Navigating market volatility can be challenging, but proper diversification and rebalancing strategies can provide invaluable assistance.
Financial markets provide resources based on supply and demand and determine asset pricing. Examples of such markets are money markets, bond markets, stock markets and derivatives markets; those found within the US financial system include capital markets, money markets, debt or credit markets and mortgage markets.
The Money Market
The money market is a form of financial market in which highly liquid securities with short maturities are traded, making up an essential element of any monetary system. Like other markets, its functioning relies on open competition between those providing bulk funds at any particular moment and those seeking bulk funding in order to find optimal distribution of available resources.
As such, the money market provides essential liquidity to financial institutions and businesses that require loans or investments, saving channels attract savings to corporations so they may expand operations and achieve economic prosperity; without these facilities businesses and individuals would find it more difficult to access funds on short-term basis.
In most Western countries, commercial banks, credit unions and savings institutions dominate the money market. Their investments include highly liquid but safe short-term securities such as government bonds, treasury bills, certificates of deposit, commercial paper or repurchase agreements.
Money market mutual funds provide consumers with exposure to wholesale transactions via money market mutual funds. Money market funds have gained in popularity recently as an easy way for investors to park funds temporarily; however, several have seen significant redemptions since Lehman Brothers filed for bankruptcy protection in September 2008.
The Stock Market
A stock market is a public marketplace where investors buy and sell publicly listed company shares. Stocks may be traded on stock exchanges around the world or over-the-counter; similarly, “stock market” can also refer to various financial instruments tied to stock prices such as exchange-traded funds (ETFs), single-stock and stock index options, equity swaps and single-stock futures which may all be traded either centralized exchanges, derivatives markets or OTC markets.
Stock market performance can have a profound effect on an investor and economy’s short-term outlook, serving as an indicator for the health of its economy and leading experts into forecasting its future trends.
An increase in stock market activity tends to signal an economic downturn and vice versa. Furthermore, healthy stock markets often encourage companies to reinvest more of their own capital back into their operations, helping to stimulate the overall economy.
The Bond Market
Bond markets provide essential funding to businesses, governments, and other entities looking to expand their operations. Investors also use bonds as an opportunity to diversify their portfolios with safe investments that pay regular interest payments over time – yielding profits when bonds mature and their principal is returned back into circulation.
Bonds issued by governments (wherein the borrower is also the government), corporations and municipalities are the major forms of bonds available today. A bond acts like an ordinary loan: buyers lend money directly to issuers for a set period known as term to maturity. Investors receive regular interest payments as they invest with issuers until eventually receiving back their principal at maturity.
Bond markets are highly sensitive to changes in interest rates. When market participants anticipate future inflation, they will seek higher bond yields (and prices will fall) in order to compensate for any reduction in purchasing power over the life of the bond. A bond’s duration measures its sensitivity to changing interest rates; longer-term bonds tend to be more responsive than shorter ones.
Investors can access the bond market via mutual funds, closed-end funds and unit investment trusts; however, they must remain wary of common behavioral biases such as overconfidence bias, confirmation bias, anchoring bias and loss aversion bias that can lead to poor investment decisions.
The Commodity Market
The commodity market is the place where individuals and companies purchase and sell physical commodities such as oil or wheat. Investors can trade commodities either through spot markets or derivatives markets (futures and options), with one major difference: commodity trading involves actual physical commodities whereas stock and bond markets involve equity shares.
The main distinction between stocks and commodities lies in the form of capital appreciation and dividends provided by stocks; while commodities usually don’t pay any. Furthermore, stock prices can be affected by economic factors while commodity prices tend to be less impacted by such issues.
As such, returns on commodity investments have typically been relatively modest compared to stock and bond returns; however, inflation can provide a positive correlation. Yet the relationship between commodity prices and macroeconomic outcomes remains complex.
Regulators have found the unregulated nature of commodities markets to be an enormously challenging terrain, posing an unprecedented set of regulatory issues to navigate. The Commodity Futures Trading Commission is working tirelessly to rein in excessive speculation while still permitting legitimate trading and price discovery – no small feat when considering volatile energy and metal markets! A study by Vissing-Jorgensen revealed that investing can be prohibitively expensive for many households while participation rates tend to be higher among those with more wealth and education.