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Jun 30

Stock and bond markets: what are they and how do they work?

Reading Time: 6 mins

When you first start dipping your toes into the vast ocean of investing, it’s hard to find the shallow waters and get yourself a solid footing. One of the best ways to get a proper foundation is to learn how the stock and bond markets work.

To help you get to grips with these two important areas, this guide will explain all the fundamentals you should understand as an investor. We’ll take a deep dive into both markets, how they work, and ways you can invest.

Keep reading for a complete breakdown of stock and bond markets, or click on a link below to jump straight to a section…

 

What is an investment market?

At its core, these are just places where investors can buy or sell different types of investments.

Depending on your interests, goals, and appetite for risk – you might want to concentrate on one area or select a few.

These markets used to be hard to access and you’d either have to be an elite member of society or have powerful connections to get involved.

Nowadays, you just need an internet connection, some basic investing knowledge, and a functional brokerage account to put your money into the different investment markets.

 

History of stock markets

Stock markets have been around in one form or another since the 1300s. The original purpose was exchanging debts and loans, giving birth to the bond markets – something we’ll cover a little later.

As business and trade developed, so too did the ability to invest. Eventually, this interlinking exchange system spread throughout Europe. Until… a problem needed a solution.

Sea voyages during the 1600s to remote places in Asia and the East Indies were proving to be both extremely profitable, and extremely risky.

A successful voyage could lead to great wealth. But, an unsuccessful venture could lead to immediate bankruptcy.

So, to spread risk, ship owners would seek investors to own a ‘share’ of the burden.

This meant lower profits. But more importantly, lower risk by spreading funds across many journeys.

Rather than keep organising this trip-by-trip, larger companies emerged. Companies that began issuing stock that would pay a dividend based on multiple trips.

This method grew in popularity and trading of these stocks in London coffee shops became a staple societal pastime.

man in chequered shirt reading the history of stock markets

 

Modern stock markets

What we have now is just a faster and more sophisticated system.

You can easily buy stocks and shares from stock markets around the world.

When investing, you are buying pieces of companies, and get to share in the profits or losses.

Companies sell shares to raise money. They then use these funds to grow, reinvest in the business, or develop new technologies.

Lots of companies, particularly UK firms, still pay a dividend.

Other stocks generate returns through capital appreciation. The stock becomes worth more, so your shares become more valuable.

 

How to invest in stock markets

You’ll need to use a brokerage account to access most stock exchanges.

Unfortunately, Pret and Costa Coffee haven’t carried the torch from the past, but perhaps someday you’ll be able to exchange shares in cafes again.

Well, technically you can. Just take your mobile phone with you, buy a coffee, then buy or sell stocks and shares whilst you sit, sipping your cappuccino.

If you don’t have an account set up or it feels somewhat daunting, we’ve created a thorough guide on how to create an account and buy shares with eToro.

The reason we’ve partnered with eToro is that it’s free for you to set up an account. And, there’s no cost to buy shares – or sell them

Along with access to a number of stock markets, you can also buy other assets once you get more comfortable as an investor.

Another great modern inventions is index funds. These allow you to invest in whole stock markets without having to pick individual stocks.

Here’s where you can read more about index fund investing.

using phone to invest in stock market

 

The bond markets

It may shock you to hear that this market is not somewhere that allows you to trade James Bond memorabilia, it’s a little drier.

Bonds, treasuries, and gilts all refer to pretty much the same thing. It’s basically a way for governments and businesses to issue debt.

You can then buy some of this debt and get a reward for lending your money for a period of time.

Although they’re not stocks, it was the buying and selling of debt that actually led to the creation of stock exchanges.

Originally, informal markets popped up as a way for Venetian merchants to trade or exchange debts with each other.

Hence the inspiration for Shakespeare’s ‘The Merchant of Venice’.

Hundreds of years later, debts and loans are still an important part of the market.

Most governments and businesses pay for things using debt. Whether that’s to pay for a war, finance a global pandemic, or access money banks aren’t willing to lend them.

 

How bonds work

Here’s the basic system that fuels the bond market:

  1. Someone wants to borrow money.
  2. You loan an amount of money to them by purchasing a bond.
  3. At an agreed date you are paid the original principal plus some interest.

Although a bond itself is quite simple, the bond markets are terribly complex.

There’s a global interlinking of debt between countries. Some are more credit worthy than others, and certain companies are more reliable than others.

Everyone gets a credit rating. Just like the one that gets checked when you want to take out a loan.

What makes the bond market more complicated is that there are secondary markets where these various debts can be resold.

The result is that you end up with a giant web weaved of debt. And if one strand snaps, it can lead to a tangle or a complete break in the whole web.

bond market web

 

How to invest in the bond market

Bonds are a little different to stocks. Often, you can’t access the majority on stock exchanges, you have to buy them directly or with a specialist broker.

The main ways to buy bonds are:

  • Buy directly from the government – HM Debt Management Office in the UK and from the US Treasury in America.
  • Purchase savings bonds directly from a bank or building society.
  • Buy corporate bonds from companies using a broker.
  • Invest in collective funds such as unit trusts or open-ended investment companies (OEICS).

In practice, buying bonds from banks tends to be the most straightforward but the return won’t knock your socks off.

Government bonds like gilts tend to be very secure, but offer a low return because it’s a ‘safe’ investment.

Like with most investments, opting for a higher risk can lead to a higher reward.

So, if you buy bonds from a government or company with a lower credit rating, there’s likely a better return on offer. But, also a higher chance of default (them not paying you back).

One of the most straightforward ways to get exposure to bond markets is by using an index fund or exchange-traded fund (ETF).

You can find these bond funds available with most popular investment platforms. Like stock market funds, they allow you to invest in a whole basket of bonds instead of picking out individual ones.

This can make investing simpler and spread your risk with some diversity. But, it can also limit your potential returns.

 

The bottom line on the stock and bond markets

These are the two key markets that you should try and get a basic understanding of.

Most of the global economy runs using the stock and bond markets as giant cogs, keeping everything ticking over.

Even if you decide not to invest, brushing up on how these markets work will open your eye to what happens with money on a global scale.

If you’d like to keep up to date with the latest market movements, news, and tips – make sure you sign up for the MoneyMagpie fortnightly newsletter.

This is not financial or investment advice. Remember to do your own research and speak to a professional advisor before parting with any money.

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