BY JOSHUA KENNON
One of the toughest parts of beginning your journey as an investor is encountering terms that you don’t understand. It can seem overwhelming in the beginning but, like anything, once you get the hang of it, you realize there was no reason to be intimidated.
As a result, I want to set aside some time to introduce you to some of the more common investing terms that you may encounter, providing a brief definition of each as well as a link to some of my articles where you can read more about that topic. My hope is that you will walk away with a greater understanding of the terminology so you feel more confident researching potential investments.
Types of Investments:
Common Stock: A share of common stock represents ownership in a legally formed corporation. For most companies, there is a single class of stock that represents the entire company. Literally, when you own a share of common stock, you own a piece of a corporation. However, some companies have multiple classes of stock, including dual classes of stock. Often, one class of the stock will have more voting rights than another class of the stock. Owners of common stock are entitled to their proportionate share of a company’s earnings, if any, some of which may be distributed as cash dividends. The best of the best stocks is usually referred to as blue-chip stocks.
Preferred Stock: Preferred stock is a class of ownership of a company that allows shareholders to get a larger dividend, and that dividend is often guaranteed. Holders of preferred stock do not have voting rights, but can receive special status if a company is going into insolvency. For example, if a company is liquidating and must pay off its creditors, preferred stock shareholders must be paid before common shareholders. In some cases, companies can repurchase shares of preferred stock from shareholders, often at a premium. It’s also possible to convert shares of preferred stock into common stock, but not vice versa. There are also different types of preferred stock such as convertible preferred stock.
Bonds: In simple terms, a bond is like a loan. When you buy a bond, you are usually agreeing to borrow money from a government or a company. Typically, the bond issuer promises to repay the entire principal loan amount on a future day, known as the maturity date, and pay interest income in the meantime based upon a coupon rate.
There are many types of bonds including those issued by governments, such as Treasury bonds, and tax-free municipal bonds. These bonds are often used to fund government operations and capital projects. There are also corporate bonds, which help companies fund their operations and invest in themselves. There are also savings bonds such as the Series EE savings bond and the Series I savings bond. There are investment grade bonds, the highest being AAA rated bonds, and, on the opposite end of the spectrum, junk bonds. If you don’t want to buy bonds individually, you can invest in bond funds.
Real Estate: Real estate is tangible property, such as land or buildings, that the owner can use or allow others to use in exchange for a payment known as rent. When you own a house, you own real estate. When you own a plot of land, you own real estate.
Types of Investment Structures:
Mutual Funds: A mutual fund is a pooled portfolio. Investors buy shares or units in a trust and the money is invested by a professional portfolio manager. The fund itself holds the individual stocks, in the case of equity funds, or bonds, in the case of bond funds. Mutual funds are a great way to get exposure to groups of stocks or bonds, freeing the investor from the need to research and purchase shares of each company individually.
For example, if you want your portfolio to include more investments in smaller companies, you can purchase shares of a small-cap mutual fund. If you are interested in understanding the mechanics of how a mutual fund is put together, read; How a Mutual Fund Is Structured. Mutual funds do not trade throughout the day to avoid allowing people to take advantage of the underlying change in net asset value. Instead, buy and sell orders are collected throughout the day and once the markets have closed, executed based upon the final calculated value for that trading day.
Exchanged Traded Funds: Also known as ETFs, exchange-traded funds are very similar to mutual funds, except that they trade throughout the day on stock exchanges as if they were stocks. This means you can actually pay more or less than the value of the underlying holdings in the fund. In some cases, ETFs might have certain tax advantages but most of their benefits compared to traditional mutual funds are largely a triumph of marketing over substance. If you want to use them in your portfolio, fine. If you prefer traditionally structured mutual funds in your portfolio, fine.
Index Funds: An index fund is a mutual fund, sometimes trading as an ETF, that allows an individual to “invest” in an index, such as the S&P 500. Index funds are designed to give investors returns that are in line with the index. So, if you’re investing in an S&P 500 index fund, your returns should mirror those of the S&P 500. There are many funds designed to track a whole host of indexes that include everything from small-cap stocks, emerging markets, and specific industries. Index funds are an example of “passive” investing.
