Author: Chuck Saletta | June 21, 2019
Market vocab 101
Investing is one of the greatest ways to build wealth that's available to us mere mortals. Still, the investing industry has a language of its own, full of potentially confusing and intimidating terms. If you want a decent shot at success, you should really know what's being said before you put your own hard earned money on the line.
These 11 market terms are ones you need to know before investing, as they’re some of the most common and important ones in the business. While knowing them won’t guarantee you’ll crush the market, remaining ignorant of their meanings will make it much tougher for you to see sustained success.
While that four letter word may seem straightforward, there are actually several different ways it gets used in investing. At its simplest, risk represents the amount of money you stand to lose if an investment goes against you. From a more nuanced perspective, risk reflects your potential loss of purchasing power from the money you have invested between now and when you need to spend it.
From that perspective, all investments are exposed to some sort of risk. Ones that may seem safe in the short term -- like money in the bank -- can be extremely risky in the long run as that money is exposed to inflation. Others that seem risky in the short term -- like stocks -- may have the potential to provide far better purchasing power protection over the long term.
From an investing perspective, your return is what you get back from the money you have put at risk. If you invested $1,000 and get back $1,100 when all is said and done, you’ve received a return of $100 -- or 10% measured in a percentage basis. Returns can be positive or negative, depending on whether you make or lose money on the investment.
Whether that’s a good return or not depends in large part on how long your money was invested. Over the long run, the stock market has provided average returns of around 9% to 10% annualized. So if you received a 10% return in under a year, you’ve done remarkably well. If, on the other hand, it took you a decade or so to receive that 10%, then you’ve probably fallen behind vs. your financial targets.
A company’s stock represents an ownership stake in the company itself. If you buy one or more shares of stock, you buy whatever portion of ownership of the company that those shares represent. So for instance, if a typical company has 1,000,000 shares of stock outstanding and you buy 10 of those shares, you would own 1/100,000 of the company.
Some companies may split their stock into multiple share classes, making things a bit more complicated and confusing. If you’re investing in a company like that, look for how the shares are different from one another. Typically, they have different economic claims on things like dividends the company may pay or voting claims for control of the company. Unless you become a very large investor, the economic claims will directly matter more to you than the voting claims, but it’s still good to know the differences exist.
A company’s bond represents the debt it took out in order to finance some part of its business. A typical bond promises to pay a certain dollar amount in interest every six months while the bond is outstanding and to pay its face value -- usually $1,000 -- when it matures. Investors who need money on a specific timeline -- such as retirees who live off their portfolios -- appreciate the known payment schedule and the relatively high likelihood of the payments being made. You can also buy bonds from governments.
Companies tend to pay their bonds on schedule because if they don’t it leads to a default. If a company defaults on its bonds, it can have very nasty consequences for it -- including the possibility of a forced liquidation or otherwise turning control of its business over to its bondholders. As a result, if a company can make its bond payments, it generally will make its bond payments. That higher certainty means investors generally can expect lower returns than with stocks -- but with a better chance of success.
An option is something known as a derivative contract -- it has no real value on its own, but it gets -- or derives -- its value from another asset which is generally worth something. A typical option is a contract to buy or sell 100 shares of a particular stock for a given price on or before the option’s expiration date. Call options give the buyer the right to buy, and put options give the buyer the right to sell.
Whoever sells the options to the buyer picks up an obligation to deliver on the transaction -- selling the stock to a call buyer or buying the stock from a put buyer -- if the buyer chooses to execute the option. At the time the options contract is created, the buyer pays a premium to the seller, which the seller keeps regardless of whether or not the buyer chooses to execute the option.
Options are a fairly advanced type of investment, however, and it’s often possible to leverage yourself to the point where you have more at risk than you’ve actually invested in them. So tread carefully and learn more about them before investing with options.
One of the rewards that many companies offer their investors is a payment that represents a portion of the profits attributed to those investors’ shares. That payment is known as a dividend, and it’s one way that investors can get compensated for the risks they’re taking by owning shares.
