If you are a new investor, you are likely to encounter terms that you do not understand. It may seem overwhelming at first, but once you become familiar with them, you will realize there is no reason to be intimidated. This is an introduction to some of the more common investing terms you may encounter.
Types of Investments
There are various ways to invest your money, such as stocks, bonds, and property. You should have a clear understanding of each option to make the best decision for growing your money.
- Common Stock: A share of common stock represents a unit of ownership in a legally formed corporation. For most companies, there is a single class of stock that represents the entire company. However, some companies have multiple classes of stock, including dual classes of stock. Often, one class of stock will have more voting rights than another class of stock.
Owners of common stock are entitled to their proportionate share of a company's earnings, if any, some of which may be distributed as cash dividends. The best stocks are usually referred to as blue-chip stocks.
- Preferred Stock: Preferred stock is a class of ownership that allows shareholders of a company to get a larger dividend, and that dividend is often guaranteed. Holders of such stock do not have voting rights, but they can receive special status if a company heads into insolvency. If a company is being liquidated and creditors need to be paid, preferred stock shareholders must be paid before common stock shareholders. In some cases, companies can repurchase shares of preferred stock from shareholders, often at a premium. It is also possible to convert shares of preferred stock into common stock, but not vice versa. There are also different types of preferred stock, such as convertible preferred stock.
- Bonds: In simple terms, a bond is like a loan. When you buy a bond, you are usually agreeing to lend money to a government or a company. Typically, the bond issuer promises to repay the entire principal loan amount on a future day, known as the maturity date, and pay interest income in the meantime based upon a coupon rate. There are many types of bonds, including those issued by governments, such as Treasury bonds and tax-free municipal bonds. These bonds are often used to fund government operations and capital projects. There are corporate bonds, which help companies fund their operations and invest in themselves. There are also savings bonds, such as the Series EE savings bond and the Series I savings bond. There are investment-grade bonds, the highest being AAA-rated bonds, and on the opposite end of the spectrum, junk bonds. If you do not want to buy bonds individually, you can invest in bond funds.
- Real Estate: Real estate is tangible property, such as land or buildings, that the owner can use or allow others to use in exchange for payment. When you own a house, you own real estate. When you own a plot of land, you own real estate.
Mutual funds are a great way to get exposure to different groups of stocks or bonds, and it frees the investor from the need to research and purchase shares of each company individually.
Types of Investment Structures
An investment strategy may include pooled or grouped classes of assets.
- Mutual Funds: A mutual fund is a pooled portfolio. Investors buy shares or units in a fund, and the money is invested by a professional portfolio manager. The fund itself holds individual stocks, in the case of equity funds, or bonds, in the case of bond funds. Mutual funds do not trade throughout the day to avoid allowing people to take advantage of the underlying change in net asset value. Instead, buy and sell orders are collected throughout the day, and once the markets have closed, they are executed based upon the final calculated value for that trading day.
- Exchange-Traded Funds: Exchange-traded funds (ETFs) are very similar to mutual funds, except that they trade throughout the day on stock exchanges as if they were stocks. You can actually pay more or less than the value of the underlying holdings in the fund. In some cases, ETFs might have certain tax advantages, but most of their benefits compared to traditional mutual funds are largely a triumph of marketing over substance. You can use these or traditionally structured mutual funds in your portfolio.
- Index Funds: An index fund is a type of mutual fund, sometimes trading as an ETF, that allows an individual to "invest" in an index, such as the S&P 500. Index funds are designed to give investors returns that are in line with the index. So if you are investing in an S&P 500 index fund, your returns should mirror those of the S&P 500. There are many funds designed to track a whole host of indices that may include small-cap stocks, emerging markets, and specific industries. Index fund investing is an example of "passive" investing, as there are no fund managers actively trying to "beat" the market. The funds are simply designed to mirror the returns of an index. As a result, they usually have low expense ratios, making them cost-effective investments.
The simplicity and low cost of index funds make these funds optimal investments for people who do not want to spend a lot of time researching stocks and managing their portfolio. In fact, many financial advisors recommend index funds as a core component of investment portfolios.
