In this article, we’ll cover two very important concepts: the money market and the capital market. Each one of these markets is structured to facilitate the transaction between investors.
Even though they may look the same at a first glance, they aren’t! The money market is designed to fit short-term credit needs by connecting the lender to the borrower. It’s unlikely to make an investment in this market and experience considerable wealthy growth.
On the other hand, the capital market offers is designed to support business and companies to meet their credit needs. Even though it can be used for the short term, the main idea is to fund long-term endeavors. Let’s find out more.
A strong capital market is vital for every economy and company. This market represents the environment where the companies can raise capital and investors can trade stocks, bonds, ETFs, and other long-term debts. This market is segmented into two other markets, as follows:
- Primary: New issuances of stocks, ETFs, and bonds. Here, the issuer offers a product to the investors. If you want to find out more about the possible reasons which make a company go public, you can read it here.
- Secondary: This is where the magic takes place. Here, the investors trade the securities between themselves without the involvement of the issuers.
ETFs (Exchange Traded Funds) are very interesting instruments that represent a pooled investment of almost everything. Do you like Uranium? Biomedicine? Disruptive technology? then it should probably have an ETF investing in these trends somewhere.
When you buy an ETF, you’re buying several companies at once. Something that can only be made through the capital market. Take for example the Vanguard Energy ETF (VDE) which is valued at ~$128,23 (closing price of 4th of November, 2022).
According to its issuer Vanguard, the objective of this ETF is to “track a market-cap-weighted index of US energy companies“. According to the site etf.com, the Top 10 holdings of this ETF are:
- Exxon Mobil
- Conoco Phillips
- EOG Resources
- Occidental Petroleum
- Marathon Petroleum
- Schlumberger NV
- Pioneer Natural Resources
- Valero Energy
- Phillips 66
Probably you don’t know many of these companies, right? Neither do I. But it doesn’t matter, since Vanguard does. Instead of buying each one of these stocks, Vanguard did its homework to pick the best ones for you. All that you have to do is to buy 1 share of this ETF. Guess how this is possible? Yes, in the capital market. Figure 1 shows how the VDE ETF is performing since its ATL (All Time Low) in March 2020.
As you can notice, the VDE ETF share increased by almost 327% during the period. If we take a look at Figure 2, then we’ll see that the VDE ETF performance was pretty similar to the performance of its biggest holder (Exxon Mobil).
They look pretty similar, but they aren’t. This happens for a reason. The main purpose of an ETF is to follow the performance of a basket of assets. Instead of stock-picking each one of these stocks by yourself, the Vanguard team will do this for you to follow a trend a whole. Where can you buy something like this? In the capital market.
It’s also possible to buy bonds in the capital market. Government bonds, for example, are used by countries to finance themselves. Bonds issued by wealthy countries are considered to have an extremely low risk. The most well-known bonds in the market are the T-Bonds (Treasury Bonds) from the United States of America.
This one is a very simple market. According to this source, this market is where “short-term financial instruments (…) are traded.”
Tether USDT (a cryptocurrency stablecoin) used many of these short-term instruments to back its stablecoin in relation to the United States Dollar (USD), as it can be shown in this article.
It’s also possible to buy bonds in the money market. And they work the same like in the capital market, already explained in the previous section: countries use these bonds to fund themselves. The most popular ones are also from the US.
Be aware that the same doesn’t happen to bonds of governments like Venezuela, Turkey, or Argentina which have enormous interest rates, high inflation, low growth, and political instability.
Figure 3 shows the US Government Bonds 10 year yield:
Banks and brokerage firms can also offer certificates of deposit to investors. The idea follows the basic: you give me your money for a certain period of time and I pay you interest. Simple as that. The same happens with commercial papers, but these ones are issued by companies.
The Money Market is as simple as that: it allows you to deposit your money and earn interest through products that have usually a lower risk, lower interest, and shorter maturity than the capital market.
The Wall Street Mojo has a great infographic about the main differences between both markets. Take a look here.
On one side, we have companies with mid to long-term objectives that are constantly raising capital to grow. On the other side, we have banks, companies, brokerage firms, and the government funding their activities through short-term financial instruments. In the middle, there is you, the investor, with your money.
Deciding where are you going to invest depends on your objectives and risk aversion. Both markets can be liquid, but the money market tends to be highly liquid. Of course, this comes at a price that results in much lower earnings than the capital market in the long run.
The truth is that we will all have to invest in both. We will need a highly liquid basket to cover any unforeseen events and we will also need high-potential investments, capable of multiplying our capital in the long term.
The right percentage to allocate to each market remains a mystery. Even though many theories have tried, this is a discovery journey that every investor has to take. Make good use of both markets.