Markets


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In broad terms, a market is any place where the sellers of a particular good or service can meet with the buyers of that good and service where there is a potential for a transaction to take place.  The buyers must have something they can offer in exchange for there to be a potential transaction.  Trade that takes place in markets forms the basis of an economy.

Brief History of Markets

Markets are almost as old as humanity itself.  As man started to evolve from a very basic form of subsistence, he started to gather more resources (e.g. food and timber) than he immediately needed.  He then learned to protect and store these resources for future use.

Storing resources meant that less of his time was spent hunting or gathering food and travelling.  This enabled him to spend time thinking of ways to improve his living conditions.  He developed tools and learned to alter the land for basic agriculture.

As various demographic groups of people created different tools and goods and stored different resources, man realised that other groups had things that he wanted.  He also quickly learned that he couldn't just take what he wanted from others without risk of attack - he had to be able to offer something in return!  This was the beginning of trade...

As groups learned they could enrich their own lives by trading things with other groups, trade became more organised.  Markets developed where people could bring their goods to be traded for other goods.  Primitive forms of money were also used (such as stones and pieces of metal) that would represent and store underlying value.

The people and groups that produced the most became the most wealthy.  Because they couldn't consume all their wealth as fast as they were creating it, they wanted a universally accepted way of storing the wealth so that they could buy things they wanted later.  This lead to the evolution of money - something that could store underlying value (wealth) and could be traded with large numbers of people.

Question
What are the three fuctions of money?

Answer
1. Medium of exchange
2. Store of value
3. Unit of account (universally accepted standard)

As people and groups developed more specialised skills and goods and had a more stable form of money, this allowed trade to evolve from simple, small markets to large scale trade over large distances.  As societies slowly evolved, the markets facilitated trade and enabled the distribution and allocation of resources in the society.  An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy.

Of course, this process was rarely without some form of conflict - fairness of trade and the balance of wealth and power caused many disputes and wars (and still does!).  There's the issue of land boundaries, communication, determining the relative value of goods, services, land etc. and of course the time delay between trading.

These issues were pondered, discussed and fought about over many, many years as man searched to refine methods of trading that would benefit himself and others.

As money became more standardised (e.g. gold and silver), political and legal systems became increasingly centralised and travel and communication became easier, then markets could become more diverse and more organised.

Through organisation and co-ordination, markets started to take on a life of their own, reflecting supply and demand pressures.  Basic markets such as small farmer markets evolved into villages, then small towns, networked by rail and roads to enable more trade.

The increase in trade led to a need for more money to keep up with the increase in goods and services being traded.  This in turn led to early forms of banking and currencies, which in turn led to the birth and evolution of financial markets for stocks (specialist organisations called companies) and commodities (standard real goods).  Money and currency markets evolved within and between nations and then prediction markets, where people could trade their predictions of future price movements of various traded entities.

What we have today are many diverse and specialised markets which are all interconnected to some degree.  As we have entered the information age, the majority of the goods and services we trade may be different from the stone age, the iron age or even the industrial age, but the markets still serve the same function - to allow buyers and sellers to exchange things.

Types of Financial Markets

A financial market is a mechanism that allows people to easily trade financial securities such as stocks and shares, bonds, commodities (e.g. precious metals or agricultural goods) and other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis.

Financial markets have evolved significantly over hundreds of years and are undergoing constant innovation to improve liquidity.  There are six main types of financial markets:

  1. Capital Markets - this includes the Stocks & Shares and Bond markets
  2. Commodity Markets - these facilitate the trading of raw and primary products such as precious metals, wheat and coffee
  3. Derivatives Markets - the market for financial instruments, whose prices are derived from the price of something else and used mainly to manage financial risk
  4. Foreign Exchange (FOREX) Markets - where banks and other official institutions facilitate the buying and selling of foreign currencies
  5. Money Markets - the global financial market for short-term borrowing and lending
  6. Insurance Markets - facilitate the redistribution of various risks

Trading on the Markets

Making money by trading and investing in the stock market requires the investor to take advantage of price movements of the underlying securities.  The majority of individuals who trade on the markets use the capital market (stocks & shares and bonds).  The other markets are mainly for professionals and financial institutions so we will not cover these in any more detail here.