- Hedge Funds: A hedge fund is a type of investment partnership. Often, it is formally listed as a limited partnership or limited liability company, and the partners pool money from investors and engage in a wide range of investing activity. Commonly, hedge funds engage in investment activity that is riskier than typical investments. Hedge funds will often use leverage (i.e., borrowed money) to amplify their returns, but they can also place bets against the market to make money—even if the market goes down. There are a variety of different hedge fund structures, but it is common for fund managers to charge investors 20% of profits plus 2% of assets as a management fee each year. This is controversial because managers of large funds can make millions of dollars in management fees, even if investments perform poorly. Due to government regulations meant to protect the inexperienced investor, investing in hedge funds can be difficult for most ordinary investors.
- Trust Funds: A trust fund is a special type of legal entity that allows a person or organization to hold assets they will eventually give to another. For example, a grandparent could hold $100,000 in stock for a grandchild, with the stipulation the grandchild receive the money when they reach age 18. Trust funds offer tremendous asset-protection benefits and, at times, tax benefits. They can hold almost any asset imaginable, from stocks, bonds, and real estate to mutual funds, hedge funds, and art.
There is a perception trust funds are only used by the wealthy, but they are available to anyone who wants to intelligently transfer assets to another person.
- Real Estate Investment Trusts: Some investors prefer to buy real estate through real estate investment trusts (REITs). They trade as if they are stocks and have special tax treatment. There are different types of REITs that specialize in various types of real estate. For example, if you wanted to invest in hotel properties, you could consider investing in a hotel REIT. REITs allow you to invest in real estate without having to buy or maintain actual buildings or land.
- Master Limited Partnerships: Master limited partnerships (MLPs) are limited partnerships that trade similarly to stocks. Given the unique tax treatment and complex rules surrounding them, inexperienced investors should generally avoid investing in MLPs, particularly in retirement accounts where the tax consequences can be unpleasant if not masterfully managed.
Portfolio Management: Portfolio managers are experienced investment professionals, who strategically group or pool together different types of assets into portfolios they manage to generate a profit for investors. You should keep in mind the following concepts associated with portfolio management.
- Investment Mandate: An investment mandate is a set of guidelines, rules, and objectives used to manage a specific portfolio or pool of capital. For example, a capital preservation investment mandate is meant for a portfolio that cannot risk meaningful volatility—even if it means accepting lower returns.
- Asset Allocation: Asset allocation is an approach for managing capital that involves setting parameters for different asset classes, such as equities (e.g., ownership or stocks), fixed-income (e.g., bonds), real estate, cash, or commodities (e.g., gold or silver).
Asset classes are believed to have different characteristics and behavior patterns. In turn, getting the right mix for a specific investor can increase the probability of a successful outcome in accordance with the investor's goals and risk tolerance. For example, stocks and bonds play a different role in an investor's portfolio beyond the returns they may generate.
- Fiduciary Duty: In the U.S. legal system, a fiduciary duty is the highest duty owed to another person. It requires the fiduciary to put the interest of the principal, often the client, above its own. This involves disclosing conflicts of interest.
- Custodial Account: A custodial account is an account that an institutional custodian operates on behalf of an investor to hold the investor's portfolio of securities. The custodian will record cash flows from interest and dividends, submit instructions on behalf of the investor for proxy voting or corporate events, and take delivery of spin-offs and make sure the shares end up in the custody account. Custody accounts are assessed custodial fees. However, some investors do not realize they pay them because brokers may offer custody services for free or at reduced prices if the investor has a minimum account size or places a certain number of stock trades each year.
- Asset Management Company: An asset management company is a business that invests capital on behalf of clients, shareholders, or partners. For instance, Vanguard's asset management business buys and sells the underlying holdings of its mutual funds and ETFs. The asset management business of J.P. Morgan's private client division builds portfolios for individuals and institutions.
- Registered Investment Advisor: A registered investment advisor (RIA) is a firm that is engaged, for compensation, in providing advice, making recommendations, issuing reports, or furnishing analyses on securities. RIAs can include asset management companies, investment advisory companies, financial planning companies, and a host of other investment business models.
