Pick a unit
Each one takes about seven minutes and ends with a quick check. They build on each other, so starting at Unit 1 helps, but you can jump to any of them.
Money, prices and why money grows
What money is
Picture a small island with just two people: a baker and a fisher. There is no money. When the fisher wants bread, he offers fish, and if the baker wants fish, they swap. Trading things directly like this is called barter.
Add a third person, a shoemaker, and barter starts to jam. The fisher wants bread, but the baker wants shoes, not fish. Barter only works when each person wants what the other one has, at the same moment.
So the islanders agree to use pretty shells instead. Shells work because they are not unlimited: each one takes real effort to find. Anyone will take a shell for their goods, because they know everyone else will take it too.
That shared agreement is all money is: a token everyone accepts in exchange for things. Today the token is dollars, euros or yen, as coins, notes or numbers in a bank account.
Why prices move
A price is how much money you hand over for a thing. Say a fish costs 2 shells. Nobody ordered that number. It settled where the fisher is happy to sell and the islanders are happy to buy.
Two forces push a price around:
- Supply: how much of a thing is for sale.
- Demand: how much of it people want to buy.
By now six families live on the island, and the fisher usually lands six fish a day. Here is what happens to his price when the catch changes.
One night a storm wrecks his nets, and he lands only two fish. Rather than go without, some families offer 3 shells, and he sells to them. When demand is bigger than supply, the price rises.
The next week the catch is huge, but only two families want fish that day. The fish will spoil by evening, so he drops the price to 1 shell to sell them all. When supply is bigger than demand, the price falls.
What inflation is
The storm made one price jump. Inflation is something wider: most prices rising together, so each unit of money buys less.
Go back to the baker and the fisher swapping with no money. After a poor catch, one fish might fetch two loaves instead of one. Fish got costlier compared with bread, which means bread got cheaper compared with fish.
In pure barter, one thing can only rise if another falls. So there is no inflation: there is no money for prices to be counted in.
Now give the island shells, and watch what a chest of new shells does to bread.
- Each day the islanders spend 10 shells on bread. The bakery makes 5 loaves, so a loaf goes for 2 shells.
- Then a chest of shells washes ashore, and everyone suddenly has twice as many.
- The ovens haven’t changed, so there is no extra bread.
- People spend 20 shells on the same 5 loaves. Buyers bid against each other, and the baker, seeing twice as many shells offered for every loaf, can ask twice as much.
- A loaf soon costs 4 shells.
There is no more bread than before, so each shell simply buys less. The same happens with just the baker and the fisher. If each woke up with twice the shells, they would soon be asking twice as many shells for a loaf or a fish.
Why prices rise in real life
Real economies don’t find chests of shells on the beach. But the same thing happens in three main ways.
In 2021 governments sent people extra Covid money, and families who had saved at home began spending. Factories and ports were still restarting, so fewer goods reached the stores.
In 2022 oil and gas prices jumped. Trucking, heating and fertilizer all cost more. Stores passed those extra costs on to shoppers.
Workers ask for bigger raises to keep up. Stores raise prices early to pay for those raises. Both push prices up, so the expected rise comes true.
All three hit at once in 2022. By mid-year, US prices were rising about 9% a year, the fastest in 40 years.
Shopping that had cost $100 a year earlier now cost about $109. The Booms and Slumps lesson shows how central banks fought back.
Who makes new money
New money today comes from two places. The first is each country’s central bank, a public bank that runs the country’s money. In the US it is the Federal Reserve, or “the Fed”.
The central bank issues the paper money. It keeps accounts for ordinary banks, much as your bank keeps an account for you, and it can add money to those accounts. It also sets the main interest rate, the price of borrowing money, which you’ll meet further down and in Unit 2.
The second source is ordinary banks. When a bank lends you $10,000 for a car, it doesn’t take the cash out of another customer’s account.
- It simply types $10,000 into yours. Money in an account is only a number the bank promises to pay out.
- The bank also writes down that you owe it $10,000.
- The new number is brand-new money, and you can spend it like any other.
- When you pay the loan back, the bank deletes the number and cancels your debt, so that money disappears again.
Most of the money in people’s bank accounts was created this way. That is why the amount of lending in an economy matters so much for prices.
Because the central bank sits at the top of this system, it is the one held responsible for inflation. Most big central banks, the Fed included, aim for prices to rise about 2% a year.
At that pace, shopping that costs $100 today costs about $122 in ten years. That is slow enough that people can plan, and that savings earning interest can keep up.
The aim is a little above zero on purpose, because falling prices start a slide:
- People put off buying (“it’ll be cheaper next month”).
- Stores sell less and cut jobs.
- Debts get harder to repay, because wages fall while the debt stays the same size.
A small, steady rise keeps a cushion between the economy and that slide. Fast inflation hurts in the other direction: savings melt away, and nobody can tell what anything should cost.
Curious? Go deeperWhen a country makes far too much money: Germany, 1923
After World War One, Germany owed huge sums. Its government paid its bills by making ever more money, and like the chest of shells, the new money chased the same goods.
By late 1923 prices were doubling every few days. Workers were paid twice a day and ran to the stores before their wages lost value. A loaf of bread cost billions of marks.
Runaway inflation like this is called hyperinflation. It ended only when Germany brought in a new currency, with strict limits on how much of it could be made.
Why lenders charge interest
Back on the island, the fisher wants a bigger boat. It would catch twice as many fish, but he doesn’t have the shells to build it. The baker has spare shells she won’t need for a year.
So she lends him 10 shells, and he promises to hand back 11 a year later. The extra shell is interest: the price of borrowing money, written as a percentage per year. Here it is 10%, because 1 shell is a tenth of 10.
The baker wants that extra shell for three reasons:
- Waiting. For a whole year she can’t use those shells herself.
- Risk. The boat might sink, and she might never be paid back.
- Rising prices. Prices might rise, so 10 shells could buy less next year.
A lender asks for more interest when the wait is longer, the borrower is shakier, or prices may rise faster. The fisher agrees because the bigger boat earns him far more than one shell.
In real life, most lending goes through banks. A bank stands in the middle, between savers and borrowers.
- Savers put money in and earn a little interest, say 2% a year.
- Borrowers take loans and pay more, say 6%.
- The gap pays the bank’s staff, covers the loans that never get paid back, and leaves a profit.
Banks still want your savings, even though they create money when they lend. A borrower usually spends the loan at someone with a different bank, so the money leaves. The lending bank then has to hand over real money it holds at the central bank.
Savers’ deposits are the cheapest way to get that money. That is why banks compete for savers, and why the interest they pay on savings moves with the interest they charge on loans.
How savings grow
Leave interest in the bank and something useful happens.
- With simple interest, you earn the same amount every year: 5% of $1,000 is $50, every year.
- With compound interest, each year’s interest is added to your pile, and next year you earn interest on that too: $50 the first year, $52.50 the second, a little more every year after.
Compounding is like a snowball rolling downhill, which picks up more snow the bigger it gets.
Over 30 years at 5%, $1,000 grows to $2,500 with simple interest and to about $4,322 with compound interest. That is more than four times what you started with, and about 1.7 times the simple result.
The same snowball works against you on a debt, such as a credit card bill left unpaid.
Slide to see how the gap opens up.
Curious? Go deeperThe rule of 72: a shortcut for doubling
To guess how long money takes to double, divide 72 by the yearly growth rate.
- At 6% a year: 72 ÷ 6 = 12, so about 12 years.
- At 8%: about 9 years.
- At 3%: about 24 years.
It works for inflation too. At 2% inflation, prices double in about 36 years. At 7%, it takes only about 10 years.
It’s an estimate, most accurate for rates around 8%, but close enough to do in your head.
Curious? Go deeperReal return: growth after inflation
The growth you see on a statement is the nominal return. What matters for your shopping is the real return: the growth minus inflation.
If your savings grow 7% while prices rise 3%, you are really about 4% better off each year.
That’s why a savings account paying 1% while prices rise 3% loses you about 2% of buying power a year, even though the number in the account goes up.
Safe and risky ways to grow money
Every way of growing money sits somewhere between safe and risky. In money, risk means how far your results can swing, in both directions.
Lending to a solid borrower for a short time is safe, but it earns little. Owning part of a business can earn much more, but in some years you lose a lot. People only take the bigger swings if they expect a bigger reward on average; otherwise everyone would pick the safe option.
The picture shows $1 put away in 1926 and left alone until the end of 2025. Over that time, prices rose 18-fold.
- Lent to the US government a few months at a time, about the safest place there is: about $25, only a little ahead of prices.
- Lent for decades at a time (as bonds, Unit 2): about $117.
- Put into shares, small pieces of big US companies (Unit 3): about $14,751. That is 14,751 times the starting money, against 18 times for prices.
But shares lost a third or more in some single years.
Money is a token everyone agrees to accept, and prices move with supply and demand. When more money chases the same goods, most prices rise together: that is inflation. Interest is what borrowers pay for using money now. Left alone, it compounds like a snowball, and investments that can grow faster can usually fall harder too.
On the island, a chest of shells washes ashore and everyone has twice as many shells. The bakery still makes the same 5 loaves a day. What happens to the price of a loaf, in shells?
Borrowing, interest rates and bonds
Why people borrow
Borrowing lets you do something now and pay for it later. Back on the island, the fisher wants a boat that costs 50 shells, and he has 10. Saving the rest would take him about five years.
Borrowing 40 shells gets him the boat this week, and the extra fish it catches pay off the loan. For the lender, shells that would have sat idle go to work and earn interest (Unit 1).
Governments and companies borrow for the same reason:
- A bridge built today will be used for 50 years, so a city borrows to build it now and pays the loan off from taxes over many years.
- A company borrows to build a factory that will earn money for decades.
- Governments also borrow in bad years, when tax money falls and more people need help.
The US government owes about $40 trillion, mostly to savers, pension funds and banks that lent it money. That is more than everything the country produces in a whole year.
What a bond is
A government that needs billions can’t get it all from one lender. Instead it splits the loan into many small IOUs and sells them to anyone who wants one. Each of these is a bond.
You hand over, say, $1,000 today, and the borrower promises two things in writing:
- A fixed interest payment every year, called the coupon: say $30, which is 3%.
- Your $1,000 back (the face value) on a set date, called the maturity.
Bonds are named after who borrows:
- Treasuries come from the US government.