This means that there are no fund managers don’t actively try to “beat” the market. These funds are simply designed to mirror the returns of the index and nothing more. Because of this, these funds usually have very low expense ratios, making them very cost-effective investments. The simplicity and low cost of index funds make them very good investments for people who don’t want to spend a lot of time researching stocks and managing their portfolio. In fact, many financial advisors recommend index funds as a core component of every investment portfolio.
Hedge Funds: A hedge fund is a type of investment partnership. Often, it’s formally listed as a limited partnership or limited liability company, and the partners will pool money from investors an engage in a wide range of investing activity. Commonly, hedge funds engage in investment activity that is riskier than what a typical investor might engage in. Hedge funds will often use leverage (borrowed money) to amplify their returns, but can also place bets against the market to make money even if the market goes down. (This is why they are called “hedge” funds.)
There are a variety of different hedge fund structures, but it’s common for fund managers to charge investors 20% of profits plus 2% of assets as a management fee each year. This is controversial because managers of large funds can make millions of dollars in management fees even if investments perform poorly. Due to government regulations meant to protect the inexperienced, investing in hedge funds can be difficult for most ordinary investors.
Trust Funds: A trust fund is a special type of legal entity that allows a person or organization to hold assets that they will eventually give to another. For example, a grandparent could hold $100,000 in stock to a grandchild, with the stipulation that the grandchild gets that money when he turns 18. Trust funds offer tremendous asset protection benefits and, sometimes, tax benefits, if intelligently structured. Trust funds can hold almost any asset imaginable from stocks, bonds, and real estate to mutual funds, hedge funds, or art. There is a perception that trust funds are only used by the wealthy, but they are available for anyone who wants to smartly transfer assets to another person.
REITs: Some investors prefer to buy real estate through real estate investment trusts, or REITs, which trade as if they were stocks and have special tax treatment. There are all different types of REITs specializing in all different types of real estate. For example, if you wanted to invest in hotel properties, you could consider investing in a hotel REIT. REITs are a great way to invest in real estate without the need to buy or maintain actual buildings or land.
Master Limited Partnerships: MLPs, as they are often known, are limited partnerships that trade similarly to stocks. Given the unique tax treatment and complex rules surrounding them, investors who don’t know what they are doing should generally avoid investing in MLPs, particularly in retirement accounts where the tax consequences can be unpleasant if not masterfully managed.
Portfolio Management:
Asset Allocation: Asset allocation is an approach to managing capital that involves setting parameters for different asset classes such as equities (ownership, or stocks), fixed-income (bonds), real estate, cash, or commodities (gold, silver, etc.). It is generally thought that fact that asset classes usually have different characteristics and behavior patterns, getting the right mix for a specific investor’s situation can increase the probability of a successful outcome in accordance with the investor’s goals and risk tolerance. For example, stocks and bonds play a different role in an investor’s portfolio beyond the returns they may generate.
Investment Mandate: An investment mandate is a set of guidelines, rules, and objective used to manage a specific portfolio or pool of capital. For example, a capital preservation investment mandate is meant for a portfolio that cannot risk meaningful volatility even if it means accepting lower returns.
Custody Account – A custody account is an account that an institutional custodian operates on behalf of an investor to hold the investor’s portfolio of securities. The custodian will record cash flows from interest and dividends, submit instructions on behalf of the investor for proxy voting or corporate events, take delivery of spin-offs and make sure the shares end up in the custody account. Custody accounts are assessed custodial fees but some investors don’t realize they pay them because brokers offer custody services for free or reduced prices in many cases if the investor has a minimum account size or places a certain number of stock trades each year, referring to their custodial services as a brokerage account.
Asset Management Company – An asset management company is a business that actually invests capital on behalf of clients, shareholders, or partners. The asset management business inside of Vanguard is the one buying and selling the underlying holdings of its mutual funds and ETFs. The asset management business at J.P Morgan’s private client division is building portfolios for individuals and institutions.
