Show of hands: Who knows what a security is in finance?

If you answered ‘I’m not quite sure but I know it has to do with money’, then chances are that you have not yet begun your investment journey, as this is a term with which you should be acquainted. Or perhaps you’ve only begun to dip your toes in at the shallow end of the investment pool and you’re curious to get involved, but certain financial terms seem to go right over your head.

In an age when investing is increasingly becoming acknowledged as a vital aspect of 21st century reality, it is important that a potential investor arm themselves with the tool of financial literacy rather than allow themselves to be intimidated, leading them to inaction.

What is a security?

In finance, a security is defined, at its most basic level, as a tradable or negotiable asset that can be exchanged between parties. It is a financial instrument that holds value and can be bought, sold or traded quickly and easily for others of its same type, making them what is referred to as “fungible”. Take this to include stocks, stock options, bonds, mutual funds, and exchange-traded funds (or ETFs). Securities can, generally speaking, be broken into three basic types: equity, debt and derivatives.

Equity

Equity securities are those that make you get partial ownership of an entity, the most common being shares of a company’s stock, making you a shareholder in that company and, thus, often entitled to certain voting rights regarding the company’s business decisions. Stocks traded on the stock market, like the Jamaica Stock Exchange, are the commonest type of equity securities. But they can also include shares of mutual funds and certain ETFs. Equity securities usually generate earnings for shareholders by way of dividends or a share of profits that the company pays out, at a set time, when it generates a profit. But it is important to note that, while dividends will usually be greater the more equity security you have in a company, there’s no guarantee as equity securities do rise and fall in value depending on the state of the financial markets or even the fortunes of the company itself.

Debt

Debt securities are basically loans provided by investors. Owners of debt securities, such as bonds and certificates of deposits (CDs), lend money (the principal) to another party, whether a company or the government, for an agreed-upon period of time, after which the party is obligated to repay the loan at a pre-determined rate of interest at regular intervals as per the terms of the agreement until the maturity date of the instrument, at which time the debtor must pay back the security owner the amount of the principal.

Derivatives

Sometimes styled as “secondary securities”, these securities are contracts that derive their value, and risk, from certain other primary securities like stocks, bonds or commodities (hence the term “derivative”). They can, depending on their nature, either be traded in public exchanges or the over-the-counter (OTC) market, which is trading done directly between two, or sometimes more, parties without the supervision of an exchange or organised market. They relate to the purchase or sale of a specific asset or pool of assets, and are used either by individuals or entities to mitigate risk, and consist generally of options, futures, forwards and swaps and expire on an agreed-upon date. They are often used by investors to either to speculate or hedge investments and make money. For the beginning investor, however, don’t get bogged down in derivatives, which can be complicated as they are, if OTC, unregulated as against those traded in an organised market. At any rate, these securities can pose great risks if you’re not a seasoned investor.

Why are securities important?

Securities are important for both investors and entities in a capitalist economy. In addition to them being easy to trade, if a company wants to raise capital, for expansion especially, and opts not to go the bank loan route because the interest rates may be too prohibitive, they can turn to the options of equity or debt securities. The upside for investors, meanwhile, for equity securities, is that, as long as the company does well, they can benefit from the company’s value appreciation through the dividends or profits their investment earns over time. Debt securities are also very appealing to investors because this type of security provides a stream of payments for a locked-in period of time, regardless of whether or not the entity does well, as the company’s assets may be secured in the event of any default.

Bottom line

You don’t have to be a big-time finance person with a business degree to understand the concept of securities. Importantly, don’t allow the different financial terms intimidate you and cause you to not take the first step on your investment journey. All it takes is a willingness to do the research to discover the best ways to make your money work for you.