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Forbes Guide to the Markets : Becoming a Savvy Investor
Marc M. Groz.
NOTE TO THE READER
The purpose of Forbes Guide to the Markets is to help you become a savvy investor, with sufficient understanding and knowledge to invest wisely, in accordance with your own needs and aspirations. Many how-to- invest books attempt to convince you that a particular approach- theirs- is best. Often these approaches are based on a narrow view of investing. Forbes Guide to the Markets is decidedly different. It provides a grounding in the wide range of today's financial markets, beginning with stocks and the markets they trade in, and moving into mutual funds and related investment products. It proceeds to explore the surprisingly varied world of bonds and the fast-paced realms of options, futures, and other so-called derivative investments. Finally, it concludes with a clear and concise presentation of the key concepts of risk and return and some provocative thoughts about the future evolution of financial markets.
Forbes Guide to the Markets is for people who want to become "street smart," to gain a realistic understanding of the world of investing. Our goal is to give you the knowledge and understanding to make investment decisions for yourself. We believe that offering you that knowledge is the best way to help you navigate through the sometimes dauntingly complex world of investing. Here's what you need to know in order to be a savvy investor:
¦ Mutual funds and related products
INTRODUCTION: BECOMING A SAVVY INVESTOR
¦ Money managers
¦ Financial planners
¦ Information providers
¦ How to evaluate products
¦ How to choose a financial service provider
¦ How to buy and sell your investments
¦ How brokers, money managers, and others are regulated
¦ Your rights and responsibilities
¦ Federal regulators
¦ State regulators
¦ Self-regulatory bodies
¦ What the regulators don't regulate
Risk and Performance
¦ The many forms of financial risk
¦ How risk depends upon your financial objectives
¦ How performance is measured and reported
¦ Relationship between historical and future performance
¦ Where to turn for high-quality information on financial products
¦ Getting the essentials without drowning in information overload
¦ Impact of costs on performance
¦ Brokerage and other sales charges
¦ Management fees
¦ Hidden costs
¦ Common types of fraud
¦ Warning signs
¦ How to protect yourself
¦ Learning the language of the street
¦ Commonly misunderstood terms and concepts
SECTION I: Establishing a Frame of Reference
From "Dumb" Barter to Intelligent Agents A Genealogy of Markets
W here did financial markets come from? What distinguishes financial markets from other forms of trade? How do financial markets work? We will briefly address the first two questions in this introduction; answering the third question is the goal of this book. Markets for the purchase and sale of financial securities such as stocks and bonds have existed for hundreds of years. Typically, these markets began with a small group of men (and maybe a few women) who met informally at a coffeehouse or restaurant to act as intermediaries between buyers and sellers of securities (here we're talking pieces of paper). As the volume of their business increased, these loose-knit groups formed associations with rules of conduct. In London, for example, "The Stock Exchange" was established in 1773 in a room in Sweeting's Alley. The building became known as The Stock Exchange Coffee House, still showing the link to its former home, a coffee-house named Jonathan's located in Change Alley.
Nineteen years later, in 1792, a small group of New York stockbrokers, who had been trading under an old buttonwood tree on Wall Street since the days following the Revolutionary War, signed a business agreement. Twenty-five years more would pass until in 1817 the "Buttonwood Group" created an association- The New York Stock and Exchange Board- and arranged to move indoors.
What distinguishes financial markets from nonfinancial markets? Financial markets can be seen more clearly if placed in the larger context of markets in general. Markets, in turn, are more easily understood if looked at in the still larger context of forms of trade between individuals and groups.
Both market and nonmarket forms of trade are as old as civilization. Both have existed even in cultures that traded goods without the use of money. Nonmonetary trade has taken many forms, most notably barter (i. e., exchange of goods and/ or services for other goods and/ or services) and various forms of ritualized gift giving. Extensive barter markets existed in Ancient Egypt and in Mesopotamia 5,000 years ago.
An early type of barter trade that required neither money nor even a shared language is mentioned by Herodotus, the Ancient Greek historian known as the Father of History. Writing nearly 2,500 years ago, he tells of Carthaginians engaged in "dumb barter" with tribes from beyond the Pillars of Hercules. Also known as "depot trade," or "silent trade," the widespread custom was practiced at one time or another in such diverse places as northern Russia, western Africa, Sumatra, and India. It worked roughly as follows.
One of the parties to a silent trade went at the appointed time to the traditional spot designated for trading (how these times and places were selected we do not know). The first party set down the goods being offered and then retreated to another location, signaling the other party with a call or other sound. On hearing the signal, the second party went to the spot, placing items considered of equal value alongside the items offered by the first party. Then that individual, too, retreated, allowing the first party to return and look over the wares offered by the second party. At this point the first party either completed the trade by removing the second party's wares or, if not satisfied, left those wares in place until the second party sweetened the offer with additional goods.
Did this type of barter constitute a market? It appears that markets require, at minimum, some goods or services for sale and a means for traders to place bids and make offers on these goods with other traders. Thus "dumb" barter does possess two of the salient features of markets: items for sale and the establishment of a fixed time and place for traders looking to make deals.
But it takes more than fixing a time and a place to constitute a market and to distinguish it from other kinds of trading. It takes only two to trade, but markets need at least three participants. This gives the participants the ability to compare what is being offered (and/ or asked for) by one party with what is being offered (and/ or asked for) by another. Dumb barter does not provide a means to look for a better deal from a different trader; there are only two parties to the trading. It does not even require a common language. On this reckoning it falls short of being a true market.