RIAs are bound by a fiduciary duty to put the needs of the client above their own rather than the lower suitability standard that applies to taxable brokerage accounts. RIA fees have to be "reasonable," and the amount varies by firm.
- Uniform Transfers to Minors Act: Accounts can be organized under the Uniform Transfers to Minors Act (UTMA) of a particular state. They allow an adult to buy a property and have it titled in their name for the benefit of a minor child until the child reaches a certain age as set forth in the UTMA. The maximum allowable age in most states is 21 years. The adult with the title of the property is known as the custodian and owes a fiduciary duty to the child. There are instances where parents received embezzlement convictions. If the child becomes an adult and "compels an accounting," you will need to produce proof of every cash flow and statement of that portfolio. Otherwise, you could be liable not only for the missing money but for the compounded value of the money had it been left alone in the portfolio.
- Stockbrokers and Stock Trades: A stockbroker is an institution or individual that executes buy-or-sell orders on behalf of a customer. Stockbrokers settle trades and make sure that cash or security gets to the right party by a certain deadline against their client's custody account. There are many different types of stock trades that you can submit to your stockbroker (at least 12 different types), but you should be careful about becoming overly dependent on them. For example, a stop-loss trade will not always protect your portfolio. In addition, it is sometimes possible to buy stock without a broker through programs, such as dividend reinvestment plans or dividend reinvestment programs (DRIPs).
- Short Selling: In cases of short selling, an investor or speculator borrows shares of stock or another asset they do not own, sells and pockets the money with the promise to replace the property in the future, and hopes the asset declines in price so it can be repurchased at a lower cost, the differential becoming the profit. If done incorrectly, an investor can become bankrupt.
- Margin: Brokers will often lend customers money against the value of certain stocks, bonds, and other securities within their custody account if the client agrees to pledge the entire account balance as collateral as well as provide a personal guarantee. When you open a brokerage account, you need to specify whether you want a cash account or a margin account. Most investors should be using cash accounts, in part, due to what appears to be a rising risk from regulatory arbitrage in the form of rehypothecation.
If you borrow on margin, a broker can issue a margin call at any time, demanding you pay off some or all of your balance. A broker also has the right to sell your investments, triggering potentially steep capital gains if you have appreciated positions, without giving you an advanced warning or an opportunity to deposit additional cash or securities.
Types of Retirement Accounts
There are various types of retirement accounts that, if started early, can set you up for a comfortable retirement.
- Roth IRA: The Roth Individual Retirement Account (Roth IRA) is a special type of account designation put on a custody account that gives it some incredible tax benefits. However, it also has certain restrictions, such as contribution amounts and types of investments held within the account. Money contributed to a Roth IRA comes from after-tax dollars. In other words, you do not receive a tax deduction for it. However, as long as you follow the rules, under the current system, you will never pay taxes on any of the profits you generate from the investments held within the Roth IRA, nor when you withdraw those profits. You can buy stocks, bonds, real estate, certificates of deposit, and other asset types within a Roth IRA.
- Traditional IRA: The Traditional IRA is the earliest type of IRA. Investors can contribute money to it if they meet certain qualifications, such as their total income. Also, investors pay no taxes on certain types of investment gains held within the account until they can withdraw the amount at 59.5 years old or are forced to at 70.5 years old.
- 401(k): The 401(k) is a special type of retirement plan offered by employers to their employees. It usually allows investors to put their money to work in mutual funds or stable value funds. Like a Traditional IRA, investors usually receive a tax deduction at the time the account is funded. There are also annual limits that are much higher than those for a Traditional IRA or Roth IRA. Employers often match contributions, such as a 50% match on the first 6% earned. There are no taxes owed until you can begin withdrawing the money at 59.5 years old, with required distributions beginning at 70.5 years old. The term 401(k) refers to the section of the tax code that created it. In recent years, there has been a rise of the self-directed 401(k) that allows the investor to buy individual stocks and bonds in the account.
- 403(b): The 403(b) is a retirement plan that is similar to the 401(k). But, it is only offered in the non-profit sector.