- Municipal bonds come from cities.
- Corporate bonds come from companies.
Unlike a bank loan, a bond can be sold to someone else before it ends. So there is a whole market of people buying and selling them.
Who sets interest rates
Interest rates are set by two forces.
It sets one short-term rate: in the US, the rate banks charge each other for overnight loans (a bank that ends the day short of money borrows from one with extra). That rate is what money costs banks. When it goes up, banks charge more on loans and pay a bit more on savings.
It works like the fish stall in Unit 1. If lots of people want to borrow and few want to lend, borrowers offer more interest to get the money, and rates rise. If lenders are plentiful, rates fall.
The central bank (Unit 1) moves its rate to steer prices.
- When prices rise too fast, it raises the rate. Loans cost more, so people and companies borrow and spend less. Less spending chasing the same goods slows the rise.
- When the economy is weak, it cuts the rate, so borrowing is cheaper and spending picks up, as the Booms and Slumps lesson shows.
For long loans, such as a 10-year bond, lenders also look ahead. If they expect fast inflation or a higher central-bank rate in the coming years, they ask for more now.
When borrowers can’t pay
The big danger with any loan is that the borrower stops paying, which is called a default. Companies called rating agencies grade bonds, from AAA (very safe) down to D (already defaulted).
The US government almost never misses a payment, so its bonds are treated as about the safest thing there is. A struggling company has to offer more interest, because lenders could always pick the safe government bond instead.
Ratings are opinions, not guarantees. Before 2008, the agencies gave top grades to bundles of home loans that later collapsed (Unit 8 tells that story).
Why bond prices move
To see why bond prices move, start back on the island. The baker lends the fisher 100 shells for 10 years. His IOU promises 3 shells a year, plus the 100 back at the end.
A year later, the baker needs her shells early, and she wants to sell the fisher’s IOU to a neighbor. What a neighbor will pay depends on what new IOUs pay by then.
Rates have gone up: a new boatbuilder sells IOUs paying 4 shells a year for 100 shells. No neighbor will pay 100 shells for her IOU paying only 3. To find a buyer, she must take less, about 93 shells.
Rates have fallen instead, and new IOUs pay only 2 shells a year. Her 3-shell IOU now looks generous. Neighbors would pay more than 100 shells for it.
The price of an old IOU moves the opposite way to the rate on new ones.
Real bonds behave the same way. In an example from the SEC (the US investing regulator), a $1,000 bond paying 3% with 9 years left drops to about $925 when new bonds start paying 4%.
So when interest rates go up, bond prices go down, and the other way round. If you keep the bond to the end, you still get your $30 a year and your $1,000 back. The lower price only hurts if you sell early.
At 3%, new bonds pay the same as yours, so it sells for $1,000.
Curious? Go deeperYield: what you really earn
The coupon is fixed, but the price you pay is not. The yield is what you actually earn per year, based on the price you paid.
Buy that $30-a-year bond for $925 instead of $1,000 and you earn more than 3%: the $30 a year, plus a $75 bonus when it repays $1,000 at the end.
That’s why news reports talk about bond yields rising: it means prices are falling.
Curious? Go deeper2022: the year “safe” bonds fell hard
In 2022 prices rose fast. The US central bank raised its interest rate from near 0% to over 4% in under a year, and bond prices did exactly what this unit predicts.
The most widely used measure of US bond prices lost about 13% that year, its worst year on record. The previous worst was a fall of about 3%, in 1994.
Shares fell too, so people who held both had nowhere to hide. Bonds that ran for 20 or 30 years fell much more than short ones: the longer you are stuck with a low coupon, the more a rate rise hurts the price.
Borrowing lets people, companies and governments spend now and pay later, and interest is the lender’s price. The central bank sets the short-term rate, and supply and demand for loans set the rest. A bond is an IOU you can sell: when interest rates rise, existing bonds lose value, and riskier borrowers must pay more.
Your bond pays 3%. New bonds now pay 5%. What happens to the price you could sell yours for?
Stocks: owning a slice of a company
Revenue, costs and profit
Start with a lemonade stand. Over one summer it sells 100 cups at $1 each.
- All the money coming in from sales is called revenue: here, $100.
- Lemons, sugar and cups cost $60. The money going out to run the business is its costs.
- What’s left, revenue minus costs, is profit: $40 for the owner.
If costs were bigger than revenue, the stand would make a loss.
Companies and shares
A company is a business set up as its own person in the eyes of the law, separate from the people who own it. It can own things, sign deals and borrow money in its own name.
If the company goes bankrupt, meaning it can’t pay its debts, the owners lose what they put in. But nobody can take their homes to pay the company’s debts. This is called limited liability, and it makes it safe to own a small piece of a business you don’t run.
Now the lemonade stand does well, and its owner wants a second stand across town. Setting it up costs $200, which she doesn’t have. She has two ways to get it.
She could take a loan (Unit 2). But then she must repay it with interest, even if it rains all summer.
A friend pays $200 and becomes owner of half of it, with a right to half of every future profit. That money never has to be paid back, with no interest, and in a bad summer the friend simply gets nothing. The price is giving up part of every future profit.
Big companies do the same on a giant scale. They split their ownership into millions of equal pieces called shares or stocks (the two words mean almost the same thing).
Own one share out of a million and you own a millionth of the business, and of its future profits.
How shares are bought and sold
The first time a company sells shares to the public is called an IPO (initial public offering). Most of the money from that sale goes to the company, to build stores or factories.
After that, owners who want their money out sell their shares to other investors on a stock exchange, such as the New York Stock Exchange or Nasdaq. A stock exchange is a marketplace, mostly run by computers, where buyers and sellers of shares meet.
Those later trades are between investors, so the company gets nothing from them.
Owners can gain in two ways:
- Cash from profits. When the company makes a profit, it may pay part of it to the owners in cash, called a dividend, or keep it to grow the business.
- A rising share price. If the business grows, each share becomes worth more, so an owner can sell it for more than they paid.
Curious? Go deeperCommon and preferred shares
Most shares are common shares. They usually come with a vote at the company’s yearly meeting, and dividends that can go up, down or stop.
Preferred shares usually pay a fixed dividend and get paid before common shareholders, but usually have no vote.
If a company goes bankrupt, here is who gets paid, in order:
- Lenders (bondholders) are paid first.
- Then preferred shareholders.
- Common shareholders get whatever is left, which is often nothing.
What moves a share’s price
A share’s price is set by supply and demand, just like the fish on the island in Unit 1.
- If more people want to buy a share than sell it at today’s price, buyers offer more until enough owners agree to sell, and the price rises.
- If more people want to sell, sellers keep cutting their price until buyers appear, and it falls.
What makes people keen to buy is the future. A share is a slice of every profit the company will ever make, so its price is people’s best guess about those profits.
News that changes the guess moves the price at once, before any money comes in. A forecast of a hot summer lifts the lemonade company’s shares.
That’s also why a share can fall on a day the company reports a profit. The profit was smaller than people expected, or the outlook got worse.
How big a company is
The price of one share tells you nothing about how big a company is. A $10 share can belong to a much bigger company than a $200 share.
Multiply the price by the number of shares to get the market value (often called market cap) of the whole company. It is what all the slices are worth together, at today’s guess.
Market values can get enormous. The biggest US companies are each valued at several trillion dollars, more than everything most countries produce in a year.
Curious? Go deeperThe price-to-earnings ratio (P/E)
Investors compare companies with the P/E ratio: the share price divided by the profit per share for one year (profit is also called earnings). A P/E of 20 means you pay $20 for each $1 of yearly profit.
A high P/E usually means people expect the profit to grow fast, so they pay more today for each dollar of profit now. A low one can mean a bargain, or a company people expect to shrink.
How far stocks can fall
Stocks have grown the most over long stretches, but they can drop fast.
- 2008: the 500 biggest US companies lost about 37% of their value over the year, and about half from their late-2007 high to the low in March 2009.
- Early 2020: as Covid spread, they fell about a third in just over a month, then climbed back within about five months.
A loss on paper only becomes real if you sell while prices are down.
A company earns revenue, pays its costs and keeps the profit. Selling shares raises money without a loan, in exchange for a slice of every future profit. A share’s price moves with supply and demand, driven by people’s best guess about those future profits, so it can swing even when nothing about the business has changed yet.
Company A’s shares cost $10 and it has 100 million of them. Company B’s cost $200 and it has 1 million. Which company is worth more?
Funds: buying the whole basket
Why picking winners is hard
Unit 3 showed that a share’s price is the crowd’s best guess about a company’s future profits. To do better than everyone else by picking shares, you need to buy a company before the crowd sees how good it is.
That is much harder than finding a good company. Thousands of full-time professionals study every big company every day, trying to do exactly the same thing.
When good news comes out, such as a strong year of sales, those professionals rush to buy in the first minutes. More people want the share than want to sell it, so the price goes up (supply and demand, Unit 1).
By the time most people read the news, the price already includes it. A well-known great company is usually priced as a great company, so buying it gives no head start.
How a fund works
A fund takes a different path. Instead of hunting for the winners, it buys a little of everything:
- A fund company collects money from many savers, say 1,000 people putting in $1,000 each.
- That makes one pot of $1 million.
- A manager spends the pot on shares of hundreds of companies.
- Each saver owns a slice of the pot, and so a tiny piece of every company in it.
The fund company doesn’t keep those shares itself. A separate firm, usually a big bank called a custodian, holds them in the fund’s name. If the fund company went bankrupt, the shares would still belong to the savers.
The price of one slice, called a fund share, is simple division. Add up what everything in the pot is worth today, and divide by the number of fund shares.
- A pot worth $1 million split into 100,000 fund shares makes each one worth $10.
- If the companies in the pot rise 5% in value, the pot is worth $1,050,000.
- Each fund share is then worth $10.50.
Curious? Go deeperWhat happens when people put money in or take it out?
When you put $1,000 into a fund whose shares are worth $10, the fund creates 100 new fund shares for you. It spends your $1,000 on more of the same companies.
The pot and the number of fund shares grow by the same amount, so the price of each fund share doesn’t change.
When someone takes money out, the fund sells a little of everything, pays them, and cancels their fund shares.
Money flowing in or out changes the size of the pot, not the price of a slice. Only the value of the companies inside moves the price.
