The Financial System
The financial system is a dynamic network that involves private companies, public entities, and individuals. Private companies, such as banks, investment firms, and insurance companies, provide financial services and products. Public companies, including government agencies and regulatory bodies, establish rules and regulations to safeguard the interests of investors and maintain stability in the financial markets. Individuals, as participants in the system, engage in activities such as saving, investing, and borrowing.
Now let's move on to the investments instruments that are offered by the participants of the financial system.
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A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental)
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A stock represents a share in the ownership of a company, including a claim on the company's earnings and assets
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Deposit consist of money placed into banking institutions for safekeeping
Debt and Share
Debt and Share are the foundations of the investment world. Other more complicated instruments are based on these two. So let's talk more about them
You can see the main features of both instruments. Debt instruments have fixed term, but shares don't, debt instruments have fixed yield to maturity, but shares don't and, finally, debt instruments have guarantee of return, but shares don't. But it's extremely important bearing in mind possible risks and manage them and it is quite a difficult task isn't it? But I'll provide you with the necessary knowledge and you will be able to start managing risk on your own.
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Risk management
Let's move back for a second and look from where do we have this risk management and why is it so important.
Individuals work and by doing so they exchange their labour for money. People like money and after receiving their wage they want to save or even increase it. They have several options, starting from the most obvious one keeping their money in cash under the bed, but it's not a good idea, because of inflation which slowly or rapidly (depends on the country) will decrease the purchasing power of the money. So, individuals want to protect their money from inflation, therefore they can, for example, open a bank deposit and put their money in a bank account, and after a certain period of time, let's say one year, they will receive some interest, as a general rule the interest that they will receive will only cover the level of inflation, so bank deposit is a secure way of saving your money, but, in my opinion, nothing more than that. Next we have bonds, we already know that bonds can be both from companies and state. In general, bonds are considered as highly reliable securities, but they are a bit more risky than bank deposits. And lastly we have stocks, they are considered to be riskier than bonds, because of its features (no fixed yield, no term...). To make everything more understandable I'm providing risk \ return curve.
The picture is taken from https://www.truwealthadvice.com.au/
How to handle risk?
Diversification is regarded as the main method of reducing risk nowadays. It is well-known approach which is described by having a wide variety of investments with different characteristics in order to reduce risk. Harry Markowitz, who was Noble Prize Recipient in economic sciences in 1990 for developing the modern portfolio theory said that "Diversification is the only free lunch in finance." The main theses of the theory can be defined by one simple expression "don't put all your eggs into one basket". Markowitz mathematically proved that it's more safe to invest in several different investments (use diversification). His theory has strongly affected the investment world. Thus you can understand how important it is to have a diverse portfolio, combining different investment instruments.