Navigating Capital Markets: Key Investment Instruments Explained

In capital markets, various types of instruments can be bought, providing different ways to invest our money. These instruments offer opportunities to grow our savings, protect them from inflation, or simply generate additional income.

Investing in the right mix of these instruments can help build a robust financial portfolio tailored to individual risk tolerances and financial goals.

There are four main categories of instruments in capital markets: bonds, derivatives, ETFs, and mutual funds.

The simplest way to invest money is by purchasing bonds. Legally, bonds are essentially documents that grants the right to be repaid the money lent to the issuer. This document, called “security” represents the bond. Bonds can be categorized into corporate bonds and government bonds, depending on the issuer—either a corporation or a sovereign state.

Bonds are among the safest investments in capital markets. The primary risk is the issuer’s potential bankruptcy, which would prevent repayment, however, this risk is relatively low, especially with government bonds, where the likelihood of a sovereign state defaulting is minimal, consequently, bond investments are less risky, but they also offer lower interest rates compared to other investments.

Investors seeking stability often turn to bonds to ensure a steady, although modest, return on investment.

Shares also come as documents with rights, but these rights are related to participating in the company’s activities rather than guaranteed repayment. Investing in shares is riskier because, in addition to the risk of bankruptcy, investors face the risk of the company underperforming, this can lead to a lack of dividends—keeping in mind that the distribution of dividends is optional and conditional to the creation of a profit—and a drop in share price, resulting in potential losses if the shares are sold during this period. However, the higher risk associated with shares also comes with the potential for higher returns, making them attractive to investors looking for significant capital gains.

In addition to common shares, there are also preferred shares, which do not grant voting rights but have the advantage of prioritized dividend payments. If dividends are distributed, preferred shareholders receive them before common shareholders. These types of shares can also be “convertible,” meaning that at some point in time, the holder may choose to convert them into common shares, potentially benefiting from future growth.

Understanding these two fundamental types of instruments—bonds and shares—lays the groundwork for exploring other financial instruments. Bonds provide a secure investment with lower returns, while shares offer higher potential returns at greater risk.

Now, let’s explore the differences between mutual funds and ETFs, which fall into the more general category of “derivatives.”

With derivative we refer to an instrument, a product (such as a future, option or warrant) whose value depend on the value of an underlaying asset, which can have different nature (such as commodity, index, currency, security etc…).

If we dig into the mutual fund and ETFs categories, they both have the same structure, these can be saw as baskets or pools of individual securities such as the stocks or bonds we explained before, but when as investors we decide to allocate all our financial resources into a single security, as a bond or a stock, we face a risk, by contrast when we invest in those baskets we benefit from the exposure to a wide variety of assets classes and niche markets through the diversification principle.  

Mutual funds have been around for a century, they come in both active and indexed varieties which is now becoming more popular, most of them are actively managed by fund managers. This instrument can be executed only at the end of each trading day having all the investors receiving the same price calculated as the net asset value. As investor, you can decide between buying the mutual fund in fractional shares or fixed dollar amounts without the presence of trading commissions, but keeping in mind that they carry additional operating fees.

ETFs are usually passive investments pegged to the performance of a particular index, they can be traded like stocks being bought or sold on the stock exchange in a continuous basis during the day. Given the fact that ETFs are traded like stocks, it’s not required any minimum investment, you just directly buy the ETF at the market price available as whole shares, paying a cost representative of both explicit and implict costs, most of them are represented by the broking commisision, the bid ask spread and maybe some premium/discount.

In conclusion, mutual funds and ETFs represents instruments which are really appelaing to investors and are becoming more and more popular, both instruments have advantages and disadvantages, the choice should rely on the intentions and needs of the investors, taking into account costs, risks and flexibility.

Unerstanding all these difference between instruments and the way we can invest our money can help investors to build a portoflio which is balanced and aligned with their financial objectives.