What an index is
Most funds of this kind copy an index: a published list of companies, plus a rule for how much each one counts. It is used to measure how a whole market is doing.
An index works like a class average, one number that sums up how a whole group did. The best known, the S&P 500, lists about 500 of the biggest US companies.
In the S&P 500, each company counts in proportion to its market value (Unit 3: share price × number of shares). The reason is that this matches where investors’ money really sits.
- Company A is worth $90 billion and Company B $10 billion.
- So 90 of every 100 dollars invested in the pair are in A.
- If A rises 10% and B falls 10%, the index rises 8%, not zero, because A counts for nine times as much.
An index built this way moves exactly as the average invested dollar does. It is also cheap to copy.
When A’s shares rise, A’s weight in the index rises by itself. A fund that already owns A’s shares stays in step without buying or selling anything.
That gives two kinds of fund:
- An index fund buys everything on an index list.
- An active fund pays experts to choose only the shares they think will do best.
Why most experts trail the index
You might expect the experts to win. To see why most of them can’t, picture a tiny market with only four investors, Ana, Ben, Cai and Dee, who together own every share in it.
- This year the market’s value rises 10%.
- Each of the four holds the same amount, and together they are the market, so their results must average out to 10%.
- If Ana makes 16% and Ben 14%, then Cai and Dee must end up below 10%, for example at 6% and 4%.
Every gain above the average is matched by someone else’s result below it. The real stock market works the same way. Index funds get the average, and active investors as a group also get the average, before costs.
Then the costs come out. Active funds pay researchers, trade often and charge roughly 0.5% to 1% or more a year, while index funds can charge under 0.1%.
So the average active dollar must end up behind the index. The economist William Sharpe set out this arithmetic in 1991.
Real results match it. A team at S&P checks every year. Over 15 years, about 9 in 10 active funds that buy big US companies did worse than the plain S&P 500.
Some funds do beat it for a while, but last period’s winners rarely stay on top. So picking the winning fund ahead of time is as hard as picking the winning share.
What fees cost you
Every fund charges a yearly fee called the expense ratio: a percentage of all your money in the fund, taken out a little at a time.
A 1% fee sounds tiny, but it is charged on your whole pile, not just on the growth. If the fund grows 7% in a year, a 1% fee takes about one-seventh of that year’s growth.
Fees also work like compounding in reverse (Unit 1). Each dollar taken out this year would have kept growing every year after, so the fee takes that future growth too.
Here is an example from the SEC, the US investing regulator:
- $100,000 grows 4% a year for 20 years.
- With a 0.25% fee, it ends at about $208,000.
- With a 1% fee, it ends at about $179,000.
- The extra three-quarters of a percent costs about $29,000, almost a third of the starting money.
Mutual funds and ETFs
Funds come in two main packages.
You buy and sell it directly with the fund company. Its price is worked out once a day, after the stock market closes, using the division above. Everyone who bought or sold that day gets that price.
It is split into fund shares that trade on a stock exchange all day long, just like a company’s shares. The price is whatever buyers and sellers agree.
Either package can hold an index fund or an active fund, and an ETF can hold shares, bonds, gold or almost anything else. What’s inside and how much it charges matter far more than the package.
Curious? Go deeperWhy an ETF’s price stays close to what it owns
An ETF’s price is set by buyers and sellers, so it could drift away from the value of the shares inside it. Big trading firms keep it in line.
These firms are allowed to hand the fund a full basket of the shares it holds and get new ETF shares in return, or to swap the other way.
If the ETF’s price rises above the basket’s value, a firm buys the cheaper basket, swaps it for ETF shares and sells those at the higher price, keeping the difference. That extra selling pushes the ETF’s price back down.
The same trick in reverse lifts the price when it falls too low, so the gap usually stays tiny.
A fund pools many savers’ money into one basket, and each slice is worth the basket divided by the number of slices. Index funds copy the whole market. Since all investors together can only earn the market’s average before costs, most expert-picked funds trail it after their higher fees, and fees compound against you.
Four investors together own a whole market, which rises 10% this year. Before any fees, what must their results average out to?
Risk, and why you spread it out
What risk means
Unit 1 called risk how far an investment’s value can swing, up as well as down. Those swings come from news.
A share’s price is the crowd’s guess about future profits (Unit 3), and every new fact changes the guess: a hot summer, a new rival, a factory fire, a rise in interest rates. When the guess improves, more people want to buy than sell, and the price rises. When it worsens, the price falls.
Nobody knows tomorrow’s news, so nobody knows next year’s price.
- Put $100 in a savings account paying 4%, and you can be almost sure of $104 a year later.
- Put $100 into one company’s shares, and a year later it could be $70 or $140, or anywhere between.
Risk is that width: how far apart the possible results lie.
How spreading out cancels risk
Some of that risk can be canceled out. Picture a small town with two shops: one sells umbrellas, the other sells ice cream.
In a rainy summer the umbrella shop makes a $20,000 profit and the ice-cream shop makes nothing. In a sunny summer it’s the other way round. Nobody can tell in advance what the weather will be.
Own all of one shop and your profit is either $20,000 or nothing. That is a wide swing, even though the average over many summers is the same $10,000.
Own half of each shop and you get $10,000 every summer, rain or shine, because a bad summer for one is a good summer for the other.
Spreading money across different investments like this is called diversification. It works because different investments are hurt by different news, so their bad years tend to come at different times.
The risk spreading can’t remove
Real companies are rarely perfect opposites like the two shops. But news comes in two kinds, and spreading out handles them very differently.
A fire at one factory doesn’t touch a bank across the country. Mix many companies and their separate surprises partly cancel. Most of the calming comes from the first 20 or 30 companies, which is why a fund holding hundreds (Unit 4) spreads this risk so well.
In a recession, the whole economy shrinks for a while: businesses sell less, some close, and people lose jobs and cut their spending. In our town, families would buy fewer umbrellas and less ice cream, whatever the weather.
When every investment falls together, nothing on the other side cancels the loss.
In 2008, a fund holding hundreds of US companies still fell by more than a third over the year, and by about half from its high to its low.
Curious? Go deeperCorrelation: why five tech companies aren’t spread out
Correlation measures how much two investments move together. The umbrella shop and the ice-cream shop move in opposite directions, the best possible pair for canceling swings.
Two investments that always rise and fall together cancel nothing: owning both is like owning one twice.
Five tech companies are hit by much of the same news, so they tend to move together and are less spread out than they look. Mixing different kinds of investments, such as big and small companies, other countries and bonds, works better.
One catch: in a real panic, almost everything falls at once, so investments that usually move separately suddenly move together. That is the recession problem above, and it’s why spreading out softened 2008 but couldn’t prevent it.
Why a few big winners matter
There’s a second reason to own many companies, and it comes from simple arithmetic.
A share can lose at most 100% of its value. It can fall to zero, but no lower, because owners are never made to pay a company’s debts (limited liability, Unit 3).
On the way up there is no ceiling. A $100 share can become $200, or $1,100 if it rises 1,000%. So one big winner can outweigh many losers.
Picture buying ten different $100 shares, $1,000 in all. Ten years later:
- Six of the companies have gone bankrupt, and their shares are worth nothing.
- Three are still at $100.
- One has risen 1,000% to $1,100.
Most of your picks failed, yet the ten together are now worth $1,400, 40% more than you paid. Had you bought only three of the ten, you would most likely have missed the one winner.
Real markets are lopsided in just this way. The researcher Hendrik Bessembinder studied every US share from 1926 to 2016, about 26,000 companies. More than half did worse over their lifetimes than Treasury bills: short loans to the US government, about the safest place to keep money.
All of the extra money that shares earned beyond what Treasury bills would have paid came from about 4 in every 100 companies, giants such as Apple and Exxon. Nobody can reliably tell in advance which companies those will be. Owning the whole market makes sure you own the few winners, without having to guess.
Risk is how widely the possible results spread. Owning many different investments lets their separate bad luck cancel out, but not a recession that hits them all. And since a share can lose at most 100% but gain far more, a few big winners carry the market, so owning all of it means owning them.
You own half of the umbrella shop and half of the ice-cream shop. Which kind of year still cuts your profit?
Futures: fixing a price today
Why crop prices swing
Shares swing with news about profits. Food and fuel swing for a more physical reason.
A farmer plants wheat months before the harvest, and how much grows depends on the weather. A drought or a flood can cut a harvest sharply, and nobody knows at planting time what the summer will bring.
Wheat is measured in bushels, a standard amount of about 27 kilograms (60 pounds). That is enough flour for roughly 70 loaves of bread.
People eat about the same amount of bread whether the harvest is big or small
- When a drought shrinks the harvest, the same hungry buyers compete for less wheat, and the price jumps a long way (supply and demand, Unit 1).
- After a huge harvest, farmers compete for the same buyers, and the price drops a long way.
Oil works the same way: people still need to drive to work, so a small shortage moves its price a lot.
When war broke out in Ukraine in early 2022, it cut off one of the world’s biggest wheat exporters. The price of wheat in Chicago shot to the highest level ever recorded in dollars, about three-quarters higher than at the start of that year.
Two opposite fears
That swing frightens both ends of the bread business, but from opposite sides.
She spends money in spring on seed, fuel and workers, say about $5 for every bushel she expects to grow. If wheat sells for only $4 at harvest, she loses money on every bushel. A few bad years in a row could cost her the farm.
He has promised stores a price for his bread months ahead. At that price he makes money only while wheat stays under about $7 a bushel. If wheat jumps to $8, his flour costs more than he planned, and he could sell bread at a loss all season.
The farmer is hurt by a low price, the baker by a high one, and neither can control the weather.
Between $5 and $7, both of them are fine.
Fixing the price ahead
Their fears are mirror images, so they can cancel them out with each other. In May, the farmer and the baker agree that in October the farmer will deliver 5,000 bushels at $6 each, whatever wheat costs by then.
Both can live with $6: it is above her $5 cost and below his $7 limit. A promise like this, to trade later at a price fixed today, is called a forward contract. Nobody pays in May; the money and the wheat change hands in October.
The baker still pays $6 and saves $2 a bushel. The farmer misses out.
The farmer still gets $6 and is the one who’s glad. The baker overpays.
Neither knew which would happen. Each gave up a possible lucky break to remove a possible disaster. Using a deal like this to cut a risk you already have is called hedging.
