Creating Wealth

We talked about the different types of assets we can use for creating wealth from capital gains as opposed to creating wealth from cash-flow. We cited dividend stocks as an example where you can make capital gains if the value of the stock goes up and you can receive cash flow when it pays out dividends. Here is a thumbnail overview of some asset classes which we might use to create wealth and where you buy and sell them.

What Is A Security?
A security is anything that you can trade that has financial value. It may represent debt, such as bonds and banknotes. It may represent equity or ownership such as shares. Or it may derive its existence from a share or a commodity and take the form of a futures contract or options so it is called a ‘derivative’.

What Is A Stock?
Imagine you start a company and you need $100,000 to buy equipment and pay for employees, marketing and materials. You can only put down $10,000, leaving $90,000. You can raise $90,000 by giving 9 other people shares in your company if they put down $10,000 each. Each person owns 10% of the company. They own stocks in the company. The words stocks and shares are interchangeable.
If the value of the company goes up to $200,000, then each person’s share goes up to $20,000.
Likewise, if the value of the company goes down to $50,000, each person’s share goes down to $5,000.
In some companies, only private individuals own shares. If a company sells shares to the public, they are bought and sold in exchanges such as the New York Stock Exchange, the NASDAQ, the London Stock Exchange, Tokyo Stock Exchange and so on. American exchanges trade over 10,000 stocks. They are represented by a symbol that appears in the media and brokerage accounts such as MSFT for Microsoft or JNJ for Johnson and Johnson.

What Is A Dividend?
When a company makes a profit, it can either reinvest the profits in buying new equipment or engaging in research, or it can share some of the profits with its shareholders in the form of a dividend payment. These are often paid quarterly but a company is not obliged to pay every quarter. The advantage of paying dividends is that they attract more investors who buy the shares and increase the value of the company. If a company is going through a difficult time or wishes to grow rapidly, it may decide to reinvest all its profit and not pay a dividend. The problem with dividends is that they represent cash-flow and are taxed as ordinary income, while if you buy the stock and hold on to it for capital gains, so that you hold it for more than one year, you only pay the lower capital gains tax when you come to sell it.

What Is A Market?
Markets are places to trade securities in order to raise capital, invest capital, speculate in the hope of profit or to hedge against fluctuations in price of a commodity. The prices of the securities constantly change and the purpose of markets is to find the right price. The right price is whatever the market participants agree it is by going through the process of price discovery. Participants in the markets may buy and sell stocks, futures contracts, bonds, currencies or options after going through price discovery.

What Is Price Discovery?
Sellers ask for a certain price and buyers bid at a certain price. They finally have to meet on a price in order to make a transaction or go away empty-handed. The balance of supply and demand determines whether the actual price moves closer to the asking price or to the bid price. The price is agreed for a certain number of shares, futures contracts, bonds, currency contracts or options between a seller and buyer at that moment, and then can change as new information and new sellers and buyers enter and exit the market. This process is called price discovery.

What Is A Stock Market?
Stocks are a way for companies to raise capital so that they can invest in new equipment and research and development. Traders and investors have the capital that companies need. Markets are the place where they meet to exchange stocks and capital. Famous stock markets are the New York Stock Exchange (NYSE) or the NASDAQ.

What Is A Futures Market?
Futures markets are a way for producers and consumers of commodities to ensure that they can buy and sell commodities without wild fluctuations in the amounts they pay or earn. The same process of sellers asking and buyers bidding takes place, but a futures contract is an agreement to buy or sell in the future.

If, for example, General Mills, which makes breakfast cereals, wants to buy wheat now for a future month, then if the actual price of wheat goes up, the value of the futures contract also goes up by the same amount, so that the profit from the futures contract offsets the loss from having to pay a higher price than before. This is called hedging. People who put down money to sell the wheat futures contract to General Mills are called speculators because they are not seeking to actually buy and take delivery of the commodity or sell it and actually deliver it.

Similarly, a farmer may sell wheat now for a future month, so if the price of wheat goes down, the value of the futures contract goes up by the same amount that the value of the actual wheat goes down because its price has declined. Again, speculators put down money to buy the futures contract from the farmer.
The Chicago Board Of Trade is famous for futures trading.

Other Markets
Bonds are another way for companies and governments, local, state and federal to raise money.
Currencies are outside the scope of this text.

What Is A Stock Index?
Many investors need a way to measure the performance of all stocks day-to-day without looking at the large number of individual stocks that change hands every day in a particular sector of the economy or the economy as a whole. A stock index combines the prices of several stocks into a single number. It is a calculation of what one share of all the component shares would be worth if they were combined into a single entity.

You might also think of an index as something you can trade (an ‘instrument’) which derives its values from actual shares or other instruments.

An index might be ‘weighted’ so that it takes both the price of an individual share and the size of the underlying company relative to other companies in the index into account, or it might simply be based on the share price alone.
For example, the Standard and Poors (S&P 500) reflects the combined performance of stocks of 500 of the top companies in the United States. Many large nations have an index that reflects their stock market. Japan has the Nikkei 225 and Britain has the FTSE 100.

What Is An ETF?
An Exchange Traded Fund (ETF) is a way of trading or investing in a particular sector of the economy or strategy without needing to pick out individual shares and buy or sell each of them in order to trade or invest in your idea. They are indexes of a set of stocks, stock indexes, commodities or bonds which have some feature in common.
For example, the Standard and Poor’s Depository Receipts (SPDR or ‘spider’) funds are a family of ETFs. The fund related to the S&P 500 stock index is an ETF that tracks the S&P 500 stock index. There are other EFTS that track the Dow Jones index and the Nasdaq. There is also a SPDR fund that tracks gold. ETFs are convenient and accessible because they have these advantages:

Flexibility – you can buy and sell them during the trading day just like any stock and you can use the same types of orders as stocks
Diversification – you can trade or invest in different sectors of the economy for relatively small amounts of money because you do not have to buy individual stocks
Tax efficiency and low cost compared with mutual funds.

They are represented by symbols, just like regular stocks. For example, SPY is the symbol for the S&P 500 ETF.

What Kinds Of ETFs Are There?
Index ETFs - most ETFs are index funds such as the S&P, Dow Jones and Nasdaq related ETFs. Other examples are the Market Vectors Gold Miners index or the iShares Dow Jones US Home Construction Index Fund.
Commodity ETFs – these invest in commodities such as gold, silver, energy and agriculture. However, they may not necessarily track the underlying commodity with complete accuracy because they may use futures contracts and other derivatives.
Currency ETFs – these invest in foreign currencies and reflect the rise and fall in value of that currency, usually in relation to the US dollar.
Bond ETFs – these invest in bonds.
Leveraged ETFs – these are designed to be more sensitive to market movements than simple indexes so they are designed to amplify any movement up or down. They might attempt to achieve two or three times the return you get if you hold a regular stock index when the market goes up or down. For this reason, they are often called ‘bull’ or ‘bear’ funds.