Invests in the Public Sector
In this lesson, we will discuss investors and how they interact with each of the other industry participants. While we might not think of the government as the first thing that comes to mind when we think of investing, investing in the public plays an important role in financial markets. We can’t own a part of the government like we can for corporations, so there is no equity involved. However, the government does issue bonds at the federal, state, and local levels.
These bonds offer certain advantages compared to corporate bonds. Interest income from US federal government bonds issued by the treasury department is free from state and local tax. Interest income from state and local bonds, often called municipal bonds or muni bonds, is free from federal tax.
While at the local and state levels there is some risk of default in a poorly managed city or state budget, the risk of the US government defaulting on its debt is extremely low. The main reason is that the federal government can always raise taxes if the need really arises. The US is also in a very strong economic position in the world - a more indirect reason. Because the risk of default is so low, the interest rate on US Treasury debt, or Treasuries are often considered “risk-free” assets. There is no such thing as totally risk free, but this is the closest thing we got as a benchmark comparison. Often times, interest rates on all sorts of securities are compared to US Treasury yields.
Invests in Corporations
The investor has two ways to invest in corporations - through its equity or its debt. Buying corporate debt is a bit more difficult for the average investor since corporate debt is usually in large denominations, like $5000 or $10,000 per bond. However, there are corporate bond ETFs available. Buying corporate equity is just buying normal stocks in the market.
Because banks are corporations as well, we can invest in banks. If we feel like our bank is charging us too much in fees, maybe they are just very profitable and we should invest in it!
Governments, Corporations, Banks, Funds (Institutional)
An investor could be almost anyone. It can be an individual with a brokerage account, a corporate treasury or pension, a country’s sovereign wealth fund, a bank’s treasury or trading desk, or typical buyside institutions like mutual funds. It is just a term for an entity that has money available and is looking to earn a return.
Each type of investor has different characteristics - generally speaking. Individuals might prefer stocks because they are easy to access. Individuals may trade from time to time but not too frequently because it is not their profession. An institutional investor might trade more often depending on the fund’s strategy. Sovereign wealth funds might predominantly invest in bonds and few equities because of a mandate or a risk-profile of the investment team and the government. The Norwegian Sovereign Wealth Fund is one of the world's largest, and invests in thousands of companies over dozens of nations.
Investment Fuels Innovation and Growth
Centuries ago, a Scottish economist named Adam Smith coined a phrase the Invisible Hand in his book The Wealth of Nations. This concept refers to a fundamental idea in Capitalism: in a free market economy, individuals pursue for their own benefit and gain, but in doing this and without intention, they also optimally benefit society at large.
A manifestation of this concept would be the spirit of entrepreneurship in the US. Many people start businesses with some intention of making money from their ideas. The more successful their idea, the wealthier they become, but society also benefits because of the great product or service that the company provides. If the product wasn’t so great and benefited no one, the company wouldn’t be successful anyways.
There are also counterexamples of how the invisible hand does not always guide society down the best path. In the energy industry, sustainable energy is least impactful on the environment which we need to preserve, but it is not the most profitable. Solar and wind companies for many years struggled to generate profits due to a variety of factors, which contributed to investors sticking with oil companies as reliable investments.
The investor plays a less obvious role in our everyday lives, but it is investment that makes innovation and growth possible. Knowing how the cogs of the economic machine works goes a long way to helping us find our way through life in a smarter way rather than becoming lost in the corporate world.