A forward is the simplest member of a family called derivatives: contracts whose value comes from (is “derived” from) the price of something else.
Once wheat reaches $8, a promise to buy it at $6 is worth $2 a bushel to whoever holds it. That value comes entirely from the wheat price.
From handshake deal to futures
A handshake deal has two weak spots:
- Finding a match. The farmer and the baker have to find each other and want exactly the same amount on the same date.
- Trust. If wheat soars to $8, the farmer is tempted to break her promise and sell elsewhere. If it crashes to $4, the baker may wish he could disappear. Between strangers, that kind of trust is hard to find.
A futures contract fixes both problems. It is a forward made standard (one wheat contract is always 5,000 bushels, for one of a few set delivery months a year). It trades on an exchange, so there is always a crowd to trade with.
After every trade, a firm called a clearing house steps into the middle. It becomes the buyer to every seller and the seller to every buyer, so nobody depends on a stranger, only on the clearing house.
The clearing house protects itself in two ways:
- Each side leaves a deposit called margin, for example $2,000 on a $30,000 contract.
- Gains and losses are settled every day instead of all at the end. If wheat rises 10 cents a bushel today, $500 moves from the farmer’s deposit to the baker’s side that evening.
If a deposit runs low, its owner must add more money by the next day, or the contract is closed. Losses can’t quietly pile up for months.
How the farmer locks in $6
To lock in her price, the farmer sells a futures contract at $6, even though she hasn’t harvested the wheat yet. In October she doesn’t deliver anything to the clearing house. Instead:
- She sells her real wheat to the local mill at whatever the price is then.
- She closes the futures contract by buying an equal one back.
- If wheat fell to $4, her futures side gained about $2 a bushel along the way. Mill price plus futures gain comes to about $6.
- If wheat rose to $8, the futures side lost $2 and the mill paid $8: about $6 again.
Who takes the other side
Farmers and bakers rarely want to trade at the same moment. Many farmers want to lock in a price around planting time, while bakers buy throughout the year.
The gap is filled by speculators: traders who will never grow or bake anything, but who buy or sell futures hoping the price moves their way. A speculator who buys the farmer’s contract in May is betting that wheat will be worth more than $6 later.
Speculators are useful because they carry the risk the farmer wants to get rid of. In that way they work a bit like an insurance company, taking on someone else’s risk in return for a chance of profit.
Because many of them are always ready to trade, a farmer can lock in a price in seconds.
Speculators almost never want the wheat, so they close their contracts before the delivery date. Only about 1 in 100 futures contracts ends with real goods changing hands.
Curious? Go deeperThe day oil cost less than nothing
On April 20, 2020, much of the world was in lockdown. Few people were driving or flying, so far less oil was being burned. But wells kept pumping, and the oil had to go somewhere.
The storage tanks at Cushing, Oklahoma, where this oil contract is delivered, were filling up fast.
A contract to receive 1,000 barrels of oil there in May was about to reach its deadline. Most holders were speculators with no tanks of their own.
Anyone still holding it at the end would have to collect oil with nowhere to put it, so holders paid others to take the contracts off their hands.
That day the price ended at minus $37.63 a barrel, against about $60 at the start of the year. Oil with nowhere to put it costs money to take. The contract for June delivery never went below zero.
Curious? Go deeperRice, samurai and the first futures markets
In 1700s Japan, samurai were paid in rice, so swings in the rice price swung their incomes.
At the Dojima rice market in Osaka, officially approved in 1730, merchants traded promises of future rice, left deposits and settled differences in cash. It’s often called one of the earliest organized futures markets.
In 1848, Chicago traders set up the Chicago Board of Trade to bring order to the grain trade, and standard futures contracts followed in 1865.
A futures contract fixes today the price of a trade months away. Farmers, bakers and others use it to remove a price risk they already have. A clearing house, deposits and daily settling let strangers trust the deal, and speculators take on the risk, hoping to profit.
Why can a farmer safely trade wheat futures with a stranger she never meets?
Options: a right, not a duty
Paying to keep a choice open
A future (Unit 6) locks both sides in: whatever happens, the trade goes ahead. Sometimes you want something looser.
Picture a used bike shop with a bike priced at $100. You won’t know until Saturday whether you got a new job, so you can’t promise to buy yet. But if you do get the job, you want that bike, and you worry that someone else will snap it up first.
So you ask the shop to hold it. The owner agrees, for $5 paid now and kept whatever happens. Until Saturday you have the right to buy the bike at $100, but no duty to.
- You get the job: you buy the bike at $100.
- You don’t: you walk away and lose only the $5.
The $5 buys you time to find out, plus a guaranteed price if things go your way.
The shop owner agrees because the $5 is theirs to keep, whatever you decide. Most of the time nothing dramatic happens: you buy at the normal price or you don’t come back, and the owner is $5 ahead.
The owner’s risk is that the bike suddenly becomes worth much more, say because a famous rider makes that model popular. The owner still has to sell it to you for $100. The $5 is their payment for carrying that risk.
What an option is
This kind of deal is an option: a paid-for right, but not a duty, to buy or sell something at a fixed price until a deadline. Options have their own words:
- The fixed price is the strike price.
- The deadline is the expiry.
- The fee is the premium.
- A call option is the right to buy, and a put option is the right to sell.
A handy way to remember: you “call” the thing to you, or “put” it onto someone else.
A call option, step by step
Options on shares are bought and sold on exchanges, much like the shares themselves. In the US one option contract usually covers 100 shares.
The seller is usually a professional trading firm, or an investor who already owns the shares and wants some extra income from them. They agree for the same reason as the bike shop: they collect the premium now, and they expect that many options will end up unused.
Here is a call option on a share, step by step:
- A share costs $100 today, and you think it will rise.
- You buy a call with a strike price of $105 that expires in one month.
- The premium is $2 per share, so $200 for the contract of 100 shares.
- That $200 goes to the seller straight away, and you never get it back.
A month later, you compare the share’s price with $105.
Your right to buy at $105 is useless, because anyone can buy the share for $103 in the market. You let the option expire and lose the $200, but nothing more. That is the big comfort of buying options: the most you can ever lose is the premium.
You use your right: you buy 100 shares at $105 and sell them straight away at $115. That is $10 a share, or $1,000 in all. Take off the $200 you paid, and you are $800 ahead: your $200 has turned into $1,000, five times what you put in.
Compare buying the share itself. The same $200 buys just 2 shares, and they gain only $30, so your $200 becomes $230.
The break-even point is $107, where the $2 a share you gain by buying at $105 just repays the $2 premium.
Every dollar the buyer makes, the seller loses. At $115 the seller must sell shares worth $115 for only $105, which costs them $1,000, less the $200 they kept. Leaving fees aside, an option simply moves money between the two sides: one side’s gain is the other side’s loss.
Slide the price to see when the option pays off.
Why most option buyers lose
That $800 is the attraction: a small stake can win big. But look at what has to go right:
- The share has to rise.
- It has to rise by more than $7.
- It has to do it within one month.
Each of those is a hurdle, and most of the time a share doesn’t clear all three. Then the option expires unused and the whole premium is gone.
Sellers also set the premium with this in mind. Like an insurance company, a seller charges enough to cover the times it has to pay out, plus a little extra for itself. So on average, buyers pay slightly more for options than the options turn out to be worth.
A large study of ordinary US investors trading options found that, as a group, they lost money. Many of them favored cheap options that expire within days, which have the least time to come good.
What sets the price of an option
Three things set the premium. Each one comes down to the chance that the option ends up worth using.
A right to buy at $105 when the share is $100 is worth more than a right to buy at $130. $105 is much easier to reach.
A share has more chances to make a big move in three months than in three days. So a longer option costs more.
A share that usually moves a dollar a week is unlikely to cross $105 in a month. A share that often leaps $10 in a day might easily cross it.
The seller of an option on the jumpy share is more likely to have to pay out, so they charge more.
As the deadline nears, the chances shrink day by day. So an unused option slowly loses value, which traders call time decay.
Puts as protection
Puts work the other way round, and their most common use is protection. Say you own 100 shares worth $100 each and you fear a crash.
You buy a put with a strike price of $90 that lasts three months, for a premium of $3 a share. Now, whatever happens before the deadline, you can sell your shares for at least $90 each.
- If the price collapses to $60, you use the put and sell at $90. You lose $10 a share instead of $40, plus the $3 premium.
- If nothing bad happens, the put expires and you are out $300, the way a car insurance payment is “lost” in a year with no accidents.
Pension funds and other big investors buy puts for exactly this. Their sellers act like insurers: they collect many small premiums, and pay out in the bad times.
Curious? Go deeperSelling options: steady income with a cliff edge
Selling options can look like easy money. Most options expire unused, so a seller collects premium after premium, month after month.
The catch is the rare big move. One crash, or one share that suddenly doubles, can cost more than years of small premiums. In a crash the sellers of puts all have to pay out at the same moment, because each must buy shares at the strike price that are now worth far less.
A seller of calls who doesn’t own the shares is in the worst spot. If the buyer uses the option, the seller must buy shares at whatever the market price is and hand them over at the strike price. A share’s price has no ceiling, so that possible loss has no limit either.
Curious? Go deeperGameStop, 2021: when option bets moved a share
In January 2021, huge numbers of ordinary investors piled into GameStop, a struggling chain of video game shops, and many of them bought call options. Trading in GameStop options rose from about $58 million on January 21 to about $2.4 billion on January 27, roughly 40 times as much in under a week.
Firms that sell calls often protect themselves by buying some of the shares. Then, if the price jumps, they already own what they might have to hand over.
With so many calls sold, that protective buying added to the demand for GameStop shares and pushed the price up. That made the calls more valuable and drew in more buyers.
The US regulator’s report said this was one part of the story, not the whole of it, and experts still argue about how big a part.
An option is a paid-for right, not a duty, to buy (a call) or sell (a put) at a fixed price before a deadline. The buyer can lose only the premium, and most buyers end up losing money, because the price has to move far enough, in the right direction, in time. The seller keeps the premium as payment for carrying that risk.
You paid $2 per share for a call with a $105 strike price. At the deadline the share is $103. What happens?
Swaps, leverage and the 2008 crash
Borrowing to invest
Picture a lemonade stand that turns every $1 of lemons and sugar into $1.20 of sales. With $100 of your own, you make $20 over the summer. Then a neighbor offers to lend you $900 at 5%:
- Now you can spend $1,000 and make $200.
