by Erin Lowry
* * *
• • •
INVESTING IS NOT unlike Mr. Fugami’s Algebra class. It will feel intimidating and overwhelming at first. Just reading an article, listening to a podcast, or watching a YouTube tutorial on Investing 101 requires stopping to look up multiple terms before you can even get a basic grasp of what’s being said.
Here’s what usually happens (inspired by quite a few similar conversations I’ve seen in comments on blogs and in forums like Reddit):
ROOKIE INVESTOR: I have $2,000 I’ve saved up to put into the stock market. What should I do?
WELL-INTENTIONED RESPONDER WITH INVESTING EXPERIENCE: Assuming you’re in a financial situation to start investing and are already saving for retirement, it’s probably best if you look into investing using a taxable account and then dump your money into an S&P 500 or Total Stock Market index fund with an expense ratio of 0.04 percent, although that expense ratio might be difficult if you’re investing only $2,000.
ROOKIE INVESTOR: Um, I understood the word investing and then got confused.
This is why the next step (after assessing that you’re ready to start investing) is to learn the common language used both in the rest of this book and also so you can decode what people like the “well-intentioned responder with investing experience” above are saying to you.
This chapter is going to explain common investing terms in three categories:
What you absolutely need to know.
Things worth knowing once you get started.
Theories.
I’m going to do a deep dive into some of these definitions to ensure we’re speaking the same language as we move throughout the book. Sometimes details are necessary when talking investments.
AN APOLOGETIC DISCLAIMER
Before you begin to frantically read the list of terms below and feel your eyes glaze over while your brain screams, “Whyyyyy?” I will make a small apology. A lot of these definitions require using another word that needs to be defined in order to explain the first term. For example, in the sentence “Asset allocation requires you to assess your risk tolerance and time horizon,” you don’t necessarily know what risk tolerance or time horizon mean. That’s all detailed here, so be patient. This process will require some bopping around until it all begins to come together. The terms below are also in a specific order to try to minimize the pain of using one term to define another.
WHAT YOU ABSOLUTELY NEED TO KNOW
This may sound silly, but one of the first things you need to understand about investing is what exactly the term investing means.
“I think the common [definition] is putting your money in the stock market versus something that I would’ve liked to hear: putting your money to work for you,” Kelly Lannan, a director at Fidelity Investments, told me. Lannan explained that reframing how you think about investing can help change your perception of investing. Besides, putting your money in the stock market itself isn’t the only way you could be investing. Plenty of people pursue a real-estate-heavy portfolio in lieu of exclusively investing in the stock market.
Okay, now it’s time to get serious about deciphering these terms.
ASSET CLASS: An asset class is a grouping of similar investments. It’s like saying IPA, lager, ale, and stout are all beer. Beer would be the asset class with IPA, lager, ale, and stout being the similar investments. Equities (stocks), bonds, cash and cash equivalents, and real estate and/or commodities are the main types of asset classes. For example: if you put money into an S&P 500 index fund, then you’ve bought into the equities asset class. Then, if you buy a municipal bond, you’ve now purchased two asset classes: equities and bonds.
PORTFOLIO: The term used to refer to your investments or the grouping of your investments. “I haven’t checked my portfolio today” means “I haven’t logged in to my account to look at the details of my investments.” It could be an all-encompassing term or may refer to something specific, like your real estate portfolio or your stock portfolio.
PUBLIC OR PUBLICLY TRADED: When a company “goes public,” that means it is no longer just owned solely by the creator of the company or a close inner circle of friends, family, or venture capitalists. Now it is publicly available for the general public to buy a piece of the company by purchasing stock.
EQUITIES/STOCK: Here’s a fun quirk: equities, stock, and shares are often used interchangeably. Equities and stock can be used as synonyms. Saying you own equities or hearing a term like equity investments means owning stock. But what does it mean to own stock?
In simple terms, owning stock means you own a piece of the company, albeit probably a very small one. You could be entitled to voting rights at shareholder meetings depending on the type of stock you own. You can also receive dividends as the result of owning stock.
Why would a company want to allow the public access to ownership? The reasons vary, but usually because the company is looking to raise money to either grow, pay off debts, or both.
SHARES: Shares are what your stock is divided into. When Jackie tells me she owns stocks, I’d take that to mean that she owns stock in multiple companies. If Jackie tells me she owns shares, then I’d ask, “In what company do you own shares?” While this isn’t exactly a “you say tomato, I say tomahto” situation, it often feels that way. Both stocks and shares refer to ownership of a company. There is a technical difference between stocks and shares, but finding the difference hazy won’t be detrimental to your ability to invest in or understand the stock market.
SHAREHOLDER AND STOCKHOLDER: Shareholder and stockholder mean essentially the same thing: you own shares of a company’s stock. You can split hairs about the technical differences, but honestly, it’s just not necessary for the purposes of this book. Shareholder tends to be the more commonly used term.
SECURITIES: You will also hear the term security or securities used to describe holding equities (stocks) and debts (bonds, certificates of deposits, etc.). It technically refers to the proof you have that you own a particular investment.