Notice that in the preceding paragraph we studiously avoided the terms buyer and seller. That is because, in the absence of money, there is no clear distinction between buyers and sellers: Each party is a little bit of both. While this lack of distinction between buyers and sellers might seem to be an artifact of primitive societies, we will see in Chapter Sixteen (on options) that a curious aspect of the information age is a form of trading known as swaps, in which the distinction between buyers and sellers is once again blurred.
The creation of barter markets was an important development in human history. Even so, its limitations are readily apparent. In a barter market, a potential buyer may not have the item that a potential seller wants. Alice may have almonds that she wants to trade for butter. Bob may have butter but needs chocolate. Charlie, who has chocolate, wants almonds. In order for Alice to get butter, she must first get chocolate (see Table 1-1). In the absence of a medium of exchange, even a simple shopping expedition can require a high degree of knowledge of the marketplace. Furthermore, buyers and sellers find it difficult to calculate prices when restricted to barter.
It is wasteful to have to engage in multiple transactions in order to get a single needed product. Not only can this type of barter be complicated, but to complete a transaction, a trader may need a great deal of information about price and availability of products he or she doesn't want and about the needs of other traders.
Even with only three people trading three products, barter can be complicated. This complexity increases exponentially with the number of products and services being traded. In a growing economy, with thousands of products and services, barter is a less and less efficient means of trade. At some point along the way, a barter system becomes unworkable. Something has to change. In the language of the theory of complex systems, a critical point has been reached. At that point something new emerges.
That something new is money. Consider Dave the banker. Dave has dollars. Instead of everyone running around in circles trying to complete increasingly labyrinthine transactions, they go to Dave and get dollars in exchange for their goods. Now, with Dave's dollars serving as a universal medium of exchange, Alice can sell her almonds directly to Charlie and buy butter directly from Bob. The emergence of money provides both a medium of exchange and a common denominator that enables traders to compare the various goods (or services) offered. Initially, this was done by selecting one item to be the standard of comparison.
With a universal medium of exchange operating in a market, the ability to discover price emerges. At any given time and place, a unique price is created for items on sale in a market. This price is sometimes called the equilibrium price, because it is the price that theoretically equalizes supply and demand. In practice, this equilibrium may not be so obvious or stable. One reason for this is that the exchanges that are supposed to set the equilibrium price are hypothetical, not actual, trades. When real trading commences, it may be affected by influences not taken into account by theory, such as the continual introduction of new products and services that compete with existing wares and the periodic revolutionary changes wrought by the emergence of new forms of trading.
Money simplifies transactions by providing a universal intermediary for goods and services. But it also serves other important purposes. Thousands of years ago, human societies began to move away from prehistoric subsistence economies in which little was produced beyond the bare necessities of life. Cities emerged, and with them came economies that produced a surplus. In these long-ago times, money began to function as a means of representing that surplus.
When the surplus is invested (put to use in a productive enterprise), it is known as capital. When used as capital, money is not only a convenience for facilitating transactions, but is an essential means of organizing complex projects and enterprises. The ability to invest money gave rise to a multiplicity of new kinds of wealth. The existence of multiple currencies gave rise to a new kind of transaction. Beyond barter, where goods and/ or services are exchanged, and beyond the purchase or sale of goods and services, a purely monetary transaction could now take place, with one kind of money being exchanged for another kind- in essence, exchanging symbol for symbol. In these purely financial transactions, we can see the beginnings of the financial markets.
Trade has developed in two independent, yet related, ways. First, it has grown more and more abstract. Second, it has grown to include larger and larger groups of people. The increasingly abstract nature of trading has fed its tendency to include larger and larger groups, while the involvement of larger and larger groups has reinforced the abstract nature of trading.
The details of how potential participants interact with each other varies from market to market, as does the amount and quality of information exchanged. There is also considerable variation in ownership and control of markets.
We can visualize the history of commerce as an increasingly specialized and complex hierarchy of trading. As we have seen, the simplest kind of trade requires neither money nor market, nor even language. Language makes it possible to negotiate over price and terms, leading to the kind of barter arrangements that exist to this day. When these are organized into a market, pricing is no longer simply a matter of two-way negotiation, but is derived from the interaction of supply and demand on the part of market participants. We can also have nonmarket trades that involve money. The combination of money and markets leads to still more elaborate forms of trading- and thus to the beginnings of financial markets.
Markets have become so widespread and popular that it is becoming hard to imagine a social order without well-developed markets. Yet it is helpful to recall that until very recently, markets were anathema in many parts of the world. In the former Soviet Union, in Communist China, and in other places, many forms of markets were illegal. The official line was that a "command economy" was best, with centralized planning and sharp limits on what could be bought and sold and who could buy and sell it. Even today, the use of barter is a very strong component of the Russian economy. Elaborate barter networks operate in a virtual economy, hiding the true extent of Russian economic activity and preventing the government from collecting taxes. By some estimates, as much as two-thirds of that economy is barter-based. In Russia, we can observe a living laboratory illustrating the relationship between money and markets, because the Russian economy today is still struggling in its transition to a money-based market economy.
Sophisticated commodities trading with future delivery of goods requires that traders develop the capacity to understand the time value of money. From here it is but a short step to the issuance of bonds and other debt securities, and to their trading. This develops both in the open marketplace and behind closed doors. In either case, technology facilitates the creation and distribution of more and more abstract forms of financial instruments. The constant evaluation of these instruments by buyers and sellers exerts a kind of evolutionary pressure on the whole complex system made up of stocks, markets, and the organizations and individuals who use them. Thus the cycle of innovation continues, from the dumb barter of ancient history to the intelligent agents at the cutting edge of today's financial technology.