- You pay the neighbor $45 in interest.
- You keep $155 instead of $20.
If what you buy earns more than the loan costs, borrowing lets you keep the difference on money that isn’t yours.
Investing with borrowed money is called leverage. (The name comes from a lever, the bar that lets a small push lift a heavy rock.)
Leverage is measured as everything you bought divided by your own money. Take $1,000 of your own, borrow $9,000 and buy $10,000 of shares, and you have 10 times leverage, written “10×”.
Most people meet leverage when they buy a home: a $40,000 deposit plus a $360,000 loan buys a $400,000 house, which is also 10×.
Gains and losses, multiplied
Now follow the $10,000 of shares, bought with $1,000 of yours and $9,000 borrowed.
They are worth $11,000. You repay the $9,000 loan and keep $2,000. Your own money has doubled, even though the shares rose only a tenth.
They are worth $9,000. You repay the $9,000 and keep nothing. Your $1,000 is gone.
The losses all land on you because a loan is a promise of a fixed amount. The lender gets its $9,000 back (plus interest) whether the shares rose or fell. So it is first in line, and you get whatever is left.
At 10×, every move in the shares is 10 times as big for your own money, in both directions.
The lemonade stand works the same way. In a rainy summer it might make only $30 on your $1,000. You still owe the neighbor $945 ($900 plus $45 interest), so of your own $100 you get back only $85.
With no borrowing, a 5% fall costs you 5%.
Margin calls
Someone who lends you money to buy shares has one safety net: the shares themselves. They are the collateral, something the lender can take and sell if you don’t repay. (A pawn shop works the same way: it keeps your watch until you pay back what it lent you.)
While the shares are worth well over the $9,000 loan, the lender is safe. As they fall toward $9,000 the safety net thins. Below $9,000 the lender starts losing its own money.
So the loan has a rule. Your own money in the deal is called your margin (the same word as the deposit in Unit 6), and it must stay above a set level. If a fall pushes it below, you get a margin call: put in more cash now, or the lender sells your shares straight away to get its money back.
You are forced out at a low price, even if prices recover next month. And when many borrowers are forced to sell at once, all that selling pushes prices down further (more sellers than buyers, Unit 1). That sets off more margin calls.
Swaps: trading one payment for another
Leverage is one big idea in this unit; swaps are the other. Some loans have a floating rate: their interest rises and falls with the central bank’s rate (Unit 2).
Picture a bakery with a $100,000 floating-rate loan, paying 5%, or $5,000 a year. If rates jump to 7%, the bill becomes $7,000, which could sink a bakery with thin profits. The owner would gladly pay a little to know the bill in advance.
A bank offers a swap: a deal to trade one stream of payments for another.
- The bakery pays the bank a fixed 5% on $100,000.
- The bank pays the bakery the floating rate.
- Only the difference changes hands.
At 7%, the bank pays the bakery $2,000, covering its higher bill. At 4%, the bakery pays the bank $1,000. Either way its cost is $5,000.
The bank charges a fee and passes the risk on to someone with the opposite wish, such as an investor who would rather receive a fixed amount.
Curious? Go deeperIs the derivatives market really worth $846 trillion?
Headlines say the world has hundreds of trillions of dollars of derivatives: about $846 trillion in mid-2025, several times what the whole world produces in a year.
That number is the notional amount: the size the payments are worked out on, like the $100,000 in the bakery’s swap. That $100,000 never changes hands; only the difference in interest does.
A more honest number is what all the contracts would cost to replace today: about $22 trillion, roughly 1/40 of the headline. Many of those contracts also cancel each other out. That is still a lot of money, but nothing like the scary figure.
Curious? Go deeperArchegos: a hidden giant bet
In March 2021 a private investment firm called Archegos used swaps to make enormous bets on a few companies’ shares.
In this kind of swap, a bank buys the shares, and Archegos receives every gain and pays every loss as if it owned them, in return for a fee. Archegos put up only a small slice of its own money: heavy leverage.
Because the banks held the shares, Archegos didn’t show up as the owner. No single bank could see how big its bets were across all the banks.
When the share prices dipped, the banks made margin calls that Archegos couldn’t meet. The banks rushed to sell the shares, which pushed the prices down further. Between them they lost about $10 billion, about half of it at one bank, Credit Suisse.
Credit default swaps
Swaps can trade other kinds of risk too. Say you own a company’s bond (Unit 2) worth $1,000 and you worry the company might default. Someone agrees that you pay them $20 a year, and if the company defaults, they pay you what you lost.
This is a credit default swap. For the buyer it works like insurance on a loan. The seller agrees because most companies don’t default, so in most years they collect the $20 and pay nothing.
Two differences from real insurance mattered later:
- You didn’t need to own the bond to buy one. That is like buying fire insurance on a neighbor’s house: it pays if the house burns, so it’s really a bet that it will.
- An insurance company must by law keep money set aside to pay claims. Before 2008, a seller of credit default swaps had no such rule, so one seller could promise far more than it could ever pay.
The 2008 crash, link by link
In 2008, these pieces (careless loans, bundles of loans, heavy borrowing and credit default swaps) linked into a chain and broke banks around the world. Each link looked sensible to the people who built it at the time.
Here is the chain in five links. The pictures below follow it one link at a time.
Lenders sold each home loan on within weeks, so checks on borrowers got sloppy.
Big banks bundled thousands of loans and sliced the bundles, and the top slices were rated AAA.
House prices fell almost everywhere at once, so many borrowers stopped paying at the same time.
Lehman Brothers owned about $30 for every $1 of its own, so a small fall wiped it out.
Nobody knew who held the bad bundles, so banks stopped lending to each other, and then to everyone else.
The chain starts with home loans, called mortgages. A mortgage is a loan to buy a home, with the home itself as the collateral: if you stop paying, the lender can take the house and sell it.
For much of the 1900s, the bank that lent you the money usually kept the loan for 20 or 30 years. If you couldn’t pay, the bank lost. So it checked your income and savings carefully before lending.
By the early 2000s, many lenders sold each mortgage on within weeks to big banks, which bundled them up. The lender was paid for each loan it made, and someone else took the loss if it went bad, so checks got sloppy.
- Some loans needed no proof of income.
- Many started at a low introductory interest rate, to attract borrowers, that jumped after two years.
House prices had risen for years, so everyone assumed a struggling borrower could simply sell the house for more than the loan.
Next, big banks bundled thousands of mortgages into one investment called a mortgage-backed security. A bank bundled loans so it could sell them for cash and make new loans. Whoever bought the bundle received a share of all the monthly repayments.
It looked safe for the reason Unit 5 gives for spreading out: if 1 in 20 borrowers stops paying, the other 19 still pay, so the bundle as a whole keeps paying.
The banks then cut each bundle into slices. Repayments went to the top slice first, then the middle, then the bottom. Losses hit the bottom slice first.
(Picture a fountain of stacked bowls: the top bowl fills first, and only its overflow reaches the bowls below.)
The top slice would lose money only if a huge number of borrowers stopped paying at once, so it was rated AAA, the safest grade. The lower slices paid more interest, to make up for losing first, so some investors wanted them.
Leftover middle slices were bundled again into CDOs, sliced again, and their top slices got AAA too.
Spreading out protects you only if borrowers fail for separate reasons: one loses a job here, another falls ill there. The rating agencies’ math assumed exactly that. It also assumed home prices across the whole country wouldn’t fall at the same time, which they hadn’t done in decades.
But many of these borrowers shared one hidden link. They could keep going only if house prices kept rising, so they could sell or borrow again when their rate jumped.
From 2006, home prices fell almost everywhere at once. Borrowers who couldn’t pay could no longer sell for more than they owed, so they stopped paying together. Losses ate through the bottom slices into the “safe” ones.
There was a second problem. The agencies were paid by the banks that built the bundles. A bank could take its bundle to whichever agency graded it best, so a strict agency risked losing the business.
None of this would have broken the world if the bundles had been bought with savings. But banks bought huge amounts of them with borrowed money. AAA bundles paid a little more interest than government bonds, and the rules let banks hold very little of their own money behind anything rated AAA.
The investment bank Lehman Brothers owned about $30 of things for every $1 of its own money: 30× leverage, the top of the slider above. At 30×, a fall of just over 3% in what Lehman owned would wipe out its own money, and the bundles fell far more.
Lehman’s lenders, who lent it money a night or a few days at a time, wanted more collateral, then stopped lending: a margin call on a whole bank. Lehman went bankrupt on September 15, 2008.
Days later the US government rescued AIG, an insurer that had sold credit default swaps on these bundles without the money to pay. The rescue took about $182 billion, later repaid with a profit.
Banks lend to each other every day. On some days more cash leaves a bank than arrives, so it borrows from another bank overnight and repays the next day.
That web of loans means one bank’s failure lands on others: everyone Lehman owed money to lost some of it. And because nobody knew which banks held the bad bundles, banks stopped trusting each other and almost stopped lending to each other at all.
Banks short of cash had to sell what they owned in a hurry. That pushed prices down and set off the margin-call spiral across the whole system.
Banks also cut back lending to businesses and families. Firms that couldn’t borrow laid people off, and in the US the share of workers without a job doubled, from about 5 in 100 to 10 in 100.
That is how unpaid home loans in America became a crisis for the whole world.
Curious? Go deeperWhat changed after 2008
Governments rewrote several rules:
- Banks must now keep much more of their own money behind what they own, so a small fall can’t wipe them out as easily.
- The biggest banks are tested each year against an imagined crash to check they would survive it.
- Most standard swaps must now go through a clearing house (Unit 6), with deposits from both sides, so a seller can no longer quietly promise far more than it can pay.
- Credit default swaps still exist, but a seller now has to put up money as its promises grow.
Leverage, investing with borrowed money, multiplies gains and losses alike, and a margin call can force you to sell at the bottom. Swaps trade one stream of payments, or one risk, for another. In 2008, careless home loans, bundles graded too kindly, heavy borrowing and swaps nobody could pay turned falling house prices into a crisis for the whole world.
You invest at 10× leverage and the price falls 10%. What happens to your own money?
Private markets: venture capital, private equity and hedge funds
Public and private companies
Every company so far in this course has been public: its shares trade on a stock exchange (Unit 3), anyone can buy them, and the price changes every second. In return, a public company must publish detailed accounts every three months and follow many extra rules. It also lives with a share price that judges its every move.
