With a myriad of unique jargon and opinionated talking heads in the media, finance can seem esoteric, intimidating and confusing. Through my column, I intend to simplify the field and equip students with the knowledge to make informed investing decisions. Whether you work in the financial services profession or not, investing will play a key role in your life, and it can be a powerful tool to improve your own happiness. I hope I can guide you along the journey to financial literacy.
Some of the most basic — but most valuable — lessons can be learned by understanding the origins of stocks. From the 15th to 17th centuries, during the Age of Discovery, European sailors conducted several expeditions to the Americas. They hoped to find valuable natural resources that they could sell upon returning to Europe.
To raise money to fund such voyages, the teams created joint-stock companies. They sold shares of the company to the public, and in return, they offered a slice of any profits they made from the trip. Needless to say, such trips were dangerous and expensive: crews had to navigate the Atlantic Ocean, find items of value to bring back and hope to make it back alive. However, there was also the possibility for incredible riches if the crew returned to Europe with gold or silver.
The formation of joint-stock companies provides a great example of the most important relationship in investing: risk and return. In finance, there is a positive relationship between risk and return; that is, the more risky an investment, the more investors will need to be compensated with a higher return to bear such risk.
Think about the price of a share of a shipping company that was exploring an unknown region compared to one making a journey that had a reliable record of bringing in profit. In the first case, there is much more risk, so investors would have to be compensated for that risk with a lower price than the safer route. Given the lower relative price, investors would have the opportunity to earn a higher return, whereas the higher price for the safer route would reduce return.
The shipping example also introduces the core concept of diversification. As an investor, it would be beneficial to purchase shares in a variety of companies sailing to different areas. If you only purchased shares in one company, you would expose yourself to a higher level of risk: storms could decimate the ship, the company might not find anything and disease could wipe out the crew. By investing the same amount in a variety of expeditions, you would reduce the risk of events specific to one investment; losses from one expedition would not be crippling if you have shares in many different voyages.
Although the origins of the joint-stock company are hundreds of years old, the same benefits of diversification, as well as the relationship between risk and reward, apply to investing today.