Monday, May 30, 2016

Investing Terms to Know (Reference Material)

WARNING: This post is meant to serve more as a glossary for your reference than an article. If you would like me to add any other terms to this list please let me know. I’m planning to start sharing a series of articles that revolve around investing, but there are a ton of terms and phrases that are used in the investment world. Without at least a basic understanding of these terms it can be very difficult to understand what is being said, and it is very difficult to teach someone who doesn’t speak the same language as you. 

And to further complicate the matter, many financial terms have completely different meaning in our normal speech. Sorry that it ended up being so long, I hate reading long articles and I really hate writing long articles, but I needed to be assured that you had a framework set before I just dove into the meat and potatoes of investing lingo. Hopefully this list will help you to build that framework of understanding about retirement savings, general investing and the financial industry if it wasn’t already present and serve an a reference to look back on if you wonder about the meaning of a term in the future.

In alphabetical order, here we go:

401(k) – The name of this investment tool refers to line number 401(k) in the IRS tax code. This line allows employers to establish a company-sponsored retirement plan for their employees which give tax advantages for the employees. Some companies establish these plans with rules that may be stricter than the IRS rules. A company’s fiduciaries determine which investment options the plan will offer. They can come in both the Traditional and ROTH flavors depending on the company.

403(b) – The name of this investment tool refers to line number 403(b) in the IRS tax code. This line allows state and local government organizations and non-profit organizations to establish retirement plans for their employees similar to a 401(k). Organizations that establish 403(b)s often have several 403(b) plans through several financial services providers.  

457 – The name of this investment tool refers to line number 457 in the IRS tax code. This line allows state and local government organizations and non-profit organizations to establish retirement plans similar to a 403(b)

Aggressive – This is used as a descriptive term applied to investors, fund managers or investments. It describes someone/something with higher levels of investment risk and more volatility. More risk is exchanged for the opportunity for a greater return, the opposite being conservative.

Annuitant – The person upon whose life an annuity is based.

Annuity – A contract between an individual and an insurance company designed to pay an income stream at some time in the future. It can be purchased to have either a single payment or a series of payments.

Annuitize  The commencement of regular payments from capital which has accumulated in an annuity.

Asset Allocation – The way an investor divides their money among asset classes.

Asset Class – All of the different mutual funds are divided into categories called asset classes based on the characteristics of the underlying investments within a fund and the funds objectives.

Asset Class Risk – Refers to the possibility that a given asset class will experience poor performance. For example, rising interest rates negatively affect the value of long-term bonds, and small cap stock values decline more sharply than large cap stock values during a recession. Along with company risk, asset class risk is an element of unsystematic risk.

  • The level of asset class risk to a portfolio can be reduced by diversifying across multiple asset classes.
Band of Savers – A great personal finance blog/community that seeks to help the world through the dissimulation of financial wisdom and insights gained through real life experiences, examples, and study with a focus on retaining capital and progressing towards financial freedom.

Cash Value – Refers to the total value of an investment account and does not consider distribution limits, surrender charges or early-withdrawal penalties.

Capital Gain – The money that your investments have generated.


Capital Gains Tax – Only some investment vehicles are subject to this tax when the owner sells the investment for a profit. Only the gains are taxed – they are called taxable gains. They are identified as either Long Term or Short Term.
  • Long Term Capital Gains – Gains earned on an investment that you’ve owned for more than 1 year. These are taxed at a lower rate than short term capital gains.
  • Short Term Capital GainsGains earned on an investment that you’ve owned for less than 1 year, and are taxed at a higher rate.

Commingled Trust Fund – These funds are managed by a bank trust department for employer-sponsored plans. They consist of a pooling of accounts that allows a lower operating cost for the bank that manages the fund and, potentially, for the employers and participants. They are generally offered as an alternative to mutual funds in some retirement plans.

Company Match – The money that some employers contribute to their employees’ employer-sponsored plan accounts as a percentage-of-employee-contribution or as a dollar-for-dollar-match. Also commonly to as an employer match. Think of this as free money and always max out your employer match.

Company Risk – Refers to the possibility that an event will negatively impact a specific company but not have a large impact upon an asset class or the aggregate market. The potential for company stock to lose value through competition, mismanagement, and financial insolvency. Along with asset class risk, company risk is an element of unsystematic risk – for example, a labor strike will negatively impact the company against which it is directed, or a defective product will negatively impact the company that produced it but not the industry in general. Note:
  • The level of company risk to a portfolio can be reduced or eliminated by maintaining exposure to a larger number of companies.
  • When a large, integrated, multi-faceted company fails – like Lehman Brothers – the negative impact is not limited merely to the company, or even to the asset class. The failure of a company like this rises to the level of negatively impacting the entire market and economy. Thus, the possibility of failure for this category of company is a market risk rather than a company risk.
Compounding – Albert Einstein referred to compounding as the 8th wonder of the world. It is when the earnings of an investment are reinvested and create growth for themselves. It’s like your investments have babies then those baby dollars grow up and have more baby dollars and the cycle continues as you get more and more earning potential.

