10 Investment Terms You Should Know
Understanding investment vocabulary is critical to understanding and making decisions about your long-term financial health. Here are 10 key terms you should know:
1. Risk Appetite
This is amount of financial risk you are willing to accept in pursuit of your goals. Risk appetite will vary depending on your individual values, age, life experiences, and financial circumstances, and it plays a large part in shaping your investment journey.
2. Asset Allocation
Asset allocation is how you divide the money you’re investing into different asset categories, such as cash, bonds and stocks (the three major asset categories). Your individual asset allocation will vary depending on the timeframe you have to invest in and your risk appetite.
3. Re-balancing
Imagine you have your asset allocation all planned and you want 20% of your portfolio in bonds. Due to price and market fluctuations, over time your 20% may creep up – or down – and no longer match your risk appetite. Re-balancing is an important process that “re-sets” your allocation to its correct proportion for you.
4. Bonds, Stocks and Mutual Funds
Federal, state, and local governments, and corporations, raise capital by selling bonds. So when you purchase bonds you are in essence loaning money to these institutions for a given period of time, and will receive a set amount of interest on your money in return. Bonds are generally less volatile than some other investments, but produce a more modest return.
Buying stock means you are buying equity or a share of ownership in a corporation, and the value of the stock is generally tied to the assets and performance of the corporation. Stocks can be volatile, but some argue they offer the greatest potential for growth.
One of the most popular investment options is the mutual fund; so popular there are virtually thousands of them to choose from. A mutual fund allows investors to pool their money together to invest in securities (or holdings) such as stocks, bonds, and various other assets. Many mutual funds are affordable, diverse, and have professional management.
5. Prospectus
A prospectus is a legal document that provides detailed information about an investment. For example, every mutual fund provides a prospectus with information covering risks, past performance, expenses, a list of holdings, and much more. At first glance, the sheer volume of information can be intimidating, but may seem more manageable if you decide what it is you want to learn and start there. (TIP: Check out expenses!)
6. Expense Ratio
This refers to the fees you pay fund managers. Calculated as a percentage of your investment, it is paid to help cover all costs associated with managing the fund. Depending on the source and type of fund, an expense ratio can range from 0.2% to 2%. So keep in mind, the higher the percentage, the less you take home.
7. Index Funds
A popular type of mutual fund, Index Funds are investments in the stocks and bonds of companies in a specific Index, such as the S&P 500 (Standard & Poor’s 500), which is an Index that tracks 500 of the largest publicly traded companies in order to measure overall market performance. For investors, Index Funds mean lower fees because you don’t have to pay a fund manager; the Index itself serves as a parameter. However, make sure you fully understand Indexes before investing and, remember, you will have less control over the holdings in each portfolio than you would if you were choosing individual companies.
8. Diversification
In order to lessen risk, investors will diversify a portfolio by purchasing a mix of different types of stocks, bonds, or mutual funds so your entire nest egg isn’t wiped out if one investment fails. There is obviously no guarantee your portfolio won’t be hurt if the market drops, but diversification can help balance the return, protecting against total loss. Diversification works hand in hand with asset allocation and re-balancing to spread risk according to your risk appetite.
9. Target-date Fund
Also known as “target date retirement funds” or “lifecycle funds”, these funds are often mutual funds intended to be a long-term investment for those with a set or planned retirement date. Here’s how it works: you select a projected retirement date, such as 2024. Your investments this year will start out with more aggressive products (i.e. higher risk – higher return) and change over time, becoming more conservative the closer you come to your retirement date. They are often available through 401k plans and are low maintenance. Beware though, they can be difficult to analyze and some would argue, are a generic investment – one that doesn’t take the needs of each unique individual into consideration.
10. Price-to-earnings (P/E) Ratio
A popular metric for stock evaluation, this ratio looks at the relationship of a company’s stock prices compared to its earnings and is used to gauge whether your stock is overvalued or not. Most sources agree that an average P/E generally falls between 10 and 17, anything lower could mean a company is undervalued or its potential overlooked. A higher P/E ratio might mean the possibility of future growth.
Whether intimately involved with your investments, or just thinking about entering the market, knowing and understanding these key investment terms (and seeking professional advice) will make you a safer, smarter investor.