To continue with the outdoor market metaphor; how did the original stock market function, and what different types of investments exist?
How buying stock was like buying mangos in the beginning
Back in the early days of the stock market things were simple. Stock was a way to give money to a company you believed in. If they used that money efficiently and effectively, they produced income that allowed the company to grow, and in turn your investment.
It’s the same idea as buying a mango because you think mangos are tasty and nutritious. You believe that over time, their value will go up and be worth more than what you bought them for. How stocks were bought and sold was also very simple. Wealthy individuals showed up to the actual stock market (a physical place) and signed stock certificates, representing their investment. They could store these physical certificates in a safe place until they wanted to sell them. This is much like going to the physical market and buying your mango.
Today's (more complex) stock market
Over time, however, the market has grown far more complex. To begin with, lets focus the different types of investments available on the modern market:
Types of investments:
Stock: plain, vanilla shares of a company. They used to be denominated into whole shares (with the exception of mutual funds or ETFs), but due to fractional share trading, stocks are now more thought of in dollars. In our market example, this is simply the goods at the market.
Options: say, for instance, you believe there’s a small chance that eating mangos are going to be proven in the future to cure disease. You might want to speculate on this but not want to commit a huge amount of money to it.
Options contracts are a way to take a bet with potential high upside without having to commit a significant portion of money to it. They have a specified timeline to do this. There are many complexities to these that we may dive into at a future date.
Futures: say, in another example, you are almost positive Lebron James is going to endorse eating mangos. You may want to bet on mangos and capture as much upside as possible by committing a significant piece of your money to them. Futures contracts are an obligation to buy or sell mangos in the future that you must do within a specified period of time. If this period of time passes, you will automatically be forced to buy or sell those mangos.
Fixed income: say a vendor’s awning broke and they need to raise money to buy a new one. They may decide to issue debt. Similar to an IPO, they would engage an underwriter to determine terms on that debt.
These terms include how long the debt will be outstanding and what the terms of paying the debt back with interest will be. Say the awning is going to cost $100. The vendor may choose to enter into debt contracts with 10 different people at $10 each. The terms might be to pay 5% interest on the outstanding debt along with $1 of the original amount each year for 10 years.
Examples of fixed income investments are treasury bonds (federal debt), municipal bonds (state and local debt), corporate bonds, and certificates of deposit.
Alternative or private investments: these take place outside of the market. Imagine buying mangos on the side of the road. Because there is far less people monitoring the underlying products, they are considered much riskier.
Due to this increased risk, there is a much higher range of return for your investment. In other words, the mangos you bought could be the most delicious and nutritious you have ever had, or they could be poison. Here’s a quick breakdown of the main types:
Private Equity: think of these as the asset managers of the private investment world. They take a bunch of people’s money (typically high net worth individuals) and invest in various private companies. Basically, they go around with a big bag of cash and buy the private mango stands on the side of the road.
Private placements: often family and friends who invest privately in a company, in exchange for equity. Can also represent angel and super angel investments, aka that person that knows a good mango when they see one.
Venture Capital: a type of private equity that focuses on companies in their earlier stages. Venture capitalists are focused on finding that one street mango stand that has the best mangos in the world and helping them set up a mango factory to sell them to the masses.
Ready for part three? Head on over to the post.