BONDS: You own a piece of a corporation’s or government’s debt when you buy a bond. Bonds are considered a less risky investment compared to stocks. There is an agreed-upon interest rate (called “coupon” or “yield”) that is paid to the bondholder at certain intervals, such as once or twice a year. Ultimately, the borrower will then repay the full debt to the bondholder once the agreed-upon term is up (known as “maturity”).
FIXED INCOME: Fixed income investments are typically considered conservative investments because you can expect a set influx of cash. Bonds are an example of fixed income. As a bondholder, you’ve lent money to a company or government, and in return, you expect to receive set payments in interest until the bond matures and you’re repaid your initial investment. Individuals close to or in retirement tend to have a fixed-income-heavy portfolio. But like any investment, there is no 100 percent iron-clad guarantee. Your borrower could default or the interest rate could lose value (known as interest rate risk) if you wanted to sell before your bond reached maturity.
CASH AND CASH EQUIVALENTS: I’m sure you get the cash part, that money in your checking account and savings account. The money you can easily access today. (This accessibility is often referred to as liquidity.) Cash equivalents refers to money that you can easily access (aka is highly liquid) and is a low-risk investment. Certificates of deposit (CDs) are generally considered cash equivalents for an individual investor.
ASSET ALLOCATION: This is one of the most critical pieces to your investing life because it’s part of what will help keep you sane and able to weather the panic when the stock market takes its many tumbles. Asset allocation is the process of deciding in which asset classes you should be investing and how much of your portfolio should go into each. You need to consider your time horizon (when you’ll need the money), goals, and risk tolerance when determini
ng your asset allocation.
DIVERSIFICATION: Ask most financial advisors for the most important term people need to know when learning about investing, and diversification will be one of the first three terms out of their mouths. Diversification is best described with the cliché “Don’t put all your eggs in one basket.” There are two ways to consider diversification in your portfolio:
You don’t want a single asset class. Don’t leave all your money in cash, or just in stocks, or exclusively in bonds, or only own real estate.
You want to diversify within an asset class. For example, you shouldn’t invest all your money in a single stock or sector. Just because you use and love Amazon doesn’t mean you should exclusively invest in Amazon stock. And just because you work in tech doesn’t mean you should only invest in the tech sector. You want to invest in the stocks of many companies across different sectors.
SECTORS: Sectors are industries, such as health care, energy, tech, real estate, or utilities. Investing exclusively in Amazon would mean you own a single stock in a single sector: technology. Should Amazon’s stock tank tomorrow, then you’d lose most of your money. By diversifying, you mitigate your risk for when a particular company or sector takes a hit.
TIME HORIZON: “What’s your time horizon?” is just a fancy way of asking “When do you need the money?” Despite its simplicity, a time horizon is a critical piece of your investing plan. You should know your time horizon before making an investment because it both informs how much risk you should take and can help calm your nerves during the market’s ups and downs. A downturn in the market should be something you can brush off if you’re well diversified and won’t need the money for a few decades. If you need that money near-term, then you’ve probably moved your investments to low-risk or even already over into cash because you knew your time horizon. Money that is being stashed away for retirement when you’re in your twenties can be invested more aggressively than the funds you want to use as a down payment on a house in a decade, because your retirement money has a longer time horizon.
RISK TOLERANCE: This is the gut reaction you feel about the potential of losing money. Risk tolerance, especially when coupled with your time horizon, is a critical part of your investing plan. Having a low risk tolerance, better known as being risk averse, generally correlates with putting your money in investments with lower yields, like bonds. Having a high risk tolerance could mean you take too much risk and don’t properly balance your portfolio. You may need to learn how to battle against your natural risk tolerance—no one likes losing money!
Here’s an example of risk tolerance and time horizon in the investing world: Many portfolio allocation models offered by companies come with names like aggressive, moderate, and conservative. These names tie into both your risk tolerance and time horizon. Aggressive means you’re willing to take more risk while conservative indicates you can’t stomach losing money. Aggressive should also mean you have a longer time horizon and won’t need access to your money in the short term, therefore giving your investments a chance to weather the ups and downs of the market. Conservative portfolios often are for shorter-term horizons and indicate that you’ll need some or all of your money relatively soon, or that you want fixed income (e.g., being in retirement).
BROKERAGE: You’ve probably heard the term broker before. In the case of investing, a broker is the person (or firm) that buys and sells investments on your behalf in exchange for a fee or commission. Yes, it’s essentially a middle man. When you hear the term brokerage or brokerage firm, it’s generally referring to the company that does the buying and selling on your behalf. Brokerages include the likes of: Charles Schwab, TD Ameritrade, Vanguard, Edward Jones, Fidelity, Scottrade, Ally Invest, and E*Trade. That’s not all of them by any means, but they’re an example of what people mean by the word brokerage. It’s imperative you know that not all brokerage firms are the same, and you need to do your due diligence before working with any person or institution.
BROKERAGE ACCOUNT: A brokerage account is where you deposit the money you want to invest. Your brokerage firm facilitates the purchases for you. There are two distinct types of brokerage accounts: full-service and discount.