In addition to the direct financial reward, dividends serve other functions for investors as well. Because payments are not guaranteed and can change over time, they often provide signals of what management really thinks of its prospects. In addition, because dividends are cash moving from management’s control to shareholders’, they both serve as a tangible reminder of who is really in charge and as a control over excessively costly empire building.
7. Capital gain
When you sell an investment for more than you paid to buy it, your profit is known as a capital gain. On the flip side, if you sell an investment for less than you paid to buy it, your loss is known as a capital loss. Along with dividends, capital gains provide the other key source of potential rewards from investing. Like dividends, capital gains are not guaranteed. In addition, your ability to actually receive a capital gain is based not only on the success of the company, but also the sentiment of the market.
Despite the fact that they’re not guaranteed payments, the advantage capital gains give you as an investor is that often you can choose when you take the gains and pay any taxes on them. Unless there’s something like an acquisition that forces you to close out a position, you can usually pick and choose which of your investments to sell and when in order to best meet your total financial needs.
8. Cost basis
Critically important in determining whether you have a capital gain or a capital loss is understanding your cost basis in your investment. Generally speaking, your cost basis is the amount you paid to buy an investment, including any commissions and other transaction fees you paid for it. For instance, if you bought 100 shares of a stock for $20 per share and paid a $10 commission, your cost basis on the investment would be $2,010 -- (100 * 20 + 10).
When you sell, you also include the commissions and related fees in determining your sales proceeds. So if you sold those same 100 shares of stock for $21 per share and paid a $10 commission, your sales proceeds would have been $2,090 (100 * 21 - 10), giving you an $80 pre-tax gain on the investment.
Occasionally, other things besides purchase and sales prices can affect your cost basis in any given investment. For instance, if a company spins off a division, you may need to split your cost basis between the original investment and the spinoff. In addition, sometimes companies distribute payments that are classified as “return of capital” rather than as dividends, which would also affect your cost basis.
9. Mutual fund
A mutual fund is an investing vehicle where you send your money to a fund company. The fund company pools it with money it receives from other people each day, and then invests that pooled cash in things like stocks or bonds on behalf of all the fund holders. How it invests the money it receives is typically spelled out in a document known as its prospectus.
Mutual funds are often a person’s first foray into investing, either because that’s what’s available in an employer sponsored retirement plan or because that’s what a broker recommended. The big advantage of investing in mutual funds is that you can get your portfolio diversified more easily than by buying individual investments. The key disadvantages are that they tend to have high costs and that you’re responsible for taxes on gains the fund receives even if you simply buy and hold your shares.
10. Index fund
An index fund is a special type of mutual fund that aims to mirror the overall market’s or a specific industry’s composition and thus investment performance. By seeking to mirror the market or a specific industry, it can keep its costs lower, since it doesn’t have to pay fund managers to research individual investments. In addition, index funds usually buy and sell shares less frequently than their actively managed counterparts do, also keeping taxes and friction costs down.
Those structurally lower costs enable index funds to quite frequently outperform most of their actively-managed brethren, despite the fact that they aim to merely match the market’s overall performance. It’s not that professional mutual fund managers are bad investors as much as it’s the fact that their high structural costs make it incredibly hard for them to beat the market average, and thus, index funds.
11. Exchange-traded fund (ETF)
An exchange-traded fund -- often called by the initials ETF -- operates similarly to a mutual fund in that it offers a one-stop way to buy a collection of stocks or bonds. Still, there are a few key differences. For one, purchases and sales of mutual funds happen only once a day, while ETFs trade throughout the day on the market like stocks and bonds do.
In addition, because ETFs trade throughout the day, their market prices may not always perfectly match the price you would get if you simply bought the underlying assets that the ETF holds. On the flip side, since mutual funds settle only once per day, their reported daily prices always match the closing prices of the underlying assets.
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