Investment Words You (Maybe) Don’t Know But Absolutely Should

Ten useful products and concepts that you’ll want to understand before putting your money to work.

Girlboss Investment Advice

When people approach me for financial advice, they often share that investing is overwhelming, confusing, or scary. But I’ve found that with just a bit of explaining, my clients leave our meetings with a much better understanding of the fundamentals—and far less anxiety.

In the hopes of assuaging some of your own fears, I’ve created a glossary of 10 useful products and concepts that you’ll want to understand before putting your money to work. Some you may already have a basic understanding of. Others might be new to you. But all will prove useful in your investing journey.

Compound Interest

Einstein is rumored to have called compound interest “the most powerful force in the universe.” Simply put, compound interest is “interest on interest.” I call it magic math.

For example, say you borrow $100 at 10 percent for one year. At the end, you owe back the principle ($100) plus the interest ($10). If you decide to roll the debt forward another year, you now pay interest on $110 (principle plus interest). This is great if you are investing and receiving the benefits of compound interest. For example, if you invest $5,000 per year for 40 years ($200,000 total) at an average rate of 6 percent per year, you will have over $885,000 40 years from now. Voila!

The flipside of this is the potentially devastating impact if you are the one paying the compound interest. Credit cards and student loans compound daily, so make sure you understand what your debt makeup looks like and find out what interest rates are associated with your debt.

Stock

Stock is often referred to as “equity.” If you own shares of a stock, you are essentially an owner of that company. You can own one share of a company or all the shares. One generally buys a stock with the hopes that the price of the stock rises in value. Some stocks pay dividends. Dividends, which are normally paid quarterly, are cash payouts paid to stockholders. You can either receive dividends in cash or you can re-invest the dividends and buy more shares of the stock.

A stock will have a ticker (usually three to four letters) to distinguish itself and will generally trade on an exchange of some kind. Stocks have varying degrees of risk, depending on the type of company you are buying. By buying lots of different stocks, you start to diversify your portfolio. If you only own one stock, you have a very concentrated portfolio.

Bond

A bond is a fixed income investment. It is considered a debt instrument, meaning that when you buy a bond, you are actually loaning the issuer of the bond (usually a corporation or government) money. There is a defined timeline that the bond issuer has to pay you back. Most bonds have a yield associated to them. The yield is the interest paid to the investor and can be a fixed or variable yield.

Bonds are rather complex instruments and have various types of risk that could impact prices. Bond prices also have an inverse correlation to interest rates, so if rates go up, bond prices go down and vice versa. Buying a bond is not a DIY project. Ask for help.

Liquidity

You know the term “cash is king”? Keep that in mind when thinking about liquidity. Liquidity describes the degree to which an asset or security can be turned into cash without affecting the asset’s price. Every asset falls somewhere on the liquidity scale.

For example, cash is the most liquid, whereas real estate, fine art, or your rare coin collection would be less liquid. Most stocks and bonds are generally liquid, depending on the type of security, the market where it trades, and general market conditions. Think about your assets and how liquid each is. This will give you a general sense of your overall liquidity, or your ability to flip to cash, if need be.

Capital Gains

A capital gain is the rise in value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The price you pay for something is called your cost or cost basis. The difference in the price where you sold it versus the cost basis is considered your capital gain or capital loss. There are distinct tax consequences when dealing with capital gains and losses so it is always important to be aware of what your tax liability would look like before you sell an asset.

A short-term capital gain occurs when you hold a security for one year or less. These gains are taxed as ordinary income. Your ordinary income is another word for your adjusted gross income, or the amount you made in a calendar year that you owe taxes on. The IRS tells us what we owe based on our tax bracket. If your tax bracket is 28 percent, you will pay 28 percent on your capital gains.

Conversely, long-term capital gains are usually taxed at a lower rate than regular income. The long-term capital gains rate is 20 percent in the highest tax bracket. Therefore, it’s generally advisable to hold your securities for longer than one year in order to mitigate your tax burden. Capital losses can be used to offset capital gains. This means that if you sold something at a gain and made $1,000 but sold something at a loss of -$500, your net capital gain is only $500.

Passive Investing Vs. Active Investing

Passive versus active investing is important to understand when making investment decisions. Active portfolio management focuses on outperforming the market compared to a specific benchmark, while passive management tries to mirror the investment holdings of a particular index. For example, when you buy a passive portfolio, you are essentially buying an index or a benchmark. Therefore if the benchmark goes up, so does your investment. In active management, the investment manager tries to beat the index by making individual security selections that she thinks will outperform the general market.

A passive strategy does not have a management team making investment decisions and can be structured as an exchange traded fund (ETF), a mutual fund, or an unit investment trust. Generally speaking, passive investments are less expensive than active investments. Actively-managed funds offer an advantage over passive funds in that portfolio choices are made on an expectation for performance, rather than on the basis of a list of companies that make up an index.

Mutual Fund

A mutual fund is an investment vehicle that is made up of a pooled amount of money from many investors (small or large) for the purpose of investing in a diversified group of underlying investments like stocks, bonds, or money market instruments. Mutual funds are operated by professional portfolio managers who invest the fund’s capital and attempt to produce capital gains and/or income for the fund’s investors.

There are several different types of mutual funds but most of mutual funds we come across are open-ended funds. This means that the investor buys or sells units at the funds’ net asset value (NAV). There are over 7,000 mutual funds in the universe today, so it’s important to have a professional help you when choosing which one is right for you.

ETF

ETF is an acronym for exchange-traded fund and is an asset that trades like a stock (it trades on an exchange), but its underlying value is based on a pooled group of diversified assets. ETFs are very similar to mutual funds, but have different bones.

ETFs have only been around since 1993 and have become much more popular in the past decade with the rise of passive investing. They are generally less expensive than mutual funds, they are more passive than mutual funds (most ETFs don’t have portfolio managers but are generally index-driven), and they can be bought and sold easily on an exchange.

Hedge Fund

In the most basic terms, a hedge fund is an investment. It is a pooled group of money (all of which comes from accredited investors) that is aggregated into an entity called a “limited partnership.” The money is then invested by professional money managers who generally have a long track record of investing and have a specific strategy for the money. An accredited investor is an individual or entity (LLC, family office, etc) who satisfies a specific list of requirements such as a) a minimum income threshold of $200,000 for individuals or $300,000 for a married couple and b) a net worth of at least $1,000,000.

As you can see, not everyone can invest in a hedge fund! Hedge funds face less regulation than mutual funds or other investment vehicles, although hedge fund regulation is changing rapidly. Hedge funds are generally open to the universe of investments and markets. Mutual funds, on the other hand, have strict limits on the types of investments in the portfolio. Hedge fund use leverage (see below). This allows hedge funds to place large bets which in turn have a greater impact in terms of profit or loss. Hedge funds can be very costly and have very specific fee structures that other investments vehicles do not normally have.

Leverage

Leverage results from using borrowed money when investing to either expand a company’s asset base (example: build a factory) or generate higher returns on capital. When using the term leverage in terms of investing, it means that a money manager (mostly hedge funds) will borrow money, invest that money and hope to increase the potential return on an investment. Leverage is very complex and can also magnify losses as well as gains. If the underlying investment goes against the investor, her loss is much greater than it would have been if she had not leveraged the investment.

Kristin O’Keeffe Merrick is a Financial Advisor with O’Keeffe Financial Partners, LLC. Views expressed are not necessarily those of Raymond James Financial Services and are subject to change without notice. 

Originally published in Girlboss, June 25, 2018.