Financial Definitions

Basic financial jargon to get you started.  This allows you to have a base understanding of the material presented along with starting to gain knowledge through your own self-education.

  • Compound Interest – This may be the most critical point regarding investing your money. If you invest your money it will grow on its own and “compound” or multiply over time. You are familiar with a bank savings account where the bank pays you a set interest rate for depositing your money with them. Your money continues to grow over time. What I am going to show you is how much of a difference it can make to have even a slightly higher return on your investment, meaning your money.  Within the Investing tab are examples of how much small amounts of money can grow over time.  It’s nothing short of amazing.
  • Inflation – Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is failing. Central banks attempt to limit inflation, and avoid deflation, to keep the economy running smoothly. Because of inflation, the purchasing power of a unit of currency falls. For example, if the inflation rate is 2%, then a pack of gum that costs $1 this year will cost $1.02 next year. As goods and services require more money to purchase, the implicit value of that money falls. Inflation is one of the primary reasons that people invest in the first place. Just as the pack of gum that costs a dollar will cost $1.02 in a year, assuming 2% inflation, a savings account that was worth $1000 would be worth $903.92 after 5 years, and $817.07 after 10 years, if you earn no interest on the deposit. Our central bank (The Federal Reserve) has a congressional mandate of “trying” to keep inflation at 2%. Inflation in the 20th century was around 3% and from 1950 until 2000 was around 3.9%.  Keep in mind that if your investments aren’t earning at least that much, you are losing money.
  • Asset Classes -These are several types of assets to invest your money in. They have many differences that would take a book to show in depth but I will attempt to give you a base understanding of the most common.Cash-This is money that you would have invested in low interest paying “safe” investments like a bank savings account, certificate of deposit, treasury bills and treasury notes. Bank accounts are insured through the FDIC (Federal Deposit Insurance Corporation) for banks and the NCUA (National Credit Union Administration) for credit unions. Obviously if you own Treasury bills or notes through the government there is negligible risk.Bonds-When you purchase bonds it is money you loan to someone with an expected interest rate paid to you beyond your initial investment. Bonds can be US government savings bonds, municipal bonds (like when Iowa City wants to build infrastructure), state bonds, US Treasury Bills, (1 year and under term) US Treasury Notes, (2 to 10-year term) US Treasury bonds (20 to 30-year term) (the federal government borrowing money) or corporate bonds (private companies borrowing money). They all pay different interest rates over different time periods for the risk involved of you investing your money. These can be purchased individually or through a mutual fund. If you purchase bonds individually and hold them to maturity they will pay the stated initial interest payments. Bond mutual funds are groups of bonds that can fluctuate in value. There is risk of default with bonds and the rate of interest paid is generally reflective of that risk, hence the term “junk bonds.”  Bonds are somewhat counterintuitive to value when in a fund. If interest rates rise, they lose value. If interest rates go down, they go up in value. This is because if rates rise, your principal is worth less to people wishing to purchase bonds because they can receive a better deal elsewhere. The opposite is true when interest rates decline, your principal is worth more because your rate is higher.Equities-This is just another term for stocks. You a purchasing shares of a company and become a part owner. You then share in the profits of the company. This can be through dividends (cash payments periodically if the company issues them, some don’t) and/or through capital appreciation meaning the share price goes up beyond what you paid and you sell them to someone else. These can be purchased individually or through a mutual fund.Others – There are many others including gold, currency and commodities such as oil, gas, agriculture products.  Many asset classes are more about speculation and trading rather than investing long-term, which is why equities, bonds and possibly real estate (not your home) make better long-term investments. They all produce income whereas the previous mentioned don’t.  Sticking with income producing assets in my view is a better choice.  Insurance is not an investment!
  • Asset Allocation – This is how you would divide up your investments within your account. An example would be 60% stocks, 30% bonds, and 10% cash or whatever amounts you decide.  This is your asset allocation.
  • Mutual Funds – A mutual fund is an investment vehicle made up of a pool of funds collected from many investors for investing in securities such as stocks and bonds. Mutual funds are operated by money managers, who invest the fund’s capital and attempt to produce gains and income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus. One of the main advantages of mutual funds is they give small investors access to professionally managed, diversified portfolios of equities, bonds and other securities. Each shareholder, therefore, participates proportionally in the gain or loss of the fund. Mutual funds invest in a wide amount of securities, and performance is usually tracked as the change in the total market cap of the fund, derived by aggregating performance of the underlying investments. Mutual fund units, or shares, can typically be purchased or redeemed as needed at the fund’s current net asset value (NAV) per share.
  • Exchange Traded Funds (ETF) – An Exchange Traded Fund is a marketable security that tracks an index, a commodity, bonds or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and can have lower fees than mutual fund shares, making them an attractive alternative for individual investors. Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated once at the end of every day like a mutual fund does.