A private company’s shares belong to a few owners, such as its founders or a fund, and aren’t traded on any exchange.
Plenty of companies choose to stay private:
- Listing on an exchange costs millions of dollars.
- Publishing accounts shows rivals what you are up to.
- Without a share price moving every day, bosses can make slow plans that pay off in ten years rather than in three months.
- A company can now raise large sums from private funds, so it no longer needs an IPO to grow.
Those private funds look after roughly $13–15 trillion, about a quarter the size of the US stock market.
How a private fund works
A private fund is a pool of money run by a firm of managers, called the general partner. The general partner uses the money to buy whole companies, or big slices of them.
The money comes mostly from limited partners: pension funds (which invest workers’ savings so they can pay each worker an income after retiring), universities and wealthy families. They are called “limited” because they can lose only what they put in, and they have no say in day-to-day choices.
The limited partners promise their money for about 10 years and can’t take it out early. A company can’t be sold in a day, and fixing one up and selling it takes years.
If investors could pull their money out whenever they liked, the fund would have to sell companies in a hurry at bad prices, like a bank facing a long line of savers who all want their cash at once. So everyone signs up for the whole ride at the start.
The 10-year lock and the fees
Investors accept the 10-year lock because they expect to be paid for it, for three reasons.
Unit 1 showed that lenders charge interest partly for the wait. In the same way, investors want a higher return in exchange for giving up the right to sell whenever they like.
A pension fund that pays pensions over the next 50 years doesn’t need most of its money back soon, so the lock costs it little.
Private funds can do deals the stock exchange can’t, like buying a family business that was never for sale.
The fees are high too. The classic deal is “2 and 20”:
- 2% of the money every year.
- 20% of the profits, usually only on profits beyond a minimum: the fund must first earn its investors about 8% a year.
On $100 million, the 2% alone is $2 million a year, before any profit.
Managers say they earn it by working closely with each company. Investors pay it because the managers with the best records are few, and the pension funds wanting to invest with them are many: supply and demand again.
Curious? Go deeperDo private funds beat the stock market after fees?
Researchers disagree.
- One large study of about 1,400 US funds found that buyout funds beat the 500 biggest US companies by roughly 3% a year after fees.
- Another found the average fund about equal to the stock market.
- A third, looking at funds from 2006 to 2019, found they roughly matched public shares while collecting a fortune in fees, a finding the industry disputes.
What they all agree on is the huge gap between funds. The best do much better than the stock market and the worst do much worse.
Picking the best one in advance is hard, much like picking the best active fund (Unit 4).
Private equity and buyouts
Private equity funds buy whole companies. Owners sell to them for ordinary reasons:
- A founder wants to retire and turn the business into cash.
- A big company wants to get rid of a part it doesn’t need.
- A public company’s shareholders are offered more than the current share price, and say yes.
The fund buys because it thinks it can run the company better, by cutting waste or growing faster, and sell it for more in a few years.
The classic method is a leveraged buyout. Here it is step by step:
- A fund buys a $100 million company with $40 million of its own money and $60 million borrowed.
- The debt is placed on the company itself, so the company’s profits pay the interest and pay the loan down.
- Five years later the debt is down to $40 million, and the fund sells the company for $150 million.
- After repaying the debt, $110 million is left: 2.75 times the fund’s $40 million.
With no debt, $100 million would have become $150 million: 1.5 times.
Debt magnifies the result for the same reason as in Unit 8: the lenders get back a fixed amount, so every dollar of gain above that goes to the owner.
It works the other way too. Had the company sold for $70 million with $60 million still owed, the fund would get $10 million back. That is a 75% loss on a company that fell only 30%.
The toy store Toys “R” Us was bought this way in 2005. It carried about $5 billion of debt and paid about $400 million a year in interest. That money couldn’t go into its stores or its website as shopping moved online, and Toys “R” Us went bankrupt in 2017.
Curious? Go deeperPrivate credit: lending without a bank
After 2008, new rules made banks keep more of their own money behind risky loans (Unit 8), so they lent less to mid-sized companies and to buyouts. Private funds stepped in to lend directly, charging higher interest.
This private credit has grown to somewhere between $2 trillion and $3.5 trillion, depending on who counts.
Borrowers accept the higher rate because the funds decide quickly and can bend the terms to fit. Investors like the extra interest.
The risk is that the loans aren’t traded, so nobody sees their value fall day by day, and trouble can stay hidden longer.
Venture capital
Venture capital funds back startups: brand-new companies trying something untested, usually with no profits yet. A bank won’t lend to them, because a loan has to be repaid from steady income and a startup has none. So startups sell slices of ownership (shares) to venture funds instead.
Most startups fail. The idea doesn’t work, a rival gets there first, or the money runs out before enough customers arrive.
A venture fund expects this and spreads its money over many startups.
A failed startup costs the fund what it put in, and no more.
A startup that grows into a giant can return 50 or 100 times the money.
So one big winner can pay for all the failures several times over. That is why venture funds look for ideas that could become enormous, rather than safe small businesses.
Curious? Go deeperWhat do hedge funds actually do?
A hedge fund is a private fund that can use almost any strategy.
The name comes from one of the first, started in 1949, which tried to hedge (Unit 6) against market falls. It bought shares it expected to rise and also bet against shares it expected to fall, so a crash would hurt one side but help the other.
Betting against a share is called short selling:
- You borrow a share from someone who owns it, for a fee, and sell it for, say, $100.
- If the price falls to $70, you buy it back for $70, return it, and keep $30.
- If the price rises instead, you must buy it back for more than you sold it for. Since a price can keep rising, the possible loss has no limit.
Today hedge funds look after about $5 trillion and do everything from betting on interest rates to fast computer trading.
Despite the name, many take big risks, often with leverage. As a group they have often trailed a plain mix of shares and bonds after their fees, which are typically like private equity’s.
How private prices are measured
A public share’s price is set by real trades all day long, so you see every wobble. A private company has no trades between the day a fund buys it and the day it sells it.
Its value in between is an estimate, usually made by the fund’s own managers every three months. They often look at what similar public companies are worth and adjust slowly.
Those estimates tend to move less than real prices, for two reasons:
- Managers smooth over short scares.
- They have little reason to mark a company down sharply while they are raising money for their next fund.
So on paper the line looks calm, while the business underneath swings just as much; the swings are simply measured less often.
Like a house with no price tag until the day it sells, a private company’s true price is known only when someone actually buys it.
Private funds buy companies and make loans away from the stock exchange. Investors lock their money up for about 10 years and pay high fees, hoping to be paid for the wait. Debt magnifies a buyout’s wins and losses, venture funds count on a few giant winners, and private prices look calmer than they are because they are rarely measured.
A fund buys a company for $100 million: $40 million of its own and $60 million borrowed. It sells the company for $120 million, with all $60 million still owed. What does the fund get back?
Property, gold, currencies and crypto
Shares pay you a slice of a company’s profits (Unit 3), and bonds pay interest (Unit 2). This unit is about things people buy that mostly pay nothing at all, plus one that does pay:
- Collectibles and gold: worth only what the next buyer pays
- Commodities: raw materials such as oil, wheat and copper
- Property: the one that pays, in rent
- Currencies: one country’s money, priced in another’s
- Bitcoin: digital money with nobody in charge
Why rare things cost more
A thing that pays nothing can still have a price, because a price is simply what someone will swap for it (Unit 1). Two things push that price up:
- few of the thing exist
- many people want it
Picture a school where only one copy of a rare trading card exists, and two kids both want it. One offers $50, the other $80, and the card goes for $80.
Then someone finds a box of 1,000 copies in an attic. Every kid who wants one can now have one, so nobody needs to outbid anybody, and the price collapses. The card itself is the same. What changed is how many exist compared with how many people want one. Being rare like this is called scarcity.
A card never pays you anything, so the only money you’ll ever get from it is what the next buyer pays. Art, old watches, rare cards and fine wine (together called collectibles) all work this way.
Collectibles also cost money to keep:
- insurance
- safe storage
- a cut for the dealer or auction house each time one is sold
So the price has to rise a lot before an owner even breaks even.
Gold and raw materials
Gold is the oldest example of a thing that pays nothing. It’s hard to dig up, so the world’s supply grows only slowly. It never rusts, it’s pretty, and people have used it as money and jewelry for thousands of years.
Nobody can print more gold, and no company or government has to keep a promise for it to keep its worth. So many people turn to gold when they stop trusting other things:
- when they fear a war
- when they fear a banking crisis
- when they fear their money will lose value to inflation (Unit 1)
In frightening times more people want gold, so its price tends to rise. But gold still pays nothing, so its price rests entirely on how much people want it, and that mood can change. Gold peaked in early 1980, then lost about two-thirds of its value by 1999.
Someone who bought at the top waited about 28 years just to get back to their 1980 price in dollars. By then everyday prices had more than doubled, so their gold bought far less than when they started.
Commodities are raw materials that get used up: oil, wheat, copper, coffee. Their prices follow supply and demand very directly. A drought shrinks the wheat harvest, bakers compete for the smaller pile, and the price jumps. A big new oil field adds supply, and oil gets cheaper.
Investors rarely store barrels in the garage. They buy futures (Unit 6) instead. Over long periods, commodities have roughly kept pace with inflation, with wild swings on the way.
Property and rent
Property is different, because it does pay. A family needs somewhere to live, but a whole home costs far more than most people have saved, and some will move again in a year. So they pay an owner to use a home instead. That payment is rent.
As a comparison, rent is to a home what interest is to money (Unit 1): the price of using something that belongs to someone else.
You can own property directly, or through a REIT (real estate investment trust). A REIT is a company that owns buildings and must pass most of its rent on to its shareholders.
House prices can still fall. A house is worth what buyers can pay, and three things can push that down.
Most buyers pay with a home loan called a mortgage (Unit 8). When rates rise, the same monthly payment repays a smaller loan, so every buyer can offer less.
More homes for sale than there are buyers means sellers have to accept less.
Job losses force some owners to sell, which adds even more homes for sale.
Here is the first one in numbers. Say a family can afford $2,000 a month for 30 years:
- At 4% interest, that repays a loan of about $420,000.
- At 7% interest, it repays only about $300,000.
