If you've ever felt confused or overwhelmed by the industry terminology used by some investment professionals and financial pundits in the media, you're definitely not alone. From basis points to derivatives, leverage to libor, financial advisors and seasoned investors certainly seem to throw around a lot of buzzwords.
But don't worry; you don't have to memorize a financial dictionary in order to invest. Learning the meanings of these 10 terms can help you gain confidence when it comes to investment planning and your strategic financial plan.
1. Asset Allocation: The Key to a Diversified Portfolio
Asset allocation may sound complex, but it's just another way to describe your wealth strategies. Within your portfolio, you'll likely assign your assets to three major categories:
- Bonds (or fixed income)
- Stocks (or equities)
2. Cash: Less Risk, Less Potential for Growth
You already know what cash is -- money -- but when it comes to your financial strategies, the term "cash" usually refers to money market savings accounts, Treasury bills or certificates of deposit, otherwise known as CDs. In general, cash investments tend to be less risky, but have lower potential to generate returns.
3. Bonds: Part of Your Strategic Financial Plan
Buying a bond is like loaning money to the government agency or company that issued the bond. When the bond "matures" after a specified period of time, you cash in your bond and collect any accrued interest.
4. Stocks: Part of Your Wealth Management Solution
When you purchase stocks, you're essentially buying a small piece of ownership in a company. Usually, when a company performs well, so do its stocks... and vice versa. As an owner of the company's stock, your reward may be experienced as an increase in the price per share or when profits are passed on to you in the form of dividends.
5. Mutual Funds: Spreading Risk
Mutual funds consist of investment dollars from a range of investors that are then used to purchase a selection of stocks or bonds. Mutual funds may reduce risk exposure, as they tend to hold hundreds of stocks or bonds. Often, mutual funds are managed by money managers who make purchasing and selling decisions -- for a fee, of course.
6. Expense Ratio: The Cost of Mutual Funds
The annual fee charged by money managers to buy and sell mutual funds are known as an expense ratio. It's generally calculated as a percentage and may also include costs such as advertising, administration, and record-keeping costs. Average expense ratios for stock mutual funds are $.74 for each $100 invested, while average expense ratios for bond mutual funds are $.61 per $100 invested, according to the ICI Fact Book.
7. Index Funds: A Lower-Cost Financial Strategy
Index funds contain "baskets" of stocks that are representative of a cross-section of the economy, such as the S&P 500, Nasdaq or Dow Jones. Indexes track the performance of these stocks, so when the group of stocks does well, so does the index fund. Index funds tend to cost less, usually about 0.2 percent.
8. Prospectus: Every Rational Investor Should Review
A prospectus is a document that details investments like mutual funds, stocks or bonds. It includes data like a fund's holdings and expense ratios. You can find them online or ask your wealth advisor.
9. Price-to-Earnings Ratio: Ask An Investment Professional
A price-to-earnings ratio consists of two numbers: a company's stock price in relations to its earnings. A ratio between 10 and 17 is average. Ratios between 0 and 10 are considered low, which may indicate that a company isn't performing well or that a stock is undervalued. Ratios over 25 can be an indication of a bubble. Price-to-earnings ratios sometimes should be taken with a grain of salt as they can be interpreted in many ways.
10. Target-Date Fund: Part of Your Comprehensive Financial Plan?
Target-date funds are often part of 401(k) plans and they're geared toward a specific retirement date. For instance, say you expect to retire in 20 years; you'd choose a 2035 target-date fund. Early in the investment period, the portfolio is exposed to more risk (i.e., more stocks), but as the retirement date nears, investments shift to a more conservative approach, i.e. more heavily weighted toward bonds.