Let's face it: Financial talk can be confusing at times. With so much jargon, it can seem like a foreign language. It's an important language to understand, though, because if you fail to understand certain basic concepts, you may put your financial health at risk.
A significant portion of Americans are not confident in their understanding of basic financial terms, according to a survey from polling firm YouGov and training organization TheKnowledgeAcademy. This makes it more difficult to plan for retirement and set yourself up for financial security, because when you don't fully understand these terms, it's harder to make smart financial decisions.
Researchers found that one of the most commonly misunderstood financial terms was "index fund," with 49% of participants saying they didn't have a strong grasp on what the term means. Other commonly confused terms included "asset allocation," "Roth IRA," and "mutual fund."
That's bad news, because each of those things may play a pivotal role in the best saving and investing plan for you.
Studying doesn't end with school
Studying financial lingo can give you a leg up as you're preparing for retirement, because the better you understand these terms, the better equipped you'll be to serve your own best interests.
Indexes are essentially large groups of investments that are assembled based on various criteria. The S&P 500, for instance, is one of the most popular indexes, and it includes a broad array of stocks that are traded on the New York Stock Exchange and Nasdaq, based on market capitalization (which is the market value of a company's outstanding shares). The Dow Jones Industrial Average (aka the Dow) is another popular index, and it tracks 30 stocks that, in theory, provide a general representation of the U.S. economy.
An index fund, then, is a portfolio that is designed to replicate a certain index. So if you're investing in an index fund that tracks the Dow, that fund would be expected to have all 30 stocks that are in the Dow in roughly the same proportions.
The biggest advantage of index funds is that they're passive investments, meaning they don't require a lot of effort by managers to maintain them. In turn, you pay less in fees. The average expense ratio (which is essentially the annual fee you pay for your investments) for passive funds was 0.17% in 2017, according to a report from Morningstar, compared to a 0.52% average among mutual funds and exchange-traded funds (ETFs). Index funds also take the guesswork out of choosing stocks for your portfolio, because instead of picking individual stocks, you can simply choose an index and invest in all the stocks it contains at once.
In general, index funds that track the broader stock market have proven to be successful over time. After all, the S&P 500 has a long-term average return of around 10%. That doesn't mean it's immune to downturns (it lost 38% in 2008 alone, for example), but over time, the stock market's returns have far outpaced the returns of other traditional investments.
A mutual fund is essentially a pool of investments, and it allows you to invest in many different stocks, bonds, and other types of securities at once. A mutual fund can be an index fund, but typically, mutual funds are overseen by a portfolio manager who decides where to invest your money in (whereas index funds are passively managed). That also means that they tend to be more expensive than index funds. The analysts who are hard at work picking investments need to make a living, after all.
Mutual funds can consist of a mixture of stocks, bonds, and other securities depending on your tolerance for risk, so you can choose a highly customized portfolio that fits your needs. However, most of the time, these actively managed investments tend to underperform passive investments (like index funds). During 2017 and 2018, for example, only 36% of active managers' portfolios outperformed similar passive investments, according to research from Morningstar -- meaning that paying for someone to manage your funds may not pay off in the form of greater returns.
That doesn't mean, though, that mutual funds aren't right for you. With the right manager, actively managed mutual funds have the ability to greatly outperform the market. You also don't need to choose just one or the other; by investing in both index funds and actively managed mutual funds, you can diversify your portfolio.
You've heard that you should never put all your eggs in one basket, and asset allocation is essentially the same principle. Because the stock market can be unpredictable and you never really know which investments will skyrocket or plummet, it's important to diversify your portfolio by putting your money in a variety of different investments.
The types of investments in your portfolio should range from very safe (Treasury notes and bills, for example) to relatively risky (stocks). The safer investments will typically have lower returns, but they're less likely to lose much of their value in the event of a financial meltdown. The riskier investments, meanwhile, usually have higher returns over the long run, which will help your funds grow faster.
Exactly how much money you put into these asset categories will depend on your tolerance for risk. If you're nearing retirement (or have already retired), you'll typically want to lean toward the conservative side -- but not too conservative, because you still want your investments to grow during retirement. If you're young and still have a few decades before you need that money, you can afford to go riskier. After all, even if the stock market takes a considerable dip, you'll have time to recoup your investments by the time you need them.
If you're not comfortable with risk at all, you may assume that it's best to stick to only the most reliable investments (like Treasury notes and bills) and avoid stocks. However, even if you start saving early in life, those types of investments may not yield the returns you need to live a comfortable retirement.
For example, say right now you have a conservative portfolio with mostly Treasury notes, bills, and bonds, with a few stocks mixed in, and you're earning an annual rate of return of 2%. If you're investing, say, $1,000 per year, you'll end up with roughly $40,000 after 30 years. If you allocate more of your money to stocks, though, and earn an annual return of, say, 8%, you'll have around $120,000 after 30 years. So while you shouldn't invest your life savings in that new tech stock you think is ready to skyrocket in value, you'll need to be at least somewhat comfortable with risk if you want your investments to grow enough to last you through retirement.
Roth IRA: When it comes to choosing a retirement account, one of your options is a Roth IRA. A Roth IRA allows you to set aside income for retirement, much like a 401(k). The money you contribute is subject to income tax, but you won't pay taxes on the funds you withdraw in retirement. As you plan for retirement, you know that the amount you have in your Roth IRA is the amount you'll be able to spend when you withdraw it, because income taxes are taken out of the equation. With other types of retirement funds (such as traditional 401(k)s and IRAs), your initial contributions are tax-deductible, but you'll owe income tax on the amount you withdraw.
Another perk Roth IRAs offer is increased flexibility when it comes to withdrawals. With traditional IRAs, if you withdraw any money from your account before age 59 1/2, you'll pay a 10% penalty on the distributed amount (in addition to the income tax). With Roth IRAs, however, you can withdraw any of your original contributions (but not your investment gains) at any time, penalty-free. That said, keep in mind that it's not a good idea to withdraw retirement savings early unless it's absolutely necessary.
While not having to pay taxes on your Roth IRA withdrawals is an advantage, it can potentially be a downside if you have a lower income when you retire than when you initially made your contributions. You're paying taxes up front, so if you're in a higher tax bracket during your earlier working years than you are when you retire, you could end up paying more in taxes than you would with a traditional IRA.
Financial jargon can sometimes make your head spin, but it's important to understand some of the fundamental terms if you want to be a savvy investor. Do your homework, and you'll be setting yourself up for financial success -- and a more enjoyable retirement.