- So when rates rise, every buyer can offer less, and sellers have to accept less.
From 2006 to 2012, US home prices fell by about a quarter.
Currencies
A currency is a country’s money: dollars, euros, yen. Its price is how much of another currency it swaps for.
Say you fly from the US to Paris. Shops there want euros, so you swap dollars for euros, at a booth or through your bank card.
- If one euro costs $1.10, a €100 hotel night costs you $110.
- If the euro’s price climbs to $1.25, the same night costs you $125.
The hotel’s price stayed at €100 the whole time, and only the euro got pricier.
The euro gets pricier when more people want euros: supply and demand again. Two reasons matter most.
Americans buying European cars, cheese or vacations must get euros first.
If savings in euros start paying more interest than savings in dollars, investors around the world swap dollars for euros to earn it. So when Europe’s central bank raises its interest rate (Unit 2), the euro usually rises.
Curious? Go deeperThe world’s biggest market, and why the dollar is in almost every trade
Currencies are traded in the biggest market of all. About $9.6 trillion changes hands every day, roughly what the whole US economy produces in four months. Most of it is banks, businesses and big investors, not tourists.
The US dollar is on one side of almost 9 in 10 of those trades. A company in Brazil paying a supplier in Korea often swaps its Brazilian money (reais) into dollars, and then the dollars into Korean money (won). It goes through dollars because so many people trade them that a match is always easy to find.
Oil is also priced in dollars. Small traders betting on tiny currency moves, often with heavy leverage (Unit 8), mostly lose money.
Bitcoin
Bitcoin, launched in 2009, is the best-known cryptocurrency (“crypto”): a digital money with no bank or government in charge.
To see how money can work with nobody in charge, picture a class that keeps track of who owes whom in a notebook. If one kid kept the notebook, that kid could cheat. So every kid keeps a copy, and a new line only counts if the copies agree.
Bitcoin is that notebook, copied on thousands of computers around the world. Each line says “this many coins moved from this account to that one”. Owning a bitcoin means the notebook says the coin is yours.
New coins are created slowly, as a reward for the computers that add new pages. The rules say there can never be more than 21 million, and nobody can print extra.
Curious? Go deeperHow does the copied notebook stay honest?
To add the next page, a computer has to win a guessing contest. It tries an enormous number of guesses, billions upon billions, until it finds one that fits a rule, which takes a lot of electricity.
The winner adds its page, and every other computer checks that each line follows the rules (for example, that nobody spends coins they don’t have). The winner receives newly created coins as its prize. This is called mining.
To cheat, say by rewriting an old page to spend the same coin twice, you would have to out-guess all the honest computers put together. That would cost far more than the cheating could win. The huge electricity bill is also why Bitcoin is often criticized for its energy use.
Why Bitcoin’s price swings so much
Bitcoin pays no profit or rent, so, like gold, its price is only what buyers will pay. Two more things make that price jumpy:
- Its supply is fixed by the rules and can’t grow when more people want coins, so every rush of excitement, or of fear, lands straight on the price.
- Many buyers borrow to buy (leverage, Unit 8). When the price dips, their lenders force them to sell, which pushes the price down further.
The result is huge swings. From its peak in late 2021, Bitcoin lost about 77% of its value by late 2022, so $1,000 at the peak became about $230. It has had falls that big several times.
2022 was also the year interest rates rose fast. Safe savings started paying again, and fewer people wanted risky things that pay nothing.
Curious? Go deeperWhy FTX collapsed
FTX was one of the biggest crypto exchanges: a website where people bought crypto and usually left it stored there, a bit like leaving a coat at a coat check. Customers believed their coins and cash sat safely in their accounts.
In fact FTX had quietly passed customer money to a sister trading firm, Alameda Research. Alameda spent it on risky bets and investments and lost much of it.
In November 2022, news reports raised doubts about the two firms. Worried customers all asked for their money at the same moment, which is called a run (Unit 11 explains why runs are so dangerous for a bank). The money wasn’t there, and FTX went bankrupt within days.
Its founder, Sam Bankman-Fried, was convicted of fraud and sentenced to 25 years in prison. A bank facing a run has government insurance behind its savers (Unit 11). A crypto exchange has none.
A thing that pays nothing is worth what the next buyer will pay, so its price rests on scarcity and on how much people want it, and it can swing a long way. Property pays rent, and its price depends on how much buyers can borrow. A currency’s price moves with trade and interest rates.
Savings in euros start paying more interest than savings in dollars. What usually happens to the price of a euro in dollars?
Who’s who: what happens when you tap “buy”
Two problems with trading with a stranger
Say you want one share of a company, and somewhere a stranger wants to sell one. You face two problems:
- Finding each other. Millions of people buy and sell every day, and you have no idea who wants to sell right now, or at what price.
- Trust. If you send your $100 first, the stranger might never send the share. If they send first, you might never pay.
On a playground, kids swapping toys solve the trust problem with a teacher who holds both toys and hands them over at the same moment.
Markets solve both problems with a chain of firms, each doing one job. Each firm takes a small cut for its job, because helping strangers trade safely is a business.
The chain of firms behind every trade
Here are the links, in the order your order meets them.
Your broker is usually the investing app. It sends your order on to an exchange or a market maker.
An exchange is a meeting place where buy and sell orders from everywhere are matched in a split second. A market maker is a firm that is always ready to buy or sell, so you never wait for a stranger to turn up.
A clearing house steps into the middle of every trade: it becomes the buyer to every seller and the seller to every buyer, so each side only has to trust the clearing house. It collects deposits from its member firms, so if one fails, there’s money to finish its trades.
A custodian keeps the record that the shares are yours. Your share is a line in a central electronic record, usually held in your broker’s name on your behalf.
You can’t trade on an exchange yourself. Only member firms, which follow strict rules and keep money set aside, may trade there, so you trade through one of them.
Paper share certificates are long gone. The whole chain runs on electronic records.
The actual swap of shares for cash is called settlement. In the US it happens one working day after the trade. This is called “T+1”, meaning trade day plus one working day, and the rule began May 28, 2024.
That day gives firms time to:
- check that both sides’ records match
- move the cash between banks
- update the central record of who owns what
When paper certificates were carried across town, settlement took five working days. Instant swaps would need every buyer’s cash and every seller’s shares ready at the very second of the trade, with no time left to catch mistakes.
Curious? Go deeperThe GameStop week: when the clearing house asked for more
In January 2021, crowds of small investors piled into shares of GameStop, a chain of video game shops, and the price rose more than tenfold in a few weeks. Trades then took two days to settle.
During those two days the price was swinging wildly, so the clearing house feared that a broker might not be able to pay for the shares its customers had bought. So it demanded billions of dollars in extra deposits.
Robinhood, a popular app, couldn’t raise that much at once and stopped customers from buying GameStop for a while. Many were furious.
The episode was one reason regulators shortened settlement to one day: the shorter the wait, the less can go wrong in between.
How the middlemen get paid
At any moment a share has two prices. To see why, picture a used-game shop. It buys your old game for $20 and sells the same game to the next customer for $25.
The $5 gap pays the shop for two things: keeping games in stock, so you never have to hunt for a buyer yourself, and the risk that a game loses value while it sits on the shelf.
A market maker is that shop, for shares. It shows two prices:
- The bid is the highest price anyone will pay you right now. You sell at the bid.
- The ask is the lowest price anyone will sell to you for. You buy at the ask.
The gap between them, called the spread, is the market maker’s pay. For a big company it’s often a cent or two, but market makers trade millions of times a day, so the cents add up.
For rarely traded things the spread is much wider. The shop may wait a long time for the next customer, and the price can move a lot meanwhile.
Many apps charge no fee per trade, yet running an app still costs money. So how do they get paid?
- Payment for order flow: market makers pay the app to send them its customers’ orders, because each order lets them earn the spread.
- Interest on cash that customers leave sitting uninvested.
- Interest from customers who borrow to invest, and paid extras.
Market makers especially welcome orders from ordinary people. One person buying a few shares rarely knows something the market maker doesn’t, so the market maker seldom loses on them.
In the US, payment for order flow is legal as long as it’s disclosed. Critics worry it tempts an app to send orders where it gets paid most, rather than where you get the best price. So “free” means there is no fee you can see, while the app still earns money from your trades.
The big firms and the rules
Behind the apps stand a few big kinds of firms.
A commercial bank is the everyday bank from Unit 1: it takes savings and lends them out.
An investment bank helps companies raise money. When a company sells shares for the first time (an IPO, Unit 3), the investment bank finds the buyers, helps set the price, and often promises to buy any shares left unsold. It also advises companies that want to buy other companies.
An asset manager runs funds (Unit 4). It doesn’t own the money: it looks after other people’s savings and charges a fee for doing so.
The biggest asset manager, BlackRock, looks after about $15 trillion, roughly half of what the whole US economy produces in a year.
Many giant firms do several of these jobs at once. JPMorgan, for example, is a commercial bank, an investment bank and an asset manager.
Every firm in this chain holds other people’s money and knows more than its customers do, so the temptation to cheat is real. FTX, in Unit 10, shows what happens with no one watching.
After the 1929 crash, when many people had been sold shares on false promises, the US set up the SEC (Securities and Exchange Commission) in 1934. It makes companies publish honest accounts, oversees exchanges, brokers and funds, and punishes fraud.
The CFTC (Commodity Futures Trading Commission) does the same job for futures and swaps, and other regulators check that banks keep enough money aside. Rules can’t stop prices falling. They try to keep the trading fair.
When a bank or broker fails
Banks have one built-in weakness. They lend out most of the savings people leave with them (Unit 1) and keep only a little as cash. That’s fine on a normal day.
But say a rumor spreads and every saver asks for their money at once. This is called a bank run. The cash isn’t there, and even a healthy bank can fail. In the early 1930s, runs and failures closed thousands of US banks.
So in 1933 the US created the FDIC, a government-backed insurance fund. If a bank fails, it repays savers up to $250,000 per person, per bank. Savers who know their money is safe have no reason to rush, so runs rarely start.
Brokers have a similar safety net, SIPC. If a broker fails and your shares or cash are missing, it covers up to $500,000, including up to $250,000 of cash.
Neither one covers a fall in prices. If your shares drop 30%, that’s the market, not a failed firm. Crypto exchanges usually have neither.