Full-service firms are that typical Wall Street image. It’s the suit-and-tie-wearing financial advisor who will likely require you to have a high asset minimum (we’re talking double commas) and will charge a flat fee that’s a percentage of your total portfolio under management. Despite the snark, I’m not implying that full-service firms are bad. In fact, you can get access to more investment options with a full-service brokerage firm, but it’s unlikely they’re a good fit for your average, rookie, just-getting-beyond-broke Millennial investor. It also makes sense that this is usually referred to as “wealth management.”
“Discount” unfortunately sounds sketchy, but it’s actually what the average DIY investors (which many rookies are) use. I use discount brokerage accounts. The discount firms are lower cost than full-service firms because you’re usually not working directly with a financial advisor who is developing your investment plan one-on-one. You decide where you’re investing and you place the trade, typically online. The brokerage just facilitates it for you. For example, you put in the order to invest $300 into an S&P 500 index fund, and the next time you log in to your account, you see that transaction reflected. Vanguard, Fidelity, and Charles Schwab are examples of firms that offer discount brokerage accounts—but this doesn’t preclude them from also offering the full-service option.
The other way to break down brokerage accounts is as cash accounts and margin accounts. Cash accounts are what we focus on throughout this book. You deposit the money to make an investment, and your brokerage buys what you requested with the funds you have. Margin accounts involve you being able to borrow from your brokerage for investments you want to make while leveraging your existing portfolio as collateral. This is not a form of investing we’ll discuss in this book.
ACTIVELY MANAGED: A professional, known as a portfolio or fund manager, is managing the investments directly by making decisions about when to buy, hold, and sell the investments within a fund. For further clarification, let’s say there are 100 companies in a fund your portfolio manager is handling. One of the tech companies in that fund starts to underperform, so your portfolio manager sells the shares he’s holding in that tech company and buys shares in a different tech company to replace them. The fund manager’s goal is to outperform a given benchmark, such as the S&P’s 500 index. Passively managed funds mirror these benchmarks, so ultimately a professional is also trying to beat a passively managed fund.
PASSIVELY MANAGED: There’s no professional involved, and investments are automated to mirror a specific index in the market. Mirroring a specific index is also known as indexing.
INDEX: A way to measure the market’s performance by just looking at a statistically significant portion. There are many indices, but two you’ll commonly hear about for the US markets are the Dow Jones and the S&P 500. For example, the S&P 500 is an index of the stocks issued by 500 large, publicly traded companies.
EXPENSE RATIO: The expense ratio is the cost you, the shareholder, have to pay in order to help cover the operational costs the brokerage incurs to run a fund. It’s generally noted as a percentage of the fund’s assets. For example, if the expense ratio on a mutual fund in which you invest is 0.62 percent, then you’ll pay $6.20 for every $1,000 invested, or $62 for every $10,000 invested.
It’s a simple concept but a critical one, because it significantly impacts how much you actually earn over time.
RETURN ON INVESTMENT (ROI): You’ve probably heard this expression used regularly in real life because it doesn’t just refer to the stock market. It’s my husband’s favorite money term, so he loves to joke about the ROI of everything, from buying tickets to a Broadway show to paying off student loans to buying organic milk. ROI can mean the return on sp
ending your time to learn a new skill or to fix something in the home yourself versus hiring a professional. What’s the ROI of waiting in the standby line for Saturday Night Live tickets for eight hours when you only have three days in New York? But for the sake of this book, ROI will generally refer to how much you make on your investment relative to its cost. It’s not just about how much your investment earned you, but what it actually earned you once you consider fees. The equation to figure out your ROI:
(Gain from investment − Cost of investment)
Cost of investment
MUTUAL FUND: You give your money to a professional who pools it with strangers’ money in order to buy investments. It sounds shady, but that’s actually the gist of what it means to own a mutual fund.
The less shady version goes something like this: Many investors don’t have either the time to do the research or the money (capital) to buy the investments required to build a diversified portfolio on their own. Remember, you want to buy more than one stock and invest in more than one sector. You probably also want to own both stocks and bonds. Mutual funds give you that option, even if you don’t have lots of money to start investing.
By using mutual funds, your money is being pooled with that of other investors to get access to investments you may otherwise not be able to afford on your own, because you can invest in hundreds, in some cases thousands, of securities at once with one mutual fund. Plus, a professional handles the research and builds the portfolio to try to get the best return for investors. However, because a professional is involved, the portfolio is actively managed, making the expense ratio higher than other options. This can eat away at some of your returns.
INDEX FUND: You still pool your money with strangers, but this time there’s no professional involved. That might sound even crazier than a mutual fund. Index funds are under the umbrella of a mutual fund and work in a similar manner. You’re combining with other investors’ money in order to increase your purchasing power. The big difference between an index fund and a mutual fund is that an index fund is passively managed. Your investments mirror a particular index—hence the name—so there is no need for an active fund manager. Removing the professional does make the expense ratio lower, which makes it more affordable.