Today we’re covering 32 finance & investing terms that every investor ought to know,
Basically, this is financial jargon for beginners.
In the next few minutes you’ll get up to speed on the financial terms you need to know to have a basic understanding of the world of finance. Watch the video below to get a walkthrough of these important terms.
I’ve also provided a transcript of the video below.
First up, stocks.
- Stocks are pretty straight forward. Each share of stock is equal to a small piece of the overall ownership of a company.
- If there are 4 shares of stock in a company and you own one share of stock. You own one-fourth or 25% of the company.
- The numbers change as the company gets larger, there are more shares and each share represents a smaller percentage ownership in the company, but the idea remains the same.
- To watch another video where I take a deeper dive into the basics of stocks, click here.
- Market cap is the value of the company on the open markets.
- It can be calculated by multiplying the price of one share of stock by the number of shares outstanding.
- It’s the value you would pay if you bought all of the shares a company has issued so far.
Here we have two investment styles:
- Growth stocks are stocks that are expected to grow fast in the future to justify their high prices relative to their cashflows. Think Amazon or Netflix.
- Value companies are stocks that are on sale versus what their true worth should really be. The trick is that your value of the company is the right one and that the market eventually realizes the stock is mispriced and bids up the share price to what it should really be. Warren Buffett is a famous value investor.
There are three sizes of companies you’ll hear about most often.
- Small cap stocks are stocks of small companies that have a market cap of less than $2 billion.
- Mid-cap stocks are stocks of medium-sized companies that have a market cap between $2 billion and $10 billion.
- Large-cap stocks are stocks of companies that have a market cap greater than $10 billion.
- Bonds, in their simplest form, are a loan that you make to a company or government and they pay you interest on that loan and eventually repay the original purchase price of that loan.
- Click here to watch another video on bonds.
- Interest rates are simply the price a borrower pays each period, usually a year, to borrow a sum of money.
- A very basic example would be a loan of $100.
- If it has an annual payment of $5 it has an interest rate of 5%.
- You pay the $5 each year as the cost of borrowing on top of the payments you make to repay the loan.
- Bonds have a certain date at which they mature, at which point you’re repaid the original loan you made to the borrower.
- Default is when a borrower (for bonds, a government or corporation) doesn’t make their scheduled interest payments.
Types of Bonds
- Treasuries are government issued bonds from the US treasury.
- Corporate bonds are bonds issued by corporations.
- Agency bonds are issued by government agencies like Fannie Mae and Freddie Mac.
- Municipal bonds, or muni bonds, are issued by local governments and municipalities.
- Mortgage-backed securities are groups of home mortgages that are packaged so that they pay you like a bond.
- Investment grade bonds are the least risky type of bonds. These bonds have a BBB rating or above. Investment grade bonds are issued by stable governments and established corporations.
- Junk bonds, or high yield bonds, are bonds with ratings below BBB. These carry a higher chance of default, but this higher risk causes them to pay higher interest rates.
- Alternative investments can be pretty complex, but at the heart of it, alternative investments include anything that isn’t a traditional stock or bond investment.
- Some examples would be real estate, commodities, currencies, options, derivatives, and then more esoteric strategies like Long/Short strategies.
Let’s just define some alternatives you’re likely to hear about.
- Real estate is easy to understand. You can invest in buildings and land either directly or more commonly through real estate investment trusts or REITs.
- Commodities are raw materials used in manufacturing or consumables that consumers buy and use. Some examples would be oil, natural gas, cotton, coffee, and copper.
- Derivatives are anything that does not have a value on its own but instead, derives its value from another investment. Basically, it is an agreement that pays off if certain circumstances are met.
- Options, futures and credit default swaps are all types of derivatives.
- A mutual fund is an investment structure that allows you to pool your money with other investors so that you can achieve economies of scale while investing.
- Together, you hire investment managers to manage the group’s money.
- All orders to buy and sell are processed at the end of the day, so no mater when you purchase it during trading hours, your order goes in at the end of the day.
- Typically all capital gains and dividends are passed along to the investor, making this a less tax-efficient way to invest in taxable accounts.
- Exchange-traded funds have become a very popular way to invest and for good reason.. Think of these like mutual funds version 2.0.
- Just like in a mutual fund, in an ETF you pool your investment funds with other investors and you hire a manager to manage them, but they are more liquid and more tax efficient due to the way that they redeem and create shares of the ETFs.
- Instead of just being traded at the end of the day, ETFs are traded like stocks. You can buy and sell them at any time of the day.
- And because of the better redemption/creation process by which ETF sponsors bundle the underlying investments, not all dividends and capital gains need to be distributed to investors, which makes them more tax efficient.
- And to put some icing on the cake, ETFs typically have much lower fees and trading costs than their mutual fund brethren.
- These sound a lot like ETFs but there is one crucial difference: you are buying a contract from an issuing bank that promises to pay you the returns on the asset class or strategy underlying the ETNs.
- So, instead of your money being directly invested in the investments that the ETN is tracking, you give your money to the issuing bank and they can either invest that money directly or use options and other derivatives to track the strategy of the ETN.
- There are some tax benefits to ETNs because most, if not all, of the gains you make from an ETN, are treated as capital gains rather than ordinary income. But you have to keep in mind that if the bank becomes insolvent, you may not get your money back because during a bankruptcy these act like bonds that aren’t secured by any collateral.
- Just like ETFs and stocks, these can be traded throughout the day, rather than only at the end of the day like mutual funds.
- These have a maturity date like a bond, at which point the ETN winds down and disburses all funds to investors.
- You might ask why I included this, but cash goes beyond just straight dollars sitting in your account.
- Cash includes anything that is liquid and can be converted to cold hard cash within 90 days or less.
- Cash, 90-day Treasury Bills and money market accounts all fall under this category.
- An insurance contract between you and an insurance company that promises to pay you a certain income over a period of time.
- Annuities nowadays are a lot more complicated than they used to be, so I offer both reviews of popular annuities and an annuity myth ebook.
The Federal Reserve
- It is the Central Bank of the United States.
- It is typically called “The Fed”.
- The Fed influences interest rates through Treasury purchases, like the quantitative easing programs you’ve heard so much about over the years.
- It also sets reserve requirements & the discount rate for loans to banks.
- And finally, it determines the supply of money in the economy as well as conducting many other regulatory oversight duties for the banking industry.
- The process of diversifying your portfolio’s holdings across several types of asset classes.
- This is one of the more important steps of portfolio construction.
- Example: 60% Global Stocks and 40% Global Bonds
- The increase in prices that typically occurs each year in a healthy economy.
- Bread was $1 last year, it increased in price to $1.02 this year, inflation was 2% over the last year.
Nominal Rate of Return
- Rates of return can be differentiated by whether they take inflation into account.
The nominal rate of return is the return on an asset before the effects of inflation are taken into account.
Nominal Rate of Return
- The real rate of return is the rate of return of an asset after you adjust for the effects of inflation.
- To get the exact number there is a different formula, but real rates of return can be approximated by simply subtracting inflation from the nominal rate of return.
- 10% Nominal Return – 2% Inflation = 8% Real Return.
I know finance can be pretty complex at times so I’m here to help make it easier to understand for you. Hopefully, this video helped make some of the more confusing terms we financial professionals use a bit more clear.
Risk is a topic that’s on the mind of many investors today. A great place to learn how to better manage risk is my free video series How To Protect (And Even Grow) Your Portfolio In Any Market. If you’re already a subscriber to my newsletter and have yet to watch them, search your inbox for the videos.
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Until next time.