How to Invest

Learn about the different asset classes, risks and platforms to help you invest.

Asset classes

Indices

A weighted or unweighted index for a basket of financial instruments. Each index has their own methodology, but typically they are weighted by price or market capitalisation (number of outstanding shares x price per share).

E.g. FTSE100 is weighted by free-float capitalisation meaning larger companies with higher float (shares actually tradable) have a larger impact on the index. Formula:

Equities

The ability to buy shares in a company which makes the shareholder a partial owner of the company. The shares reflect how much the company is physically worth, also known as the net asset value (=total assets-total liabilities). The share will change in price depending on the supply and demand. By physically owning the share, companies will pay out their profits to shareholders in the form of dividends.

Foreign Exchange (FOREX)

Currencies are measured against each other on the FOREX market and the prices represent the over-the-counter value.

For example:

The price depends on the supply and demand for each currency. The supply curve depends on the demand for foreign currencies- affected by factors such as foreign exports, holidays abroad and foreign investments. The demand curve depends on the demand for domestic currency- affected by factors such as domestic exports, tourism, and domestic investment. Other factors like interest rates (higher relative interest rates attracts hot money, increasing demand) and the health of the economy influence the supply and demand for a currency. Note, the FOREX market is considered the most liquid market (fastest/easiest to buy and sell).

Bonds

Companies and governments issue bonds to investors to borrow money. The issuer receives a principle, £Xm, now and pays a coupon (or interest) rate, i, to owner of the bond every year. This coupon rate is either fixed, typically the case (hence the name fixed income), or variable depending on the nature of the bond. When the bond reaches maturity (expires), the owner of the bond receives their principle, £Xm.

Note that the bond price and bond yield (interest/coupon rate) are inversely correlated, i.e. if the price increases then the yield falls and vice versa. The coupon rate is determined by the risk premium. For example, loaning to a company is more risky than the government, so companies offer a higher coupon rate. Also, the higher the maturity of the bond, the higher the risk premium because there is a higher chance of deferring the payment; illustrated by an upwards sloping yield curve.

Commodities

A commodity is defined as a raw material or a primary good, typically used in the production of goods and services. Commodities of the same type are homogenous/interchangeable. The price of a commodity is simply determined by the supply and demand. Typically, commodities (especially gold) are used in finance to hedge against inflation and diversify portfolios because they are usually finite a material and have a low correlation with financial instruments.

Risks

With risk comes reward. In finance, risk means how far the actual outcome deviates from the expected outcome. This is measured by the mathematical term σ^2, the standard deviation squared or the variance:

where N is the number of observations, xi is the observed value of the item, and x ̅ is the mean value of the observations. A volatile asset will have a high standard deviation.

Individuals are risk taking (have a preference for risk), risk neutral (indifferent about risk) or risk adverse (prefer not to take risks). Most individuals are risk adverse and will attempt to mitigate risk in their portfolios/investments by hedging. A risk adverse individual can hedge a risky bet by investing in an asset with opposite correlation (price moves in the opposite direction).

The types of risk we observe in markets are systematic risk and unsystematic risk. Systematic risk is the market risk, affecting the entire economic market. It is difficult to diversify a portfolio against systematic risk because most assets move in the same direction. Market risk is given by β, which measures the individuals investment risk against the markets. For example, the 2008 recession was an example of systematic risk. On the other hand, unsystematic risk can be diversified against. It is the risk only observed in a specific type of industry or company. For example, a change in government regulation affects an industry or firm.

It is important to note that short selling has unlimited risk because an asset’s price can rise to infinity, where as a buy and hold position has limited risk because it is impossible for the asset’s price to fall below zero.

Mean-Variance Model

A statistic analysis used in a portfolio to maximise expected return and minimise risk or variance. For a two asset (1,2) portfolio, the expected return is:

and the variance is:

where Wx is the weight of each asset in the portfolio and ρ1,2 is the correlation between the two assets (where Cov1,2=ρ1,2 σ1 σ2). Note that the lower the correlation (how the assets move to one another), the lower the risk, which is why portfolios’ use certain assets as a hedge.

Platforms

There are a number of platforms available if you are interested in actively managing your own funds, including City Index, IG and Oanda. All of these platforms charge low fees for buying, holding, and selling a vast array of assets (see each platforms terms and conditions). However, you must be prepared to incur a loss when trading. If you are an inexperienced trader, then we would be more than happy to talk to you and give you general guidance. InAgent will be introducing a fund for individuals to invest in, if this would be of interest to you please do not hesitate to get in contact with one of our investment analysts via our “Contact Us” page or our twitter handle.

Tools

There is software available to create buy or sell signals for shares, according to set of technical/fundamental parameters. For example,  Trading View gives you the opportunity to set a fundamental, technical and descriptive filters to generate a list of shares. Software also exists for back-testing; a vital component for portfolio construction. For example, MetaStock and TrendSpider provide back-testing and forecasting analysis.

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