If you are new to investing, all the terms and jargon might seem overwhelming. But today’s post will help you learn some of the more common terms used in investing. Remember, learning to invest is like eating a pizza; you have to eat it piece by piece, and eventually, you will have it all down.
In today’s post, we will learn:
- Different Investment Types
- Investing Platforms
- Types of Retirement Accounts
- Financial Statement Terms
- Financial Ratios and Associated Terms
Okay, let’s dive in and learn more about investment terms everyone should know.
Different Investment Types
There are multiple ways to invest your hard-earned money; below are a few of the common investment types. There are other choices for investments, such as crypto, art, collectibles, and futures, but these are the most commonly used terms.
- Common stock: a share of common stock indicates ownership in a piece of a business. Common stock gives you the right to vote, in some cases, and any dividends or special cash distributions the company might distribute. Common stock, also known as equity, gives the owners of the company the best returns for your money over the long term. Over the last one hundred years, the investment returns for common stocks range between 8 to 10%, which is easily the best.
- Preferred Stock: Preferred stock is also ownership in the company, but with a larger dividend, usually guaranteed, but without the voting rights of common stock. Preferred stockholders have a higher claim on equity if the company should declare bankruptcy than common stockholders. There are additional rules with preferred stocks, such as companies may repurchase preferred stock from owners at a premium. There are also some classes of preferred stock that allow for conversion to common stock. The preferred stock trades at set prices, such as $25 per share, and not all companies issue preferred stock to the general public.
- Bonds: The simplest way to think of a bond is like a loan. When we buy a bond, we agree to give the company or government a loan, which they agree to pay back the principal, $100, plus interest over the life of the loan. The life of the loan, also known as the maturity date, is typically set before purchase, along with interest (coupon). The coupon, or interest, pays out on a quarterly, semi-annually, or annual basis. The bond market, also known as fixed income, comes in many different flavors because the returns are set before purchase. There are government bonds, both local, state, and federal, such as treasuries or municipal bonds. There are also corporate bonds issued by public companies, which the companies use to fund projects or reinvestments. Along with the above bonds, savings bonds such as the EE-savings bond or Series I Bond are other options. Another term floated around in the bond world is the credit ratings ranging from AAA (best) to junk (worst), which tell investors the company’s financial strength. You have the option to buy individual bonds or to buy bond funds when investing in bonds. The bond market is also the largest investment market in the world, tripling the stock market.
- Real Estate: When you buy land, a house, rental properties, or land, you buy real estate, which is a tangible investment, unlike stocks or bonds. Real estate offers the opportunity to own something tangible, and the choices are limitless. Real estate offers the opportunity to receive consistent returns via rent or sell the home or property for a cash return. Many consider real estate a great way to lessen the impact of inflation.
- Commodities: Commodities are basic goods used in commerce, such as grains, beef, or oil. They are traded on an exchange, and they tend to fluctuate from year to year, sometimes quite wildly. Unlike buying products from a company, there is little difference between oil producers, for example. Commodities are bought and sold on the market via cash or traded as futures or options. One of the most common commodity investments is gold, which many consider the ultimate hedge against inflation and the end of the world.
- Cash and Equivalents: One of the most liquid of all investments, cash and equivalents are typically held in money market accounts or similar investments. Their main advantage is their liquidity, or ability to access them right away. Their returns are not great, but they offer liquidity while earning something. Savings accounts, CDs (certified deposits), and money market accounts are the most common investments.
There are many different platforms to invest through that combine different assets together.
- Asset Allocation: Asset allocation is the idea behind investing in different assets such as common stocks, bonds, real estate, commodities, or cash. The reason for investing in different assets is these assets have different characteristics and behaviors. These different behaviors or characteristics can enhance your returns over time by choosing unrelated assets. The idea being that when common stocks do well, bonds suffer, and vice-versa.
- Diversification: Diversification is the idea of digging deeper than asset allocation and spreading around your risks by investing in unrelated assets and investments. For example, buying all bank stocks or tech stocks can lead to underperformance or lots of volatility. Investment in both banks and tech stocks can help your risk tolerance because by spreading around the risk among different investments, you allow one group to do well while the other struggles.
- Brokerage Accounts: Brokerage accounts are the banking platforms that we use to buy and sell our investments. They are most commonly associated with buying and selling stocks, but we can also buy bonds, ETFs, index funds, and much more. You can choose from traditional brokerages such as Charles Schwab, Fidelity, and Goldman Sachs. But with the rise of technology, many apps allow you to invest from your phone. One of the most important considerations, fees, is something to consider. Most online brokerages allow trade-free accounts, and I highly encourage you to use those accounts. The brokerage accounts also have many educational articles, blogs, podcasts, and other resources to help you learn. They are also a great source of investment research and stock screeners.
