You don’t have to understand everything about investing in order to start investing. That said, there are some basic investment terms you should know to help ensure that how you invest your money is actually in alignment with your investing goals.
No matter how much or how little you plan to invest – or what you invest in – you’ll want to clearly understand asset allocation and diversification, for example. If you’re concerned about funding your retirement, you’ll want to make sure you invest in the right type of account and exactly what it means for contributions or earnings to be tax-deferred.
Admittedly, this isn’t the most glamorous topic of all time. Trust me, I hear you.
Reading over a list of definitions probably won’t be the most exciting thing you do today. Frankly, I hope it isn’t. But I promise that being able to decipher investment jargon will make you more comfortable actually investing. That’s the idea behind this post – to set you up so you can better navigate the stock market and the investment process.
Investing terminology 101
If you’ve never invested before, or even if you have, you may find the whole concept complex and overwhelming. That’s okay. In truth, investments can be confusing. The two biggest barriers to investing that I hear most often are 1) not knowing where to start and 2) not understanding the terminology. We’ll get the first issue in another post. For now, let’s define some of the most common investing terms.
What is a stock?
A stock or “share”, simply put, is a small piece of a company. Companies sell stock – or pieces of their company – in order to raise money. If you own Amazon stock, then you actually own a piece of Amazon and are entitled to share in its profits.
What is a bond?
You can think of bonds as the opposite of stocks. Whereas a stock represents ownership (i.e. you’re buying a piece of a company), a bond represents a loan. When you buy a bond you’re lending money to a company, city, municipality or other entity. In return, they pay you back the loan amount plus interest. Because they’re loans, bonds have a “maturity” date. This is the date the debt is due and the full value of the loan is paid back.
*Government bonds are usually called treasuries.
What is a mutual fund?
Mutual funds pool together the money of many investors in order to buy a collection of stocks, bonds or other equities. Instead of buying a single stock or bond, you are buying a “basket” of investments that may be comprised of hundreds of individual securities. It’s a very easy way to gain access to many companies that you might otherwise not be able to afford if you bought them each individually.
Mutual funds are professionally managed and are great for reducing your investment risk since you’re not reliant on the performance of a single company. If a few stocks within the fund perform poorly, other stocks that perform well will help balance out losses.
What is an index fund?
There are many different types of mutual funds. Vanguard alone offers 129 to choose from and there are thousands upon thousands across the entire stock market. You may have heard the term low-cost index fund – if so, it’s for good reason. Index funds are excellent, well-diversified investment options, especially for new investors. Index funds are mutual funds but with two main differences.
- They are passively managed. Most mutual funds have a manager (or management team) who actively manages the fund and its investment decisions. Index funds are passively managed instead. They are automated to track an index and require very little oversight. This means they cost less to invest in – hence the term low-cost.
- They track an index. There are several indexes, but two you’ll recognize by name are the S&P 500 and the Dow Jones Industrial Average. The S&P 500 measures the performance of 500 of the largest and best known US companies – you can think of it as a hypothetical fund that invests in all of the big names. By comparison, an S&P 500 index fund is a real fund that actually invests in those same 500 companies in order to replicate the index’s performance.
Bottom line: Index funds are smart, hands-off, well-diversified, low-cost investments.
What is a lifecycle (or target date) fund?
Lifecycle funds are mutual funds that are based on a retirement target date. For this reason, lifecycle funds are also called “target date” funds. These funds automatically adjust from more aggressive to less aggressive as the target date nears. If you anticipate retiring in 2053, you might look for a 2050 or 2055 target fund.
For example, a lifecycle fund with a target date of 2050 will be more heavily invested in stocks now, but will adjust to have a greater proportion of bonds and other, safer investments as 2050 nears. These are great for hands off investors who want a simple way to ensure they maintain the appropriate mix of assets and asset allocation as they age.
What is an ETF?
ETF stands for exchange traded fund. ETFs and index and mutual funds are all very similar – each are a a basket of securities – but I’d like to highlight four primary differences.
