True story: I came home the other night and sat down to eat dinner next to my roommate. Instead of asking me a normal question like, say, “How was your day?,” he says, “So are you feeling bullish or bearish about the stock market?” I about spit out my metaphorical soup — pretty sure it’s the first time I’ve been asked that question. Lest you think he is some Wall Street finance douchebag, no. He studies forest fires … not exactly db material.
The cool thing about his question was that I actually knew what he meant, and I had an answer. Ten years ago I would have just looked confused and responded with my best bear impression. (OK, it might be possible I still did that.) I know that investment vocabulary can be confusing and intimidating to the uninitiated, so hopefully this list will help clarify some common terms you might see floating around on places like, say, this blog. At the very least, you can confidently say you speaka da lingo:
I don’t, however, suggest you walk into your nearest stockbroker’s office and bust into song. You will probably get arrested and the last thing I want is that kind of guilt weighing on my cheesy little shoulders. Try some of these vocabulary words on for size instead …
Securities are “financial instruments” such a stocks and bonds — a virtual piece of paper representing an interest in a company (or government, in the case of some bonds) that can be bought and sold (in financial speak, they are “negotiable”).
A company issues stock as a share of ownership of the company — when you buy stock (measured in number of shares), you have an equity interest in that company, meaning you own a percentage of it. As the company’s value goes up, so does your share. When a company first “goes public” — meaning its stock can be traded on an open stock market such as the New York Stock Exchange (NYSE) or NASDAQ Stock Market so that people like us can buy it — it will have an Initial Public Offering or IPO. In addition to increasing in value over time, many stocks pay dividends, which represent a small percentage of profits that a company will pay out to shareholders a few times a year (usually quarterly).
A bond, on the other hand, is a debt interest rather than an equity interest. It’s basically an IOU from a company or government acknowledging that it owes you money in exchange for a loan (your investment). In the case of a municipal bond, a city might “sell” bonds to build a new road or (in worse ideas) a stadium. Treasury bills (also called treasuries or T-bills or government securities) are bonds issued by a national government. When people talk about the U.S. National Debt, they’re generally referring to the amount of outstanding treasuries (though this is a little more complicated). Unlike stocks, bonds have a fixed interest rate, so if you hold them until maturity (if you loan me $100 and I promise I will pay you back in a year at 3% interest, the loan matures in a year), you are guaranteed to get back your principal ($100) plus any interest ($3), which is usually paid in set increments prior to maturity. The only way you wouldn’t get this is if there was a default, meaning that the company can’t pay back the loans (often due to bankruptcy). For this reason, bonds are often viewed as a much safer investment than stocks, but you don’t have the potential for large gains that you do with stocks.
Mutual funds are like a grab bag of stocks. Sometimes they’re organized by size (e.g., small-cap, mid-cap, or large-cap funds categorized by a companies’ sizes in terms of capitalization, or how much money they have — strangely, not by their font choices or what size hat they wear!), by geography (e.g., Latin American companies), or sector (e.g., health care stocks). Instead of buying one share of ten different companies, you buy a share of the mutual fund and as part of that get a portion of a share of each company it holds. Actively managed mutual funds will have a person or people who review stocks and decide what should be included in the fund.
Similarly, index funds are mutual funds that track a particular index, which is a generic measurement of how certain categories of stocks perform as a whole. An index fund usually covers a very broad category and includes a lot of different stocks, such as a total market index fund (which tracks “the market” as a whole) or an S&P 500 index fund (which tracks the 500 large companies identified by the financial firm that used to be called Standard & Poors). You might also hear about the Dow Jones Industrial Average, which is similarly an index tracking the performance of 30 large companies. Exchange Traded Funds or ETFs operate like index funds but are traded like stocks rather than mutual funds and can be a little more flexible.
Because index funds and ETFs are often not actively managed in the same way as mutual funds, their expense ratios, or the total amount of fees they charge investors, will generally be significantly lower. This means that they are cheaper to own. A mutual fund might have an expense ratio of 0.2%, whereas an index fund could be 0.02%, making the mutual fund ten times more expensive to own (a $1,000 investment would cost $2/year as opposed to 20 cents/year). It may not seem like a lot, but those fees can add up fast.
As you build your portfolio, or the balance of stocks, bonds, and funds you hold in your investment account, you will want to think about asset allocation. This refers to how you balance the percentages of what you own — for example, 90% stocks and 10% bonds, or 50% large-cap and 50% small-cap, or 100% Hot Cheetos.
Confused yet? Feel free to ask any questions in the comments or email me. My next post will cover some considerations for building a portfolio and determining the asset allocation that’s right for you.
In the meantime, what was my answer to my roommate’s question? I said I was feeling cowish, and then I mooed. It turns out cowish is not a real thing, but what I meant was not quite a bull (thinking the market will grow stronger) and not quite a bear (thinking we are in for a decline). Historically/statistically speaking, we are due another recession soon, but I don’t think it’s imminent because things in the U.S. seem to be doing pretty well despite the fact that the rest of the world might be falling apart. We’ll see — my next post will also cover why I think none of this really matters, so don’t freak out quite yet!
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