- ETFs (exchange-traded funds): Probably the most popular investment vehicle in today’s investment universe. ETFs trade like stocks, with prices that fluctuate during the market open, and you can buy and sell your shares during business hours. ETFs bundle many different companies together to either match the markets they are in or give investors the ability to choose themes for their investments. For example, if you want to invest in Green Energy, they bundle companies that focus on those industries such as solar, electric batteries, electric vehicles, or wind power. Or, if you want to match the S&P 500 or the Nasdaq, you can buy an ETF that matches the performance of that market. Some ETFs bundle foreign investments or bonds as investments. The sky is the limit for investing in ETFs, and another benefit is tax benefits and the low fees. ETFs are the classic passive investment strategy.
- Index Funds: Index funds are investments made up of a collection of stocks or bonds that mirror different market indexes, such as the S&P 500. Index funds are passive investments, meaning there is not much buying and selling going on in the fund, and they have an extremely low fee structure. Index funds are not, by design, meant to beat the markets they mirror; instead, they match them. Index funds, like ETFs, can track the whole market or smaller sections such as small-cap, specific industries, or foreign markets. Index funds and ETFs are the perfect investment platforms for investors who want to invest but are not interested in the work involved to buy individual common stocks, for example.
- Mutual Funds: the mutual fund is a pool of money collected by professional money managers with investors buying and selling the mutual fund units. The money manager buys and sells different assets within the mutual fund, trying to beat the market (S&P 500). Mutual funds don’t trade during the day; instead, the buy and sell orders are held until the end of the day before settling. Mutual funds are an active investment and tend to rack up high fees because of the active management by the managers.
- Hedge Funds: a hedge fund is a pooled investment fund that trades in more complex types of investments. The partners collect money from investors and put that to work in different portfolio constructions and risk profiles in an attempt to beat the market. Many hedge funds engage in short-selling (betting a stock will fall), leverage (borrowed money), derivatives, and other risky investments. Many hedge funds charge large fees, 20% of profits generated, plus 2% of assets managed (total investment), which creates tremendous wealth for the hedge fund, regardless of the fund’s performance. Hedge fund managers are some of the big glamour names in finance, such as George Soros, Bill Ackman, and Chuck Akre.
- REITs (Real Estate Investment Trusts): REITs allow investors to invest in real estate without buying the actual building or land. REITs trade like stocks and have special tax treatment, along with paying big dividends. There are many different flavors of REITs to buy; for example, you can buy apartment REITs, shopping mall REITs, or hospital REITs. They are great investments for those wanting to dip their toes in real estate without the hassle of building maintenance or raising funds to buy the building or land.
- MLP (master limited partnership): MLPs trade like stocks, similar to REITs and have special tax treatments towards dividends. MLPs generally invest in natural gas and oil companies such as drillers and gas lines. Because of their complicated nature and tax structures, they are difficult investments to manage and are not recommended for beginners, especially in retirement accounts.
Types of Retirement Accounts
Many different accounts types are tax-advantaged to help you grow your retirement savings, depending on your tax situation. Before opening your brokerage account, it is best to decide your goals and how you want to treat your taxes.
- Traditional IRA: The first type of IRA allows investors to invest their money before withdrawing taxes from their paycheck. That allows your money to grow before you can withdraw it at the minimum age of 59.5 or are forced to begin mandatory withdrawals at 70.5. The advantage of the Traditional is it reduces your yearly taxable income by your contributions. But the downside is you will pay taxes at your tax bracket at retirement because Uncle Sam will want his cut at some point. There are maximum investment amounts, depending on your income levels, and the IRS updates the requirements yearly, so it is best to check those before opening your account.
- Roth IRA: The Roth is an after-tax investment account that allows you to invest your money tax-free for the life of the investment. It is a great account for young investors as it allows them to invest tax-free for life. There is no tax-deduction like the Traditional, and there are certain age, relationship, and income level restrictions. It is best to check on your situation before opening a Roth. Roth IRAs are great for dividend investors because you don’t pay taxes on the dividends, which helps you grow your balances.
- 401k: The 401k is an investment account offered by employers as a benefit. The 401k typically offers mutual funds, index funds, or ETFs as investments and is professionally managed by your employer or third party. They offer both the Roth and Traditional tax advantages, along with employer matching. Employer matching benefits many investors by matching your contribution; for example, if you invest 5%, the employer will also invest 5%, doubling your investment.
- 403b: Similar to the 401k, but offered only in the non-profit sector.