- Rollover IRA: When an employee leaves their employer, they can opt to roll over their 401(k) balance and have it deposited into a Rollover IRA, which otherwise behaves like a Traditional IRA.
- SIMPLE IRA: The Savings Incentive Match Plan for Employees (SIMPLE) IRA is for small business owners with fewer than 100 employees who want to offer some sort of retirement benefits to their employees, but do not want to deal with the complexity of a 401(k).
- SEP IRA: The Simplified Employee Pension (SEP) IRA can be used by self-employed individuals and small business owners under certain circumstances, allowing them to put aside substantially more money than they otherwise would have been able to invest due to much higher contribution limits calculated as a percentage of income.
Company-Related Investment Terms
Some common investment terms specific to companies include:
- Board of Directors: A company's board of directors is elected by stockholders. They are required to watch out for the stockholders' interests, hire and fire the Chief Executive Officer, set the official dividend payout policy, and consider recommending or voting against proposed mergers.
- Enterprise Value: Enterprise value refers to the total cost of acquiring all of a company's stock and debt.
- Market Capitalization: Market capitalization refers to the value of all outstanding shares of a company's stock if you could buy them at the current stock price.
- Income Statement: An income statement shows a company's revenues, expenses, taxes, and net income.
- Balance Sheet: A balance sheet shows a company's assets, liabilities, and shareholders' equity.
- Form 10-K: Form 10-K is an annual disclosure document certain firms are required to file with the Securities and Exchange Commission. It contains in-depth information about a business, including its finances, business model, and much more.
Other Investment Terms
Other terms common to the investment world include:
- Stock Exchange: A stock exchange is an institution, organization, or association that hosts a market for buyers and sellers of equities to come together during certain business hours and trade with one another. The most important stock exchange in the world is the New York Stock Exchange (NYSE). Companies that want their shares listed on "The Big Board," as the NYSE is sometimes called, must meet strict criteria. If the company fails to continue meeting these requirements, it is subsequently de-listed.
- Price-to-Earnings (PE) Ratio: The price-to-earnings (PE) ratio tells you how many years it would take for a company to pay back its purchase price per share from after-tax profits alone at current profits with no growth. In other words, the PE ratio tells you how much money you are paying for $1 of the company's earnings. If a company is reporting a profit of $2 per share, and the stock is selling for $20 per share, the PE ratio is 10 ($20 per share divided by $2 per share earnings equals 10). The ratio can also be inverted to calculate the earnings yield.
- PEG Ratio: The price-to-earnings-to-growth (PEG) ratio is a modified form of the PE ratio that factors growth into the metric. For instance, the ratio shows that a company growing at 15% per annum and trading at 20x earnings can be cheaper than a company trading at 8x earnings and shrinking by 10% per annum.
- Dividend-Adjusted PEG Ratio: A dividend-adjusted PEG ratio is a modified form of the PEG ratio that factors dividends into the metric. The ratio accounts for the fact that, at times, slower growth is the result of a company paying out significant portions of its earnings in the form of cash dividends, which contribute to total return.
- Dividend Yield: The dividend yield is the current yield of a common stock at its present dividend rate. If a stock is trading at $100 per share and pays out $5 in annual dividends, the dividend yield would be 5%.
- Volatility: Volatility refers to the degree to which a traded security fluctuates in price.
- Derivative: A derivative is an asset that derives its value from another source.
As you consider the various ways in which to invest your money, continue to use these terms and definitions as a resource. With a greater understanding of these terms, you can feel more confident researching potential investments.
Frequently Asked Questions (FAQs)
How does investing work?
At its most basic level, investing is making your money work for you. There are two ways you can use your money to create profits: capital gains and income. Capital gains occur when you sell something (like a stock) for more than you spent to buy it. Income occurs when your investment pays you, such as through dividends (like from stock) or interest payments (like from bonds).
How do you start investing?
To start investing, you need access to the market, such as through a brokerage or retirement account. Once you've opened the right type of account, link an existing bank account to it so that you can transfer funds. The funds you transfer into the investment account can be used to invest in stocks, bonds, ETFs, or other securities.