Investing: Key Terms and Concepts

Below are summaries of some basic principles you should understand when evaluating an investment opportunity or making an investment decision. Rest assured, this is not rocket science. In fact, you’ll see that the most important principle on which to base your investment education is simply good common sense.You’ve decided to start investing. If you’ve had little or no experience, you’re probably apprehensive about how to begin. Even after you’ve found a trusted financial advisor, it’s wise to educate yourself, so you can evaluate his or her advice and ask good questions. The better you understand the advice you get, the more comfortable you will be with the course you’ve chosen.

Don’t be intimidated by jargon
Don’t worry if you can’t understand the experts in the financial media right away. Much of what they say is jargon that is actually less complicated than it sounds. You’ll learn it soon enough, and there is no reason to wait to invest until you know everything.

IRAs hold investments–they aren’t investments themselves
One of the most common questions we answer is rooted in a key source of confusion that throws many new investors off: If you have an individual retirement account (IRA), a 401(k), or any other retirement plan, you should recognize the distinction between that account or plan itself and the actual investments you own within that account or plan. Your IRA or 401(k) is just a tax-advantaged container that holds your investments. Many consumers are often become confused when this distinction is not emphasized (i.e. You cannot buy $1000 worth of an IRA; you can buy $1000 worth of a mutual fund that you hold within an IRA).

Understand stocks, mutual funds, and bonds
Almost every portfolio contains these kinds of assets.

If you buy stock (or a stock mutual fund), you are literally buying pieces of companies from an existing owner who wants to sell. You become an owner, or shareholder, of the company. As such, you take a stake in the company’s future. If the company prospers, there’s no limit to how much your share can increase in value. If the company fails, you can lose every dollar of your investment.

If you buy bonds, you’re lending money to the company (or governmental body) that issued the bonds. You become a creditor, not an owner, of the bond issuer. The bond is your IOU. As a lender, your return is limited to the interest rate and terms under which the bond was issued. You can still lose the amount of the loan (your investment) if the company or governmental body fails, but the risk of loss to creditors (bondholders) is generally less than the risk for owners (shareholders). This is because, to stay in business, a company must maintain as good a credit rating as possible, so creditors will usually pay on time if there is any way at all to do so. In addition, the law favors bondholders over shareholders in the event of bankruptcy.

FYI — Stocks (and stock mutual funds) are referred to as “equity investments”, while bonds (and mutual funds containing bonds) are often called “investments in debt”.

Diversify–don’t put all your eggs in one basket
This is the most important of all investment principles, as well as the most familiar and sensible.

Consider using several different classes of investments for your portfolio. Examples of investment classes include stocks, bonds, mutual funds, art, and precious metals. Investment classes often rise and fall at different rates and times. Ideally, in a diversified portfolio of investments, if some are losing value during a particular period, others will be gaining value at the same time. The gainers help offset the losers, and the total risk of loss is minimized. The goal is to find the right balance of different assets for your portfolio. This process is called asset allocation.

Recognize the trade-off between the risk and return of an investment
For present purposes, we define risk as the possibility of losing your money, or that your investments will produce lower returns than expected. Return, of course, is your reward for making the investment. Return can be measured by an increase in the value of your initial investment principal and/or by cash payments directly to you during the life of the investment. There is a direct relationship between investment risk and return.

Between the extremes, every investor aims to find a level of risk–and corresponding expected return–that he or she feels comfortable with.

Investing for growth vs. Investing for income
As an investor, you face an immediate choice: Do you want growth in the value of your original investment over time, or is your goal to produce predictable, spendable current income–or a little of both?

There is no right or wrong answer to the “growth or income” question. Your decision should depend on your individual circumstances and needs (e.g., your need, if any, for income today, or your need to accumulate a college fund, not to be tapped for 15 years).

The power of compounding
A simple example of compounding occurs with a bank certificate of deposit that is allowed to roll over each time it matures. Interest earned in one period becomes part of the investment itself, earning interest in subsequent periods. In the early years of an investment, the benefit of compounding on overall return is not exciting. As the years go by, however, a “rolling snowball” effect seems to operate, and the compounding’s long-term boost to investment return becomes dramatic.