Financial Terms Every Investor Should Know
Financial planners and other industry professionals use many terms to describe investments and the market. Here’s what the most common ones mean. As Ben Franklin said, “An investment in knowledge pays the best interest.”
General Financial Planning
Asset allocation. In short, your financial plan, such as 60% of your investments are in stocks, 30% in bonds, and 10% in cash.
Broker. Someone who buys and sells assets, such as stocks or bonds, on a client’s behalf. Brokers may or may not be financial planners as well, and vary widely in terms of the services they provide.
Bull/Bear Markets. A bull market is one where the item being traded (stocks, bonds, commodities, precious metals, etc.) is generally rising. A bear market is one where prices are falling. A bull, or someone who is bullish, believes the market will rise; a bear is the opposite.
Capital gain (or loss). The difference between what you paid for an investment and what you received when you sold it.
Cash. Cash is not only bills and coins, but equivalents such as checking and savings accounts, certificates of deposit (CDs), money market accounts and Treasury bills.
ETF: Exchange-traded funds, a type of investment fund that trades like a stock. Investors buy and sell ETFs on the same exchanges as shares of stock. Often ETFs own the same types of investments as index funds.
Exchanges. Places where investments are bought and sold. Once physical, now most are virtual. The New York Stock Exchange and the NASDAQ are the leading stock exchanges in America. Other exchanges specialize in commodities, precious metals, bonds and other investments.
Expense Ratio. The amount a fund manager charges investors to manage a mutual fund (see Mutual Fund). This is typically expressed as a percentage of the amount invested, as in “this mutual fund’s expense ratio is 0.50%.” In this example, for every $1,000 invested the fund manager will charge investors $5 per year.
Index. A tool used to statistically measure the progress of a group of investments that share characteristics. This can include a group of stocks, a group of bonds, or a group of other assets.
Index Funds. A mutual fund that tracks a specific stock or bond index. For example, there are many index funds that buy stocks to duplicate the S&P 500 index. These funds are considered passive, because a fund manager isn’t actively making buy and sell decisions. These funds are typically very low cost, because most of the fund’s transactions are automated.
Market Capitalization. A company’s share price multiplied by the number shares outstanding, i.e. the number of shares held by investors. A company with one million shares of stock outstanding and a share price of $20 would have a $20 million market capitalization (or market cap). Large companies have market caps in the billions.
Money Market. A money market account is an interest-bearing account that will usually pay a higher interest rate than a bank savings account.
Mutual Fund. A pool of money used to buy a number of stocks, bonds, or other investments. Typically a fund manager would use that money to buy the investments and pay the fund’s expenses.
Price-to-earnings ratio. The relationship between a stock’s price and the company’s earnings. Investors can use the P/E ratio to determine whether a stock is overvalued (too expensive) or undervalued (good value). The P/E ratio represents how much an investor is paying for $1 of the company’s earnings. If a company reports a profit of $3 per share, and the stock is selling for $30 per share, the P/E ratio would be 10.
Prospectus. A guide that contains important information about a mutual fund, including its history, managers, investment style, performance, and fees.
Target-date fund. A mutual fund designed to be an all-in-one portfolio tied to a specific retirement date. For example, a fund designed for a retirement date 30 years in the future will begin with a riskier portfolio more weighted toward stocks, then gradually decrease stock holdings and increase bond holdings over the years to become more conservative. These types of funds are often included in 401(k) and 403(b) retirement plans.
Dividends. A portion of a company’s profits that is paid out to shareholders. Typically payments are made quarterly or annually. The “yield” is the percentage paid to shareholders on an annualized basis. For example, if the price of one share of stock is $100 and shareholders receive $0.75 a share quarterly, or $3 over the course of a year, the yield would be 3%. Companies will generally announce upcoming dividend payments; payments can fluctuate every quarter.
Dow Jones Industrial Average. A collection of 30 blue chip stocks that is often used to illustrate the general direction of the stock market. The make-up varies from time to time; stocks are added or dropped occasionally.
Standard and Poors 500. The S&P 500 consists of the stocks of the 500 largest companies in the stock market. Like the Dow Jones Industrial Average, the S&P 500 is considered an indicator of the general movement of the stock market.
Stocks. When you buy stock in a company, you’re purchasing a tiny bit of ownership in the firm. Typically you purchase shares of stock, which indicate how much of a company you own. For example, if you purchased 500 shares of Apple stock you’d own a little less than 0.0001% of the company. Equities is another term for stocks.
Bonds. A loan you make to a company or government agency. When you buy a bond, you’re giving your money, and in return the borrower is promising to pay your money back on a certain date with interest. Some types of bonds may pay you interest for as long as you own the bond, rather than at the maturity date.
Maturity Date. The date when a bond “matures,” or becomes due. This is the date when the company or agency that issued the bond will redeem the bond and pay you your investment plus interest. Think of it as an IOU with a date.