The Stock Market

Success in the stock market requires traders and investors to 'buy low' and 'sell high'.  The exception to this is if they are betting on the chances of a security falling in value with futures and / or options.

To be able to do this with skill and consistency requires two main elements: fundamental analysis and technical analysis.  Fundamental analysis means researching the strength, quality and soundness of a company and estimating future profitability.  The objective is to find a good company, with good future profit projections that is currently undervalued in the market.  Technical analysis is the study of market movement, mainly with the use of charts and statistics.

When you invest in the stock market, there are 4 factors that will influence the returns you get as summarised in the diagram below:

Investment
Vehicle

Market
Direction

Market
Timing

Market
Strength

You may notice that there are two factors that are in your control and two that are not.  The investment vehicle(s) you choose and your timing in (buy) and out (sell) of the market.  Market direction and strength and not in your control as they are influenced by supply and demand forces of thousands or millions of people.  The most you can do to try and predict market direction and strength is to study trends - which areas and industries capital will be flowing to in the months and years ahead.

You will see that your success as a stock market investor is measured by your ability to choose strong investments (through fundamental analysis) and buying and selling them at the right times (technical analysis).

Investment Funds

Investment funds are collective investment schemes and usually consist of a portfolio of underlying equities  (e.g. stocks and shares) and fixed income securities (e.g. bonds).  One of the main advantages of a collective investment is the reduction in investment risk by diversification.

Example of funds are Exchange Traded Funds (ETFs), Open Ended Investment Companies (OEICs), Real Estate Investment Trusts (REITs) and Unit Trusts.

Investment funds are an attractive way of investing for people who don't have the time or inclination to learn the knowledge and skills to become a professional investor and don't want the risk of investing in individual stocks.  Most funds can also be protected by your ISA allowance which makes them an even more attractive option.

Successful fund investing requires the same ingredients as successful stocks and shares investing.  The fundamental analysis consists of researching the past (and likely future) performance of the fund manager.  Technical analysis is the study of market movement.

The Property Market

The fundamental forces that influence the price movement of securities also influence the price movement of property; these being the type of property and supply and demand in a particular area.  However, making money from investing in property requires a different set of rules from making money in the stock market.  The main ones are:

  • Investing in property almost always requires an initial deposit.  This usually ranges from 10 - 40% depending on lending criteria at that particular time.  This can be a significant sum of money depending on the value of the property.  This therefore requires investors to have ample available cash

  • If you're investing in property for long-term equity growth, you tap into a gearing effect.  This means you control the whole asset with a small (10 - 40%) deposit and therefore benefit from any equity growth of the whole asset.  The situation akin to this in the stock market is if you use borrowed money to invest and / or use options

  • Making money from buying and selling, or from buying and renting property usually requires some work doing on the property to add value e.g. modernising it.  The successful investor will be able to do this themselves and / or have a good team who can do it

  • Investors who want to rent a property (either residential or commercial) rely on finding good tenants, preferably long-term ones.  This requires research into the rental market of an area and what trends may influence demand for rental properties e.g. economic growth and employment

  • Investors who are looking to sell their properties for a profit have to understand that the property market is less liquid than the stock market i.e. it takes longer to sell the asset and to realise cash profits

  • There are ongoing costs to consider in renting out property such as possible management fees, maintenance and self funding a mortgage during vacant periods

  • You will be eligible for capital gains tax (CGT) on any profits you make when sell your holdings (after your CGT allowance).  This applies not only to property, but to stocks, shares, antiques etc.

N.B. Another often overlooked influence on the relative price of any asset is the amount of money in circulation and the availability of credit.  These factors are chiefly controlled by the central banks and commercial banks through money (credit) creation.  All growth in asset value should factor inflation into the figures.

Useful Links

>>> Learn how to open an online  trading account
>>> Learn about the Stocks & Shares Markets
>>> Learn about stocks and shares ISAs
>>> Learn about investment funds
>>> Learn about ISA Trend Investing
>>> Learn how to become a successful property investor
>>> Learn what inflation is

 

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