Conservative – This is a descriptive term applied to investors, fund managers or investments. Generally associated with lower levels of investment risk and less volatility. The acceptance of less risk and lower returns in exchange for a greater level of asset protection. This is the opposite of aggressive.

Contribution – The money an investor places in a retirement savings vehicle.

Contribution Limit – The maximum amount that the IRS will allow to be invested in a given retirement savings vehicle per calendar year.


Cost Basis – The total amount of money contributed to an investment, regardless of gains, losses, penalties or fees. This is often required for tax purposes.

Distribution – A withdrawal of money from a retirement savings vehicle. There are many IRS and company-specific rules that govern distributions.

Diversification – The practice of purchasing a wider variety of investments in order to mitigate the risk associated with any single investment.

  • Asset Class Diversification – When you spread your investments over a variety of asset classes so that a market downturn in one sector will have a smaller effect upon your entire portfolio. Generally described by the analogy of not putting all your eggs in one basket.
Dollar Cost Averaging – A long-term investing strategy in which an investor contributes the same amount of money to an investment account on a dedicated schedule instead of more sporadic lump sums.

The Efficient Frontier – A mathematical process is used to calculate either the level of risk an investor should expect for a given level of return or the level of return that should be expected for a given level of risk. Multiple optimum-risk/optimum-return levels are calculated and plotted on a graph, and the resulting line represents The Efficient Frontier. The Efficient Frontier is a major element in Modern Portfolio Theory. An example is shown in the following graph.


ETF – Acronym that stands for an Exchange Traded Fund. An ETF is an investment shell that trades throughout the day on an exchange, similarly to stocks. Since they are less regulated than mutual funds, ETFs have the ability to carry more diverse underlying investments.

Fiduciary – Any person/entity who exercises any discretionary authority or control over the management of a retirement plan or its assets. Fiduciaries are legally required to act in the best interests of the plan’s participants.

Income Investing – An investment strategy where the goal is to buy investments that will pay an ongoing income. Example: Buying rental properties so that you can collect the rent every month.

Index – A compilation of investments, often stocks, of a particular category that is used as a benchmark to reflect the overall performance of all investments within the designated category. They are generally, created by financial services companies. For example, the S&P 500 is an index created using a sampling of 500 large US companies that Standard & Poor’s believe is representative/reflective of all large US companies.

Index Fund
 – A type of mutual fund that matches or tracks the components of a market index like the S&P 500 Index or Wilshire 5000. They can provide exposure to a large number of companies within a specific market segment. Typically, Index Funds have lower management fees than other mutual funds and returns similar to those of the indices they track.

Market Capitalization – Also called market cap, is a number that describes the value of a company on the open market. It is computed by multiplying the number of shares available to the public by the current price per share. All companies are categorized either large, mid, or small cap.

Market Risk – The risk associated with the overall financial market and economy as a whole. This type of risk is also referred to as systematic risk, since it systematically affects everyone in the market. Note that:
  • Aside from abstaining from investing in financial markets entirely, there is little an investor can do to eliminate market risk.
  • Many investors are unsuccessful in attempting to eliminate market risk by trying to engage in market timing. Among investors who fail to achieve average market returns, poor timing decisions are a major factor.
MSCI EAFE Index – An index fund that stands for the Morgan Stanley Capital Index Europe, Australasia, Far East index. This index is a benchmark for equity market performance in developed countries, excluding the U.S. and Canada.

Modern Portfolio Theory – The theory that provides numerical evidence that, by owning multiple investments in a portfolio, investors can reduce portfolio risk to a level that is lower than any single investment in the portfolio. It uses an equation called The Efficient Frontier to calculate which portfolios at each risk level have the highest expected returns. It was developed by Harry Markowitz, who won a Nobel Prize for MPT research and writing.

Money Market Fund – A conservative category of mutual funds that has the objective of earning interest for shareholders while maintaining a net asset value of $1 per share. Comprised of short-term (less than one year) securities representing high-quality, liquid debt and monetary instruments.

Mutual Fund – A product that allows a group of investors to pool money together and invest as a group in a wide variety of securities, most commonly stocks and bonds. Each mutual fund will hold different assets based on its stated objectives.

Option Contract – A contract that can be bought and sold on exchanges that entitles the owner to buy (call option) or sell (put option) shares of a security at a designated price. Example: A farmer might buy a call option that would give him the option to buy his tractor fuel for a set price in 6 months from now just in case the price of fuel increases. Or he can buy a put option that would allow him to sell his corn at a specific price in case the price for corn drops before he can harvest.

Penalty – A fine assessed by the IRS when an employee takes a distribution that is outside the IRS parameters for distributions from that plan type. Generally a penalty is 10%. Penalties do not eliminate the need to assess regular income taxes on a distribution.

