1.3 Financial Products

Before diving into the different financial products available, you need to understand what an investment is. An investment is an exchange of money for an asset that is expected to generate income or increase in value, or both. The asset can be either physical or non-physical. Physical assets are often referred to as tangible, whereas non-physical assets are referred to as intangible or financial. Examples of physical assets include land, houses, vehicles, buildings, machinery, precious metals, and art collectibles. Examples of non-physical financial assets include bank deposits, bonds, and stocks. A collection of these assets is referred to as a portfolio. The most important thing to understand about investments is that risk and return go together. Generally speaking, the riskier the investment, the higher the expected return. However, the riskier the investment the greater the likelihood of financial loss. Investors must constantly battle with this trade-off. The main source of risk on an investment is the uncertainty in the outcome, which is the main differentiator among the following financial products.

Debt versus Equity

The two main investment categories are debt and equity. Debt is a form of “IOU” through which a borrower promises to pay back a lender the principal amount borrowed plus interest. Most individuals and companies cannot afford to buy everything they need or want. Suppose you want to buy a new Jeep Wrangler that costs $50,000. The cost of this car most likely exceeds the amount that you have saved. You must then find someone that is willing to lend you the difference between what you have accumulated in savings and the remaining cost of the car. However, the money that you take from the lender must be paid back in full plus interest. The lender, oftentimes a bank, is satisfied with this arrangement because it will have more money in the future than it does today. Similarly, businesses and governments (federal, state, and local) issue long-term debt products called bonds to cover expenditures. These bonds often make periodic interest payments and always return the principal amount upon expiration or maturity. While issuers view bonds as liabilities, investors view them as assets.

Equity represents ownership interest in a business or property. In order to cover costs, companies often sell ownership rights to their businesses in the form of common stock. Suppose you were the one who came up with the idea of colored pencils. To develop this idea into an actual product, you need money. Where can you obtain this money? Your family and friends are probably a good starting point. However, after you have tapped out those resources, what next? To borrow money, you need to find someone who trusts that you will pay them back, and without a proven track record this is easier said than done. Your only other option is to give up ownership rights, which means that you will no longer have claim to 100% of the business. You might bring on a partner and split the business 50-50. The more owners you bring on, or the more stock you sell, the smaller your rights become. Every individual and company that buys stock from you becomes a part owner. Therefore, stockholders want to see the business do well. Some companies give a percentage of their profits to equity owners in the form of cash or stock disbursements called dividends.

Derivatives

A derivative is a financial security that obtains its value from the price behavior of another underlying asset, like commodities, stocks, and bonds. In other words, the value of the derivative is ultimately determined by movements in the underlying asset price. The most common types of derivative products are futures and options.

A futures contract is a standardized agreement to deliver or receive an asset at some future date at a pre-specified price. Suppose you are a wheat farmer. Suppose further that wheat prices are currently $10 a bushel, but you worry that wheat prices may fall when it is time to harvest. To reduce your risk, you enter into a futures agreement with a local grocery store that promises to pay you $10 per bushel. If the price of wheat increases to $12 per bushel, then the grocery store is the net winner, as it only has to pay you $10 per bushel and can immediately turn around and sell it to customers at a higher price. If the price of wheat decreases to $8 per bushel, then you are the net winner, as you can sell your product for $10 as outlined in the contract.

An option contract gives the holder the right, but not the obligation, to buy (or sell) an asset at a future date for a pre-specified price. For example, a stock option gives the holder the right, but not the obligation, to buy (or sell) a set amount of stock for a pre-specified price on or before a set expiration date. It is important to note that the owner of the option does not have equity claim and, therefore, does not receive any dividend payments.

Funds

A fund is a pool of money that is allocated for a specific purpose. A mutual fund, as discussed previously, is professionally managed by a mutual fund company that pools money together from investors to purchase a basket of financial assets. Similarly, an exchange-traded fund (ETF) is managed by an authorized sponsor, such as a securities firm, that collects money from investors and purchases financial assets. The main difference between the two types of funds is that ETFs can be traded intra-day through your brokerage account, while mutual funds can only be purchased and sold at the end of each trading day.

There are several advantages of owning a fund. First, you are able to obtain a diversified portfolio of assets while only having to invest in one. Second, you are hiring a professional money manager who is devoted to the success of the fund. Third, you are able to invest in relatively small amounts, as it would cost a small fortune to buy all of the financial assets in the fund separately. The main disadvantage of mutual fund ownership is the fees, such as transaction fees, management fees, commission fees, and marketing fees. The expense ratio tells you the total fund cost relative to the total fund assets.