1. The map of asset classes: stocks, bonds, ETFs, commodities and currencies

Theory 3: Asset classes and how to read a company

Nobody trading oil in a financial market wants barrels literally delivered to their door. And yet they buy and sell oil every single day.

So far this course has used stocks as almost its only example. But the universe of assets traded in financial markets is much wider, and each asset class behaves according to a different economic logic.

Understanding those differences is essential before building any portfolio or strategy that combines more than one type of asset.

Stocks: ownership

Stocks, as we already know, represent ownership.

Their return depends on how the underlying business evolves. And their risk comes largely from the fact that shareholders are paid last if things go wrong.

Bonds: debt, not ownership

Bonds are the other big piece of the puzzle. They represent debt, not ownership.

When you buy a bond you are essentially lending money to whoever issued it — a government, a municipality, a company — in exchange for two things:

• Having that money returned on a specific date: the maturity.
• Periodic interest payments: the coupon.

Unlike a shareholder, a bondholder does not participate in the future growth of the business. If the issuing company doubles its profits, the bondholder still collects exactly the same agreed coupon, not a cent more.

In exchange, they are paid before shareholders if something goes wrong. That is why bonds, all else being equal, are usually considered less risky than the shares of the same entity.

Less risky does not mean risk-free. A bond can default if the issuer cannot meet its obligations. And its price in the secondary market also rises and falls, mainly with prevailing interest rates.

ETFs: not an asset class, but a wrapper

ETFs (Exchange-Traded Funds) are not an asset class in themselves, but a wrapper. A basket of assets that trades on an exchange as if it were a single share.

That basket is usually stocks, though there are also bond ETFs, commodity ETFs and ETFs of other baskets.

Buying a unit of an ETF tracking the S&P 500 means, in practice, buying a tiny fraction of all 500 companies in the index in one go. With the liquidity and operational simplicity of buying any individual stock.

ETFs have hugely popularized low-cost diversification. And they have done so precisely because they spare an individual investor from having to buy, manage and rebalance hundreds of individual positions on their own.

Commodities: physical goods, physical drivers

Commodities — oil, gold, wheat, copper — are physical goods traded in their own markets. Almost always through futures contracts, rather than by buying the physical good directly. Hence the scene we opened with.

Their price does not depend on corporate profits or coupons, but on physical supply and demand for the specific good:

• Weather and harvests, for agricultural goods.
• Production decisions by exporting countries, for oil.
• Industrial and investment demand, for metals.

That is why their behavior tends to bear little relation to that of stocks. Low correlation, a concept we will go deeper into in the next level. And that makes them a common portfolio diversification tool.

Currencies: prices that only exist in pairs

Currencies (forex) are the most heavily traded asset class in the world by daily volume, and they work differently from the rest.

They are always quoted in pairs — EUR/USD, USD/JPY — because the price of a currency makes no sense in the abstract, only relative to another.

Their value depends on several factors at once:

• Interest rate differentials between countries.
• Inflation expectations.
• The trade balance.
• And, ultimately, relative confidence in each economy.

There is a fundamental difference with stocks or bonds. A currency generates no profits and pays no coupons of its own: its only source of return is the relative price movement within the pair.

That makes it a purely speculative or hedging asset, rather than a long-term investment in the traditional sense.