Pre-tax – Refers to money that has not yet incurred income tax. Pre-tax contributions are withdrawn from income before it is taxed, which lowers taxable income but the tax is later paid on the distribution amount. A limited number of other items can be paid with pre-tax income, like health insurance premiums.

Redemption Fee
 – Some 
mutual funds charge shareholders when they redeem shares. The fee is used to pay for the costs associated with redemption – it is not a commission payment or broker fee.

Required Minimum Distribution – Partial annual payments from retirement accounts like 401(k)s and IRAs required by the IRS beginning by the April following the calendar year in which the account owner turns 70.


Risk – The possibility of incurring a loss and the uncertainty of achieving a specific result. Quantified by standard deviation and associated with volatility. Investment risk can be further explained by delineating the term into three sub-categories: market risk, asset class risk and company risk. Each class of risk can independently impact an investment.

Roth – Refers to a portion of tax law that enables individuals to contribute to a retirement account on an after-tax basis. Money contributed on a Roth basis will not be taxed upon distribution. The only Roth accounts currently available are Roth IRA and Roth 401(k). Named for Senator William Roth Jr. who sponsored the legislation that enabled Roth contributions.

S&P 500 – An index name standing for Standard & Poor's 500. This one of most commonly used benchmarks for the overall performance of the U.S. stock market. It was designed to be a leading indicator of U.S. equities and to reflect the risk/return characteristics of large U.S. company stocks.

Security
 – Basically anything that has value as an investment. According to Section 2(a)(1) of the Securities Act of 1933, unless context otherwise requires, a security includes “any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘security,’ or any certificate of interest of participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”


Separately Managed Account – Also known as a sub-advised fund. They are managed by a management team or firm other than the firm that holds the assets. Most often found in wrap programs or variable annuities
  • Unlike a traditional, publicly available mutual fund, a separately managed account is sponsored by a retirement plan provider solely for that provider's retirement accounts. A mutual fund manager is hired to manage this unique fund. Although these funds may be managed by the same managers as some publicly traded funds, they have their own unique performance. An investor must consult their fund provider for performance information.
Stable Value Fund – A mutual fund with holdings that include high-quality bonds and interest-bearing contracts purchased from banks and insurance companies. The interest-bearing contracts have a guarantee, called a wrapper, that the principal and interest payments will remain steady. They are commonly offered as an alternative to money market funds in retirement plans.

Surrender Charge – Some financial contracts with cash value, like life insurance and annuities, charge the owner an early termination fee deducted from the 
cash value upon termination. Most surrender charges gradually decrease over a period of time until they disappear to deter people from walking away early after they realize how badly their getting ripped off.

Systematic Risk – Investment risk that is tied to the entire, aggregate market and economy. Also called market risk. The opposite of unsystematic risk. The possibility that the entire market and economy will show losses, which would negatively impact nearly every investment.

Target Date Funds – Mutual funds that periodically re-set asset allocation in accordance with a selected time frame, generally becoming more conservative as the target date approaches. Please note, these funds are designed to work alone in a portfolio. If you have any other mutual funds don’t bother with these. Also, they are set up only according to you age and reflect nothing about your actual retirement goals or situations. Because of this, these are now wise investments.

Taxable Income
 – The amount of income that the IRS taxes. Taxable income can be far lower than gross income because the IRS allows pre-tax 
contributions to some investment accounts and pre-tax payment of some expenses.

Tax-deferred – Income that is not subject to 
capital gains taxes.

Tax Loss Harvesting – The practice of selling securities for a loss to offset capital gains.


Thrift Savings Plan – Established in 1986 by the Federal Employee’s Retirement System Act, the TSP is for civil and military employees of the federal government and functions like a 401(k).

Unsystematic risk – Investment risk that is not tied to the entire, aggregate market and economy. Company risk and asset class risk are categories of unsystematic risk. It is the opposite of systematic risk - also called market risk. The possibility that an investment or a category of investments will decline in value without having a major impact upon the entire market.

Variable – A descriptive term for a non-guaranteed, non-fixed return investment. If returns will vary, depending upon performance, an investment is variable.

Volatility – The tendency to vary greatly. Refers to the frequency with which investments tend to rise and fall in value and the amount of variation in value. Part of the measure of risk

Wrap Fee
 – A charge levied against a client by an investment manager or investment adviser, either a firm or an individual, for providing a bundle of services like investment advice, investment research and brokerage services. It is generally a percentage of the assets under management.

  • Wrap fees allow an investment adviser to charge one straightforward fee to clients, simplifying the process for both the adviser and the customer.


Wow, that was actually rather painful. This is probably the only time that I’ll ever say this but I actually hope that you didn’t read all of that – unless you really were that unfamiliar with those terms. My hope for this was that it will stand more as a reference than a leisure read. If you would like me to add any terms to this list or need more information on any of them please let me know.