Registered Investment Advisor – An RIA is a firm that is engaged, for compensation, in the act of providing advice, making recommendations, issuing reports or furnishing analyses on securities, either directly or through publications. RIAs can include asset management companies, investment advisory companies, financial planning companies, and a host of other investment business models. The special thing about RIAs is that they are bound by a fiduciary duty to put the needs of the client above their own rather than the lower suitability standard that applies to taxable brokerage accounts. Registered investment advisor fees have to be “reasonable” and vary from firm to firm.
Fiduciary Duty – In the American legal system, a fiduciary duty is the highest duty owed to another person. It requires the fiduciary to put the interest of the principle (often the client) above its own. This involves disclosing conflicts of interest.
UTMA – This is an account organized under the Uniform Transfers to Minors Act of a particular state. It allows an adult to buy property, titled in his or her name for the benefit of the minor child until the minor child reaches a certain age set in the UTMA documentation with 21 years old being the maximum allowable age in most states. The adult with the title of the property is known as the custodian and owes a fiduciary duty to the child.
There have been cases of parents who gave their kids stock, only to turn around and use that stock for necessary medical care for the child, who later are hauled into court for effective embezzlement. If the child becomes an adult and “compels an accounting”, you need to be able to produce every cash flow, every statement or else you could be on the hook for not only the missing money but the compounded value of what that money should have grown into had it been left alone in the portfolio.
Stock Broker – A stockbroker is an institution or individual who or which executes buy or sell orders on behalf of a customer. Stockbrokers settle trades – making sure cash gets to the right party and the security gets to the right party by a certain deadline – against their client’s custody account. There are many different types of stock trades you can submit to your stock broker but be careful about becoming over-reliant upon them. A stop-loss trade, by way of illustration, won’t always protect your portfolio. Additionally, it is sometimes possible to buy stock without a broker through programs such as DRIPs.
Stock Trades – There are at least twelve different types of stock trades you can place with a broker to buy or sell ownership in companies including market orders, limit orders, and stop loss orders.
Selling Short – Also known as short selling, this is when an investor or speculator borrows shares of stock or another asset he or she doesn’t own, sells it, pockets the money with the promise to replace the property someday, and hopes the asset declines in price so it can be repurchased at a lower cost, the differential becoming the profit. Done wrongly, it can bankrupt you. One poor guy had $37,000 in his brokerage account and in a matter of hours had not only lost the entire amount but discovered he was in debt to his brokerage firm by $106,445.56.
Margin – Brokers will often lend customers money against the value of certain stocks, bonds, and other securities within their custody account if the client agrees to pledge the entire account balance as collateral as well as provide a personal guarantee. When you open a brokerage account, you need to specify if you want a cash account or a margin account.
Almost all investors should be using cash accounts in part due to what appears to be a rising risk from regulatory arbitrage in the form of rehypothecation. If you borrow on margin, the broker can issue a margin call at any moment, for any reason, demanding you pay off some or all of your balance. It even has the right to sell your investments, triggering potentially steep capital gains if you have appreciated positions, without giving you an advanced warning or an opportunity to deposit additional cash or securities.
Types of Retirement Accounts
Roth IRA – A Roth IRA – IRA stands for individual retirement account – is a special type of account designation put on a custody account that gives it some incredible tax benefits, while simultaneously restricting the amount you can contribute to it and the types of investments you can hold within it unless you want to face some fairly draconian consequences. Money contributed to a Roth IRA comes from after-tax dollars, meaning you don’t get a tax deduction for it, but, as long as you follow the rules, under the current system, you would never pay a penny in taxes on any of the profits you generated from the investments held within the Roth IRA, nor when you went to withdrawal those profits, for the rest of your life. You can buy stocks, bonds, real estate, certificates of deposit, and some other asset types within a Roth IRA.
