Financial literacy is an important skill, but many young people are never properly introduced to the basics of business, economics and finance.

As the leader of the Finance Society at my school in the UK, I have experience teaching these subjects to a class of more than 40 beginner students aged 13 to 18. Through that experience, I understand that finance can be much less intimidating to learn when explained in simple terms.

This explainer will be the first one in a series that will break down key financial topics into simple language for beginners and help them learn more about how the financial world works.

Here, we begin with the basics of investing: what stocks are; what bonds are; how markets rise and fall; and why diversification matters.

Stocks

Stocks (also called shares) are essentially small parts of companies that can be owned by individuals called stockholders (or shareholders).

Companies issue stocks to raise money to fund their operations, grow the business and expand their capabilities. This is done through a process called an initial public offering (IPO).

With every stock you own, you get certain benefits such as voting rights (the ability to vote on a company’s actions) and receiving dividends.

Dividends are a portion of a company’s yearly profits that go back to shareholders. They are given as a form of reward for people owning the company stock.

Very commonly, people on the stock market, known as investors, buy stocks and wait for them to increase in value. Then they sell the same stock but for a greater price, thus making a profit.

 

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Bonds

Bonds are types of loans. When someone buys a bond, they are lending money and thus become the creditor (or bondholder). The company, government or other organisation that “issues” the bond is borrowing money and therefore becomes the debtor.

As with stocks, companies issue bonds to raise money. However, this means that they take on debt rather than losing a portion of their company. Bonds tend to be safer investments than stocks, but tend to offer lower returns.

Bonds generally have four distinct characteristics:

Maturity date: The date by which the loan needs to be fully repaid. If the debtor cannot repay the loan, they are considered to “default”.

Coupon rate: The interest rate on the bond; the additional cost of borrowing paid by the debtor to the creditor. Interest rates vary from loan to loan depending on the creditworthiness of the entity borrowing the money.

Face value: The original amount of money the debtor promises to repay to the creditor. For example, if a company issues a bond with a face value of $1,000, that is the amount the bondholder will be repaid when the bond matures.

Indenture: The legal contracts that outline the terms of the bond, usually involving a form of collateral or credit rating.

Bull market

Stocks are traded on stock exchanges, a famous example being the New York Stock Exchange (NYSE) on Wall Street. The price of a stock depends on the highest price a buyer is willing to pay for a stock and the lowest price a seller is willing to sell their stock for.

Bull markets are categorised by a consistent increase in the average price of stocks in a stock market. Specifically, this is when stocks have risen by 20% or more from a recent low over a period of at least two months.

Investor feelings are crucial in setting the price of stocks.

During a bull market, people do not want to miss out on the potential profits, therefore they decide to buy as well. This creates a positive feedback loop that drives stock prices even further up.

Bear market

Diversification

Diversification is an investment strategy that is often referenced in day-to-day conversations. It is the idea that “you shouldn’t put all your eggs in one basket”. The same applies to traders in stock markets.

To diversify means decreasing your exposure to one specific company or market. It means that your profits and downsides are spread across multiple sectors, which makes your portfolio more resilient to the poor performance of any single investment.