They can result in investors losing more money than their initial ‘stake’ in the trading position, and, due to their complexity, they are not at all suitable for beginners or inexperienced investors.
What have we learnt?
Well, there’s a lot to digest.
There are several types of security, and, within each category there are many separate strategies and considerations.
Each type of security offers different risk and return profiles, making them suitable for different investor types.
Debt instruments, such as bonds, offer comparatively lower risks and steady income, while equities can provide higher growth but with higher risk.
Derivatives are more complex and yet more risky, making them less suitable for inexperienced investors.
Its essential that new investors consider their investment goals and their tolerance for risk, when considering which securities they include in their investment strategies.