Traditional IRA – A Traditional IRA is the earliest type of IRA. Investors can contribute money to it if they qualify based on the income limitations and pay no taxes on certain types of investment gains held within the account until they withdrawal it at 59.5 years old or are forced to at 70.5 years old.
401(k) – A special type of retirement plan offered by employers to their employees, a 401(k) usually allows investors to put their money to work in mutual funds or stable value funds. Like a Traditional IRA, the investor usually gets a tax deduction at the time the account is funded, there are annual limits (albeit much higher than those on a Traditional IRA or Roth IRA), employers often match contributions (e.g., 50% match on the first 6%), and there are no taxes owed until you begin withdrawing the money (59.5 years old at the earliest but required distributions begin at 70.5 years old). The term 401(k) refers to the section of the tax code that created it. In recent years, there has been a rise of so-called self-directed 401(k)s that allow the investor to buy individual stocks and bonds in the account.
403(b) – A retirement plan that is much like a 401(k) only offered in the non-profit sector.
Rollover IRA – When an employee leaves his or her employer, he or she can opt to rollover the 401(k) balance and have it deposited into a Rollover IRA, which otherwise behaves almost exactly like a Traditional IRA.
SIMPLE IRA – A type of IRA for small business owners with fewer than 100 employees who want to offer some sort of retirement benefits to their employees but don’t want to deal with the complexity that comes from a 401(k).
SEP-IRA – Short for Simplified Employee Pension Individual Retirement Account, a SEP-IRA can be used by self-employed people and small business owners under certain circumstances, allowing them to put aside substantially more money than they otherwise would have been able to invest due to much higher contribution limits calculated as a percentage of income.
Investment Terms Related to Companies
Board of Directors – A company’s board of directors is elected by the stockholders to watch out for their interests, hire and fire the CEO, set the official dividend payout policy, and consider recommending or voting against proposed mergers.
Enterprise Value – Enterprise value refers to the total cost of acquiring all of a company’s stock and debt.
Market Capitalization – Market capitalization refers to the value of all outstanding shares of a company’s stock if you could buy them at the current stock price.
Income Statement – An income statement shows a company’s revenues, expenses, taxes, and net income.
Balance Sheet – A balance sheet shows a company’s assets, liabilities, and shareholders’ equity.
Form 10-K – An annual disclosure document certain firms are required to file with the SEC, it contains in-depth information about a business including its finances, business model, and much more.
Other Investment Terms You May Want To Know
Stock Exchange – A stock exchange is an institution, organization, or association which hosts a market for buyers and sellers of equities to come together during certain business hours and trade with one another. The most important stock exchange in the world is the New York Stock Exchange, or NYSE. Companies that want their shares listed on “The Big Board”, as the NYSE is sometimes called, must meet strict criteria. If the company fails to continue meeting these requirements, it is subsequently de-listed.
Price-to-Earnings Ratio – Also known as the p/e ratio, it tells you how many years it would take for a company to pay back its purchase price per share from after-tax profits alone at current profits with no growth. In other words, the p/e ratio tells you how much money you are paying for $1 of the company’s earnings. If a company is reporting a profit of $2 per share, and the stock is selling for $20 per share, the P/E ratio is 10 because you are paying ten times earnings ($20 per share divided by $2 per share earnings = 10 P/E.) It can be inverted to calculate something known as the earnings yield.
PEG Ratio – A modified form of the p/e ratio that factors growth into the metric to show that a company growing at 15% per annum and trading at 20x earnings can be cheaper than a company trading at 8x earnings and shrinking by 10% per annum.
Dividend-Adjusted PEG Ratio – A modified form the PEG ratio which factors dividends into the metric to account for the fact that sometimes, slower growth is the result of a company paying out significant portions of its earnings in the form of cash dividends, which contribute to total return.
Dividend Yield – The current yield of a common stock at its present dividend rate. If a stock is trading at $100 per share and pays out $5 in annual dividends, the dividend yield would be 5%.
Volatility – Volatility refers to the degree to which a traded security fluctuates in price.
Derivative – A derivative is an asset that derives its value from another source.