  • Managed vs. Passive Mutual Funds – A managed fund is when an investment company or “professional money manager” offers a fund that may specialize in equities (stocks), bonds or other asset classes. They would have you believe that their expertise in knowing what to own and when to buy and sell will increase your returns and lower your risk. There are more of these funds available than individual stocks for purchase. I wonder why?  A passive fund is when a specific index is tracked like the S & P 500 index (composite of 500 largest companies in the US) or various others. There is little or no management necessary which generally but not always allows for very low expenses to run the fund. This allows you to keep more of your money and as I well show, generally outperforms managed funds.
  • Expenses and Loads – All mutual funds have fees attached to them. When an investor purchases shares in a mutual fund, they are assessed a fee known as an expense ratio. A fund’s expense ratio is the summation of its advisory fee or management fee and its administrative costs. Additionally, these fees can be assessed on the front-end or back-end, known as the load of a mutual fund. When a mutual fund has a front-end load, fees are assessed at the time of the initial purchase. For a back-end load, mutual fund fees are assessed when an investor sell his shares. These loads can be as high as 5.75%. Actively managed funds typically have much higher expenses than index funds. Funds with high expenses and loads should be avoided.  They generally predict inferior returns.
  • Prospectus – This is a statement of investing objectives that each fund is required to provide to investors.  This should be read prior to investing.  It may be hard to understand at first, but you will at least have some idea of what you are investing in.
  • Indexes or Indices/Stock Exchanges/Benchmarks (performance gauge) – In finance an index typically refers to a statistical measure of change in a securities market. In the case of financial markets, stock and bond market indices consist of a hypothetical portfolio of securities representing a market or a segment of it. When putting together mutual funds and exchange-traded funds (ETFs), fund sponsors attempt to create portfolios mirroring the components of a certain index. This allows an investor to buy a security likely to rise and fall in tandem with the stock market or with a segment of the market.
    • a. Dow Jones Wilshire 5000 – This is commonly considered to be the total stock market index. Although there are typically only 3500 companies listed in this index they make up 99% of all market capitalization in the United States. In other words, you are buying the United States economy. This is an excellent broad based index with maximum diversification in stocks.
    • b. S & P 500 – This is the 500 largest companies in the United States. This is one of the indexes that is quoted regularly on television and radio. These companies make up approximately 70% of the market capitalization in the United States.
    • c. Dow Jones – This is an index of 30 large diverse companies. It is one of the oldest and most recognizable indexes. This also gets a lot of exposure daily on news broadcasts.
    • d. Nasdaq – The Nasdaq is a stock market exchange where stocks are bought and sold. They use all the companies on the exchange to have an index of value. Many of the companies listed are technology oriented. This is also well known and shown daily in most media outlets.
    • e. Others-International, Sectors, etc. – There are other indexes that cover small companies, international companies and other sectors. Most every country in the world has their own version of an overall index. Germany has the Dax, in Britain it is the FTSE, and so forth. There are indexes that cover Small Cap, Mid Cap and Large Cap equities, etc. They are too numerous to mention.
  • Individual Retirement Account (IRA) – An individual retirement account is an investing tool used by individuals to earn and earmark funds for retirement savings. There are several types of IRAs as of 2016: Traditional IRAs, Roth IRAs, Simple IRAs and SEP IRAs. Sometimes referred to as individual retirement arrangements, IRAs can consist of a range of financial products such as stocks, bonds or mutual funds.  These accounts are typically tax advantaged.
  • Traditional IRA – In most cases, contributions to traditional IRAs are tax deductible. For example, if someone contributes money to his Traditional IRA, they can claim that amount as a deduction on their income tax return, and the IRS does not apply income tax to those earnings. However, when the individual withdraws from the account during retirement, his withdrawals are taxed as income. As of 2017, annual individual contributions to traditional IRAs cannot exceed more than $5500. People over 50 can contribute up to $6500. You cannot withdraw the money until age 59 ½ without penalty. The penalty is 10% of your investment gains plus the initial taxes owed. There are other stipulations and income limits as well. Not everyone qualifies to contribute.
  • Roth IRA – This works like a traditional IRA but the investment is after tax meaning you don’t receive an upfront tax advantage. The advantage of a Roth IRA is you will never pay any tax on the gains in your investment. This is a huge advantage for someone who will not be withdrawing the money for extended periods of time. There are income limits and stipulations on the Roth IRA as well, but it does have some considerations for early withdraw on your gains without penalty such as college tuition. You can withdraw your principal at any time without penalty. If you withdraw gains before 59 1/2 for non-qualified withdraws you will be penalized 10% of the amount.
  • Company Retirement Plans – 401K, 403B, SEP, Simple – These are retirement plans that are administered through your employer or can be used if you are self-employed.  A 401K is from a private employer, a 403B is from a non-profit government employer, an SEP is for the self-employed, a Simple plan is for a small business, and there are others as well.  Your IRA is held within those plans until you leave that employment.