- ETFs are traded like stocks, whereas mutual and index funds are only settled once per day (after the market closes). This allows for some additional flexibility if you’re trying to buy or sell at a particular price point.
- ETFs don’t have minimum investment requirements; mutual funds often do.
- ETFs are more tax friendly because they tend to have fewer capital gains.
- Unlike mutual funds, ETFs do have trade commissions. If you buy or sell often, this may make them more expensive in the long run.
What is a portfolio?
An investment portfolio is a person’s entire collection of investments. Your portfolio would include your 401K, IRA, any mutual funds, stocks or bonds held within a brokerage account, and any other investments you own – e.g. stock options or REITS.
What is diversification?
Diversification is a way to reduce risk. We all know the saying, don’t put all your eggs in one basket. If you invest primarily in one company then you become entirely dependent on that one company to perform well. If they perform poorly, then it’s possible for you to lose money – perhaps your entire investment. It’s critical to recognize that no investment is a sure thing and no company is immune to risk. Not even the ones we might think of as “too big to fail”.
Instead, you want to diversify your portfolio. Rather than buying 100 shares of Amazon stock and calling it a day, you want to invest in many stocks and bonds, across a variety of industries. The easiest way to do this is by investing in mutual funds.
What is asset allocation?
Asset allocation refers to the proportion of each type of asset category you invest in. For example, your asset allocation might be 60% stocks, 30% bonds, and 10% cash. Your asset allocation is important because it reflects how much risk you’re willing to take in the market. People are often willing to accept more risk in exchange potentially higher returns. Since stocks are more volatile than bonds, a person whose asset allocation is 90% stocks and 10% bonds is willing to accept a lot more risk than someone whose portfolio is 60% bonds and 40% stocks.
It’s important to point out that a person who is in their 20s or 30s can afford to take more risks with their investments because they’ll have time to recover from market downturns. As you move closer to retirement age, however, many people choose to adjust their asset allocation to lower their risk and better protect their investments.
What is an expense ratio?
An “expense ratio” refers to the cost (or expense) of owning a mutual fund. This can include annual maintenance fees, annual administration fees, and even advertising fees. The lower the expense ratio, the lower your fees. This is very important because fees cut into profits.
Let’s compare three mutual funds. VTSAX, a low-cost index fund; TLRIX, a lifecycle retirement fund; and MAPPX, a large growth fund. Their expense ratios are 0.04%, 0.37%, and 1.2% respectively.
For demonstrative purposes only, let’s assume that we invest the same $10,000 in all 3 funds, and we earn the same 7% return over 10 years for all three of them as well. Thanks to this handy tool from FINRA, we can see that after 10 years, this is what we would have in each account after expenses:
- VTSAX: $19,592.99 (total cost: $57.05)
- TLRIX: $18,957.03 (total cost: $518.16)
- MAPPX: $16,531.25 (total cost: $2,046.33)
The difference between each expense ratio may not seem significant until you look at the long-term cost. In this example, the difference between 0.04% and 1.2% is actually equal to $1989.28.
What is tax-deferred?
A tax-deferred account is one that is approved by the IRS for special tax treatment. This commonly includes retirement accounts such as a 401K or IRA, as well as college savings plans such as 529 and Coverdell accounts. The basic idea is that investments can grow tax-free which provides additional earnings potential.
*Along with tax benefits, these accounts also require you follow certain strict contribution and withdrawal rules. Depending on the account, taxes are typically paid upon withdrawal.
What is dollar-cost averaging?
Dollar-cost averaging is a simple investment technique that takes the guessing out of when to invest. In practice, it just means investing a regular amount at regular intervals, regardless of an investment’s cost. If you’re investing in a 401K then you’re almost certainly already using this strategy. I have automatic transfers and an automatic deferral set up so that I invest a set amount into my retirement and non-retirement accounts every month, without regard to what the market is doing.
There are two key benefits to this. One, it’s automatic. This simplifies things and ensures you don’t skip or forget to make an investment. Two, it effectively takes the emotion out of investing and helps you avoid mistiming the market – frequently a losing strategy in the long run.
Questions? Advice to share? Let me know in the comments!