Curious? Go deeperWhat really happens when a broker or bank fails
US rules make brokers keep customers’ shares and cash separate from the firm’s own money. So when a broker fails, the usual outcome is undramatic: customers’ accounts are moved to another broker, and SIPC pays only for whatever turns out to be missing.
For banks, the $250,000 FDIC limit adds together all your accounts in your own name at one bank. Accounts held another way count separately, such as jointly with someone or in a retirement account like an IRA at a bank.
People with more money than that often spread it across several banks.
Trading with a stranger needs two problems solved: finding each other and trusting each other. Brokers, exchanges and market makers do the finding; clearing houses and custodians handle the trust. Each firm takes a small cut, sometimes hidden, like the spread. Insurance protects you if a firm fails, never if prices fall.
A bank fails while you have $300,000 saved there in one account in your own name. How much is protected by FDIC insurance?
The whole map: risk, value and bubbles
The risk ladder
Put everything from this course side by side and the pattern from Unit 1 returns: the more an investment can grow, the further it can fall on the way.
- Cash in a savings account never falls in dollars, but over the long run has only about kept up with rising prices.
- Shares have grown about 10% a year on average since 1926, with falls of about half roughly once or twice a generation.
The ladder has a reason. Picture two investments expected to grow by the same amount on average, where one sometimes crashes. Everyone would pick the calm one, so buyers would bid up its price and leave the jumpy one cheap.
Buying something cheap means more growth for each dollar you put in. So prices settle where the jumpy investment offers more growth on average, as payment for the fright.
These are long-run averages, though. In any single year, the order can flip.
What future money is worth today
Professionals value almost anything with one idea, called present value: what money you’ll get later is worth today. Money later is worth less than money now, for the same reasons lenders charge interest (Unit 1):
- Most people would rather have a cookie now than a cookie next week.
- A promise to pay later might be broken.
- Prices may rise while you wait.
- Money you hold today could be earning interest in the meantime.
Take that last reason. At 5% a year, $95 put in the bank today grows to about $100 in a year. So $100 promised a year from now is worth about $95 today: it’s the amount you’d need now to end up in the same place.
Money two years away shrinks twice ($100 then is worth about $91 today), and money far in the future shrinks a lot.
Valuing a business
Now value a business. A lemonade stand will make $100 of profit a year for five years, then close. Adding it up gives $500, but nobody should pay $500 today, because each $100 arrives later than the one before and shrinks more.
At 5%, the five payments are worth this much today:
- year 1: about $95
- year 2: about $91
- year 3: about $86
- year 4: about $82
- year 5: about $78
Together that’s about $433, the stand’s present value.
Valuing a share of a real company works the same way, with guesses about profits stretching decades ahead.
Next, let interest rates rise to 10%. A buyer could instead put the same money in safe savings and earn 10%, so the stand must now be cheap enough to beat that.
Each later $100 shrinks a little. This is what a buyer would pay for the stand.
Each later $100 shrinks more. The lemonade is just as good, but the stand’s price fell because the safe alternative got better.
That’s why rising rates push down the prices of bonds (Unit 2), shares and buildings together, as in 2022. Companies whose profits lie far in the future get hit hardest.
How bubbles grow and pop
Normally a higher price brings fewer buyers (Unit 1). In a bubble, it works the other way: rising prices attract more buyers. People buy not for the profits or the rent, but because they expect to sell to someone else for more later.
Each rise makes the news, friends brag about their gains, more people pile in, and the price rises again. Borrowed money speeds the loop up, because borrowers can buy more than they could afford alone.
The loop needs a steady stream of new buyers, and eventually they run out: everyone who was going to buy has bought. Sometimes something else breaks it, such as interest rates rising so borrowing costs more.
Then the loop runs in reverse. Falling prices scare people into selling, borrowers are forced to sell (Unit 8), and prices fall further.
Take the dot-com bubble, around 2000, when investors piled into internet companies, many with no profits yet. The Nasdaq, an index full of tech companies, fell about 78% from 2000 to 2002 and took 15 years to get back to its peak.
Curious? Go deeperTulip mania: the bubble that may be a myth
In the Netherlands in early 1637, prices of rare tulip bulbs shot up and then collapsed within weeks. It’s often told as the first great bubble, one that ruined a nation.
Historians who went back to the records, like Anne Goldgar, found it was much smaller than the legend: few people were ruined and the Dutch economy carried on. The story spread mostly through moral pamphlets written afterwards.
Curious? Go deeperThree crashes compared
- Dot-com, 2000–2002: prices built on hopes for internet companies that often had no profits. Tech shares fell about three-quarters.
- 2008: borrowed money, home loans and swaps (Unit 8). Banks failed and shares fell by about half.
- 2022: inflation pushed interest rates up fast, so future money was suddenly worth less today. Shares and bonds fell together, so holding both didn’t cushion the blow that year.
Why people buy high and sell low
The last piece is about people, not products. Investors tend to buy after prices have already risen and sell after they’ve fallen: the opposite of “buy low, sell high”. Feelings drive it.
When prices have climbed for a while, friends brag, the news is cheerful, and buying feels safe and urgent. When prices drop, fear takes over. Studies often find a loss hurts about twice as much as an equal gain pleases, so a falling balance is very hard to watch.
Selling after a fall turns a loss on paper into a real one, and the seller often misses the recovery. In 2020, shares fell about a third in a month and were back within about five months.
Researchers disagree on how much this habit costs ordinary fund investors, with estimates from about 1% to 4% a year. Add fees (Unit 4), and costs and timing can matter as much as which product someone picks.
The whole map in four kinds
Every product in this course is one of four things.
Savings accounts and bonds pay you interest for the use of your money.
Shares, funds, property and private companies pay you part of the profits or the rent.
Futures, options and swaps move risk from one person to another.
Gold or Bitcoin is worth what the next buyer pays.
And every price you see is people’s best guess at the future money a thing will bring, shrunk back to today, then pushed around by supply and demand, hopes and fears.
So when a headline says “shares fell as interest rates rose”, you can follow each step:
- safe savings now pay more
- future profits are worth less today
- buyers offer less
- prices drop
The same steps work for a lemonade stand and for the whole stock market.
The more an investment can grow, the further it can fall. Anything’s value is its future money shrunk back to today, so rising rates push prices down. Bubbles grow while new buyers keep coming, and fear and excitement lead people to buy high and sell low.
A lemonade stand will earn $100 a year for five years. Interest rates rise from 5% to 10%. What happens to what a buyer will pay for the stand today?
Remember these 8 things
- Money is a shared token, and prices are set by supply and demand. When more money chases the same goods, prices rise: that’s inflation.
- Interest is the price of waiting and risk, and compounding makes it snowball. Investments that can grow faster usually fall harder too.
- Bonds are lending. Fixed interest and your money back, but their price falls when interest rates rise.
- Stocks are owning. A slice of a company, priced on hopes for its future profits.
- Spread it out. Cheap index funds hold hundreds of companies, and most expert-picked funds trail them after fees.
- Derivatives move risk. Futures fix a price; options sell a right, not a duty; swaps trade one stream of payments for another.
- Leverage cuts both ways. Borrowed money multiplies gains and losses, from a single trade to Lehman Brothers and private equity buyouts.
- Value is future money brought back to today, so rising interest rates pull prices down, and bubbles happen when hope runs ahead of it.
Money Quiz
Twelve quick questions, one for each unit. Every answer comes with the reason why.
What to explore next
Questions people ask about financial products
What is the difference between stocks and bonds?
A stock (share) makes you part-owner of a company: you share in its future profits, and its price can rise or fall a lot. A bond is a loan to a government or company: you get fixed interest and your money back on a set date. Bonds usually swing less, but their prices fall when interest rates rise.
What is an index fund?
An index fund buys every investment on a published list, such as the S&P 500, which holds about 500 of the biggest US companies. Because it just copies the list, it is cheap to run. Over 15 years, about 9 in 10 actively managed US large-company funds have done worse than the S&P 500, largely because of their higher fees.
What are derivatives, in simple words?
A derivative is a contract whose value comes from something else, such as the price of wheat, oil, a share or an interest rate. The main kinds are futures (fix a price today for a trade later), options (pay for the right, but not the duty, to buy or sell at a set price) and swaps (trade one stream of payments for another). They are used to reduce risk and to bet on prices.
What is the difference between a call and a put option?
A call option is the right to buy something at a set price before a deadline, so it gains value if the price rises. A put option is the right to sell at a set price, so it gains value if the price falls, which makes it work like insurance. The buyer pays a fee called the premium and can lose at most that fee.
What is private equity, explained simply?
Private equity funds buy whole companies that don’t trade on a stock exchange, often using a lot of borrowed money (a leveraged buyout). They try to improve the company and sell it a few years later. Investors lock up their money for about 10 years and usually pay “2 and 20”: 2% of the money a year plus 20% of the profits.
Why do bond prices fall when interest rates rise?
A bond pays a fixed amount of interest. If new bonds start paying more, nobody will pay full price for an older bond paying less, so its price drops until its return matches the new ones. For example, a $1,000 bond paying 3% falls to about $925 when rates on similar new bonds rise to 4%.
What is leverage in investing?
Leverage means investing with borrowed money to make a bet bigger. With 10 times leverage, a 10% rise doubles your own money, but a 10% fall wipes it out completely, because the lender still wants its money back. Heavy leverage at banks like Lehman Brothers turned falling house prices into the 2008 financial crisis.
- SEC Investor.gov: Bonds
- SEC Investor.gov: Interest rate risk (the $925 bond example)
- SEC Investor.gov: How fees and expenses affect your portfolio
- SEC Investor.gov: Mutual funds and ETFs
- SEC Investor.gov: Introduction to options
- CFA Institute Research Foundation: The past 100 years of US markets
- S&P Dow Jones Indices: SPIVA US scorecard
- Bessembinder: Do stocks outperform Treasury bills? (ASU summary)
- US EIA: Oil futures prices fell below zero (April 2020)
- CME Group: Margins and performance bonds
- BIS: OTC derivatives statistics
- BIS: Triennial survey of foreign exchange trading, 2025
- Financial Crisis Inquiry Commission (Wikipedia)
- Harris, Jenkinson & Kaplan: Private equity performance, what do we know?
- FDIC: Deposit insurance
- SIPC: What SIPC protects
- Tulip mania (Wikipedia)