How to navigate the financial markets

Tim Bennett explains workings of the financial markets, and gives three rules of thumb for novice investors.

Financial markets exist for one reason: they bring investors (or lenders) together with borrowers. The institutions that form the financial markets brokers, banks and so on make money by acting as the middlemen. Take a traditional high-street (or 'retail') bank. It takes your savings and pays you a return (in the form of interest). Your money is then lent out to individuals or companies who need loans or mortgages. As long as the amount charged to borrowers exceeds the amount paid to savers, the bank profits.

This is the basic template for everything that happens in financial markets. Every instrument or security that has ever been created exists to facilitate the transfer of capital from those who have it to those who need it and, never forget, to make money for the bank that creates it.

How companies raise money

For short-term financing needs, there are the 'money market' specialists. Typically, borrowers in the money markets are looking for finance for a period of up to 12 months, although many only need funds for a few weeks, or even just overnight. Most retail investors don't get involved in the money markets.

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Longer term, firms looking to grow say an airline hoping to buy new aircraft tap into the 'capital markets', where they try to raise finance for longer periods. There are two ways to do this via debt or equity. Debt finance is simply borrowing. As an individual, you'd be likely to approach a bank for a loan. Firms can do the same. But bigger firms could do a bond issue instead. Say a large firm wants to raise £100m. It could pay an investment bank to take the £100m and break it into, say, a million bonds worth £100 each. These IOUs will typically pay a fixed interest rate and have a set 'redemption' date when the borrower will repay them.

The alternative slightly more expensive option is a share issue. Here a company tries to bring in new owners. These investors are bottom of the pile if a firm goes bust, and so demand higher returns than bondholders, perhaps in the form of regular dividend payments. A third option, 'hybrids', combine features of both debt and equity. For example, convertibles are debt securities that may be converted into a specified number of shares by the holder at a later date.

How securities are traded

The big challenge for a company raising finance is persuading enough people to invest in its securities (bonds or shares). This is where 'new issues' teams at investment banks make a living. They advise a firm on how to get the marketing and timing right, and also on who to sell to. Often new listings are restricted to institutional investors, such as pension funds. But if a company is particularly high profile a football club, say it can be worth the expense and hassle of giving private investors the chance to invest.

Once the securities have been issued, there's the question of where they will trade. Some, including many bonds, trade over the counter (OTC). This is where trading is done directly between counterparties (say two investment banks) with specialist 'interdealer brokers' helping to arrange terms where a trade is large or involves an infrequently traded ('illiquid') security. For retail investors, access to such securities can be tough. Alternatively, securities can be made available 'on exchange' such as shares listed at the London Stock Exchange. These tend to be more liquid and held by a wider range of investors. That makes it easier for a company to raise money; the downsides include the cost of extra regulation, plus the added scrutiny applied to a 'public' company.

Three rules of thumb for novice investors

What can investors take from this? The key is to grasp the role of financial institutions. They don't provide this market place out of the goodness of their hearts, they do it to make money. That means their interests are not always aligned with yours. So:

Keep it simple

The more complicated the financial product, the more likely you are to be overcharged for it. If it sounds like you're getting a good deal a return that beats your bank account with 'no risk', say then always look for the hidden catch.

Never forget liquidity risk

The last thing you want is to be unable to access your money when you need it. Smaller stocks, and less easily tradeable assets such as bonds, will cost more to buy and sell, and may be hard to offload at volatile times.

Don't believe the hype

The more you trade, the more fees financial institutions make. So it's in their interest to keep tempting you into the 'next big thing'. Don't be swayed by clever marketing into feeling that you 'must' invest in any specific stock or theme.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.