Basic Investment Terms that every investor should know

Mutual Funds

Mutual funds are a collection of investment assets such as stocks, bonds, other types of securities or even other funds which are managed by a professional investment manager or an investment company. A mutual fund typically focuses on a specific investment type and uses a pools of money from a large group of investors, often individual such a you and I. As such, mutual funds are an easy way for a small individual investor to buy into diversified portfolios and get access to professional management. Management and administrative fees are usually levied on your holdings in a mutual fund.

Index Funds

An Index Fund is a type of mutual fund that is structured in such a way to match or track a specific market index such as the NASDAQ (Nasdaq Composite), S&P 500 (Standard and Poor’s 500 index) or the DJIA (Dow Jones Industrial Average). An index fund is set up to replicate the performance of the index not to beat the market index. Advantages of an index fund include lower operating costs, ease of management, lower stocks turnover. This results in a lower management fees.

Exchange Traded Funds (ETFS)

An ETF is in many ways similar to an index fund, however, they are traded like stocks on a stock exchange. This means that they experience price changes and can be bought and sold throughout the day just like regular stocks. Some of the advantages of trading in ETFs include flexibility in buying and selling and lower expense ratio (management fees).

Asset Class

An Asset Class is a group of securities, such as stocks, bonds and currencies, that behave in a similar way in it’s market place and are subjects to the same laws and regulations.

Stocks

An individual stock is a share in the ownership of a specific company. When you, as an individual, own a stock in a specific company, you are one of its shareholders and have a claim to the company’s dividends, when applicable, and you have also voting rights when required. You can also make money from price appreciation by selling your stocks when the price goes up.

Bonds

A bond is a debt security which includes municipal bonds, corporate bonds, savings bonds, Treasury bills, etc. When you buy someone’s bond, you are basically lending money to the bond issuer (borrower) with the hopes of generating income from interest payments during the life of the bond. Also, you want to get the principal (face value of the bond) back at the maturity date. The farther away the maturity date, the higher the rate of interest a bond will pay, the higher the risk associated to the face value.

Simple Interest

A simple interest is interest calculated on the original amount of money and does not include interests on any interest already earned. For example, 10% annual simple interest on 1000$ (10% x 1000) is 100$ for the first year and will remains $100 for the second year and so on. As such, the 100$ interest earned in the first year is not taken into consideration when calculating the simple interest for the second year and so on.

Compound interest

The compounded interest is calculated not only on the initial amount (principal) but also on the accumulated interest earned to this date. As ab example, you have a 1000$ investment that earns a 10% returns each year. For the first year, the interest, simple interest, is 100$ (10% of 1000$). In this case we assume that all returns/interest are re-invested in the same investment. The second year, the return/interest earned will be 110$ (10% of 1100$). Now, your investment rate of growth is much higher than with simple interest (see above). Both Warren Buffet (financial) and Albert Einstein (universal) say that compound interest is a powerful force. It has the potential to significantly multiply your investments over time. But be wary because it works the same way with debt. Compound interest is an very powerful investment force and is one of the main strategies serious and smart investor uses to build wealth.

Time value of money

This financial concept might be hard to grasp. It means that money you have on hand today is worth more than that same amount of money in the future. This concept is based on the premise that the money you currently have can be invested to earn interest and as such might be worth more than the initial value at some point in the future.

Bear Market

A Bear Market happens when securities, such as stocks, prices are falling because seller, called bears, are overwhelming the buyers, called bulls. The market is often called bearish when the market outlook is pessimistic.

Bull Market

A Bull Market happens when securities, such as stocks, prices are rising because buyers, called bulls, are overwhelming the sellers, called bears. The market is often called bullish when the market outlook is optimistic.

Long Position

A long position describes when an investor buys a stock or security and holds it, for a long term prospect, with the hope that the price will rise.

Short selling, short position

Short selling is a security trading technique in which a investor/trader sells a stock/security that they have borrowed through their broker, without holding the stock, with the expectation that the stock’s price will decline. After the price drop, they can then buy the stocks/securities back at a lower price, return the stocks/security to the lender through their broker and keep the difference in price as profit. Needless to say that it is a risky technique with which you could lose money.

Diversification

Diversification of a portfolio is a risk management technique. You spread your investments over different asset classes (stocks, bonds, commodities, real estate) such as to reduce the exposure you have to any one type of security, area and domain. Diversification may help to prevent a higher loss if the market experiences an upheaval.

Asset Allocation

Asset Allocation is a strategy utilized for a portfolio diversification. You, as an investor, spreads out your investments over a variety of asset classes (see above). The proportion of funds (money) invested in each asset class is reflective of the risk tolerance, the goals and time frame as set by the investor.

Financial Risk

Financial Risk is the potential for financial loss based on the uncertainty of return from your assets. Every investment you can possibly make carries a certain level of risk.

Risk vs Return

For all investment, there is a relationship between risk and return. Normally, the higher the risk, the greater the potential for returns, but also the potential for larger losses. The lower the risk, the lower the potential for returns or for smaller losses. If am investment does not follow that and as a high risk but a low potential for return, stay clear of it.

Risk Tolerance

The risk tolerance is defined as the amount of financial risk/uncertainty an investor is willing to take. Several factors influences your own risk tolerance: your investor’s background, age, investing horizon (timeline), financial capacity, investing knowledge and other. A risk averse investor prefers a conservative investing approach with limited risk and limited return potential while a risky investor is at the opposite and prefers a less conservative approach with higher return potential but higher risk.

Market Volatility

The market volatility is the rate of change in the price of a security. Security, mostly stock, prices normally move up and down during the day. It is said that Volatility is high when the price changes rapidly over a short period of time.

Liquidity

Liquidity of an asset is the ability to convert that asset into cash quickly without suffering to great of a loss in value. Liquidity of a particular asset is dependent on the availability of market participants (buyers) to fill the buying side of the transaction.

Dollar Cost Averaging

The Dollar Cost Averaging strategies call for investing a fixed amount of money at regular intervals over a period of time regardless of the share price. This is considered a smart investment strategy because the investor does not need to try to pick tops and bottoms.

Expense Ratio

The expense ratio is the annual fees, expressed in percentage, paid for professional management of your money, usually from mutual funds or ETFs. It usually includes administrative fees, management fees, and other fees as disclosed by the funds management. A high expense ratio will reduce the overall return of the investment by the stated percentage. Minimizing the expense ratio over several years will have a significant impact on your overall return.

Dividends

This investment term means that it is money paid out by a company to its shareholders from its profits as part of profit sharing strategy.

The Final Take

I hope that your will have learn some of the basic investment terms that are required to understand the investment world’s lingo.  There are numerous ofther investment terms that you might learn in the course of your journey to financial freedom.  A good start would be to read the bookd on this list.

Don’t forget to keep the dream alive.