Oran Hall | Understand the markets before investing

QUESTION: I was encouraged to purchase a few stocks, but I have no clue of the financial market. Hence, I am seeking your assistance.

– Noel

FINANCIAL ADVISER: Although it is a good idea to participate in the financial market, which includes the bond market, the money market, and the stock market, it is best to have some knowledge of them before participating in them.

Having a knowledge of the markets and the financial instruments will help you to make better decisions – decisions that are more suitable for you and that can help you realise your goals. Even so, there is no guarantee that every decision will give favourable results.

The truth is that market conditions do change, and even your own circumstances can change. Beyond that, you can miscalculate the situation or fail to take the appropriate action because of emotional conditions like fear or greed.

Before you participate in the market, you should have an understanding of your own needs. You should understand if you need income or more capital. If you need income, your focus should be on earning interest, but dividends are also a source of income as is rent.

If you want your capital to grow, your focus should be on ordinary shares, real estate, and unit trusts and mutual funds that invest primarily in these two types of investment instruments. These very instruments can also cause you to lose some of the principal that you invest because their market price can fall. Of course, you only realise a loss when you sell.

The instruments that primarily give you income tend not to expose you to any serious loss of principal, but they tend not to give you capital gains. Let us take a look at some of the instruments and the markets where they are generally found.

The money market is for interest-bearing instruments that mature in one year or less. Investors receive the sum they invest and the interest it earns at maturity – which could be 30 days, 90 days, 180 days, or 365 days after they are issued. Their price tends not to change, so the risk of losing any of your principal is generally nil. Examples of these instruments are certificates of deposit and treasury bills issued by the Bank of Jamaica.

The bond market is for longer-term interest-bearing securities, for example, bonds. Like money market instruments, these are loans issued by the Government or corporations. When held to maturity, the investor receives the face value of the instrument. If the investor sells the instrument before the maturity date, it is possible that there could be a loss or gain on the investment.

A loss is incurred when interest rates on newer instruments increase, thus causing the price of older bonds to fall to align their returns to those of the new bonds. Bond prices increase when the interest rate on new bonds decrease.

Interest on bonds is generally paid quarterly or half-yearly, and the principal is repaid on the maturity date. Because bonds tend to have a relatively long life, the interest they pay tends to be worth less in real terms – after adjusting for inflation – over time. Similarly, although sum invested is generally what is returned to the investor, its real value is less than the value of the original investment – meaning that it is not able to buy the same amount of goods and services as the original sum.

Depending on their quality, bonds may sell readily, but it may also take time to sell them. General market conditions may also determine how readily they can trade.

Mutual funds and unit trusts are pooled investment vehicles that are managed by professional investment managers. They pool the funds of the investors to acquire a wide range of investment instruments – some wider than others. Investors buy units in the unit trusts and shares in the mutual funds and not individual instruments like stocks and bonds. The performance of your investment in these cases reflects the performance of all the instruments in the portfolio of investment instruments.

New investors often find unit trusts and mutual funds as attractive introductions to the market. They do not have to worry about the performance of individual securities and can be comforted that the gains on some instruments can compensate for the loss on others. In addition to the costs that the funds incur to buy and sell securities – like all other investors – the managers charge management fees to the funds, which, naturally, affect their value.

Stocks, also called ordinary shares or equities, may not be the best introduction to the financial market for the inexperienced. Apart from the risk of fluctuating prices, it takes time – time to do research, for example. It is generally better for investors to have an idea about the sectors of the economy that they prefer, the industries they like or expect to do well, and to have an appreciation of how the economy is doing and how it is expected to do.

Although no one – the so-called gurus included – can tell with precision what will happen in the market, prices should be expected to fluctuate. Investors need to have the capacity to handle unfavourable price movements, on the one hand, and sober headedness to avoid the temptation to yield to greed.

If you are buying stocks, be first satisfied that you have the time to invest in the activity, can manage the risk, and have some basic understanding of the market even if you are engaging the services of an adviser.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.finviser.jm@gmail.com