Updated: Sep 24
The financial services industry is built upon the idea that complicated is better than simple and expensive is better than cheap. Mutual fund companies make billions of dollars each year by touting the benefits of active management and new strategies, despite the fact that almost all research over the last twenty years points to the fact that passive management will beat active management. Talking heads on CNBC keep their jobs by making investing more complicated than need be, throwing out terms like active share, delta, and hedging. The truth is that 90% of what you hear on CNBC is pure fluff, meant to fill up the 24 hour news cycle.
That being said, there are some terms that you need to know in order to be a well-educated consumer and investor. Below you’ll find a list I put together with ten of the terms that I believe to be most important. If you know and understand these ten terms and nothing else, you’ll be better off than the majority of investors.
1. Compound Interest – I’ve previously written about compound interest (Here), but I’ll rehash it here because it’s so important. Compound interest is, essentially, interest on interest. Your money earns interest and that interest earns interest as well. Compound interest can be visualized by thinking of a snowball rolling down a hill. It picks up speed and grows faster and faster as it gets farther down the hill. Money grows in the same way with compound interest.
2. Asset Allocation – This refers to how you have your money invested. You can break asset allocation into two different components. The first is where you have your money invested, i.e. stocks versus bonds. You can also break it down further by specifying the exact breakdown into various categories such as international, large cap or small cap. The second part of asset allocation is the percentage of your funds you have invested in each position. Asset allocation is important because it is what determines how risky your portfolio will be; you should match your allocation to your risk tolerance. You can learn about strategies for finding your asset allocation HERE.
3. Volatility – Fluctuation in price. All assets fluctuate in price, some more than others. By looking at the volatility of an asset, you can get an idea if an asset fits into your portfolio, or if it’s too volatile for you. A key point to remember with volatility is that volatility isn’t a bad thing on its own, so long as you’re compensated for that volatility through higher returns.
4. Risk – The chance of losing money when purchasing an asset. Risk correlates with volatility, however they aren’t the same thing. There is also a correlation between risk and return. Generally, investments with a higher amount of risk will have a higher level of return as well.
5. Stock – A share of stock is ownership in a tiny piece of a corporation. Also known as equity, stocks allow you to participate in the growth of a company.
6. Bond – While stock is a method of owning a piece of a company, a bond is the same as making a loan to a company. While stocks have greater risk, and greater return, bonds generally provide a safer investment with a lower rate of return.
7. Fund – There are several types of funds, the most common being a mutual fund. A mutual fund allows an investor to invest in a basket of other securities, i.e. stocks and bonds. This allows the investor to diversify their investment more than they would be able to on their own because it cuts down on the transaction costs involved with purchasing shares of stocks or bonds.
8. IRA – An IRA is a type of retirement account which provides certain tax benefits for investors. Almost any type of investment can be held in IRA’s, from mutual funds, to REIT’s, to ETF’s. Traditional IRA’s provide a tax deduction and tax deferral on growth while Roth IRA’s provide tax free growth. I wrote about IRA’s in more detail here.
9. ETF’s – ETF stands for exchange-traded fund. It’s much like a mutual fund, in that it allows for easy and cheap diversification, but it trades like a stock. ETF’s are a great option for many investors because they offer an easy way for investors to build a diversified portfolio while minimizing their costs.
10. Rebalancing – An important component of investing for the long term is having a plan and sticking with it. You find the right asset allocation for your risk tolerance and stick with it. You stick with it by rebalancing. Rebalancing means to buy (or sell) securities in order to stick with your asset allocation. You do this because the various securities will change in price at different rates, so occasionally you’ll need to sell some and buy others in order to get back to your original allocation. Essentially you’re going to sell the winners and buy the losers, which sounds counterintuitive but makes sense when you consider it more. You’re selling higher priced assets in order to purchase other assets at a discount.