- Rollover IRA: When you leave your employer, you can rollover your 401k to another account and deposit it in a rollover IRA, which acts like a Traditional IRA. It is free to do, and you are allowed one rollover every twelve months.
- Simple IRA: Simple IRA is, in essence, a 401k for small business owners with less than 100 employees. They offer the same advantages and profiles as a 401k, but without the complexity for the business owner.
Financial Statement Terms
Below are common terms associated with the financial statements generated by companies.
- Annual report or 10-k: The form 10-k or annual report is a report that each publicly-traded company must release on an annual basis, according to their fiscal year. The form is filed with the SEC (Securities and Exchange Commission) and is a public document. The 10-k contains detailed information regarding the company’s finances, business model, and more. It is required reading if you want to buy and sell individual stocks.
- Quarterly report or 10-q: Similar to the 10-k, but filed every three months. It is unaudited, meaning no accountants verify the financials. It also required reading for an investor wishing to buy and sell individual stocks and gave a great update to the performance throughout the year. It also includes management discussions on performance throughout the year.
- Income Statement: The income statement, part of the big three financial reports, informs investors about revenues, expenses, costs, taxes, and income for the period reported. Also known as the P&L, it is the main source of information for earnings or net income and the top line, revenues.
- Balance Sheet: The balance sheet is a snapshot in time that informs an investor about the status of the company’s assets, liabilities, and equity. It is filed each period, but it represents one day in the life where the income statement and cash flow statement are accrued balances.
- Cash Flow Statement: Think of this as the checking account of the company. The three financial statements flow from one to the other, with all three interconnected. The income statement leads to the cash flow statement, which leads to the balance sheet. The cash flow statement relates to the actual cash inflows and outflows of the company.
- Market Cap: The market cap or market capitalization refers to the value of all the company’s outstanding shares if you purchased them at the current market price. For example, if Apple has a market price of $144.1 and outstanding shares of 16,929.2 million, then we multiply those two numbers, and we get $2.34 trillion.
- Enterprise Value: The enterprise value represents the value of the company’s market cap and its outstanding debt if added up.
Financial Ratios and Assorted Terms
Below are common ratios and terms associated with measuring the financial performance of a company.
- P/E Ratio: The most common ratio used in finance, the P/E ratio represents the company’s earnings related to the company’s market price. For example, a P/E of 15 tells us that the market values $1 of the company’s earnings at $15. Think of it this way, if the company is earning $4.50 per share and trades for $144 in the market, it has a P/E ratio of 32 ($144/$4.5). We can also invert the relationship to give us an earnings yield or return we could expect. For example, $4.5 / $144 equals 3.1%, which is the return we might expect from investing in a company with a P/E of 32.
- P/S Ratio: Similar to the P/E ratio, the revenue per share is calculated by the market price. For example, if Apple is earning $18.98 per share of revenue, and we divide it by the current market price of $144, we get a P/S ratio of 7.58. The P/S ratio is a common ratio for young companies and the growth companies dominating the markets today.
- Income or Revenue: The income or revenue represents the total sales of the company. It relates to how or when a company records a sale and is also known as the top-line number at the top of the income statement.
- Net income: Also known as net earnings, earnings, or the bottom line because it is at the bottom of the income statement. The net income is the final result of subtracting all the costs, expenses, and taxes from creating the companies revenues.
- Operating Income: The operating income represents the income generated from the company’s operations less the costs and expenses used to create the company’s revenue. Operating income also reflects the company’s efficiency in creating profits from its operations.
- Return on Equity: Return on equity is a ratio that represents the company’s rate of return on the equity (shareholders equity) of the company. The return on equity (ROE) measures how well a company generates profits from its equity, and the higher, the better. It measures the relationship between the net income from the income statement and the shareholders’ equity on the balance sheet.
- Return on Invested Capital (ROIC): Return on invested capital measures its efficiency in reinvesting its capital (debt and equity) into the company to generate revenue growth. The higher the ratio, the better, and it is one of Warren Buffett’s favorite company performance measures.
- Dividends: Dividends are the cash distribution from a company’s earnings to common stockholders. Dividends are one of the ways that companies return capital to investors. Dividends are one of the keys to growing your wealth, especially if you utilize the DRIP (dividend reinvestment program) to reinvest your dividends and buy more shares of your investment.
- Dividend Yield: The dividend yield is the return an investor gets related to its share price and its annual dividend distribution. For example, if a company trades at $50 and pays out a $2.50 annual dividend, then the company has a dividend yield of 5% ($50 / $2.5).
- Intangibles/Goodwill: Asset line items on the balance sheet that are not physical. Examples are brands, trademarks, patents, or copyrights. The rise of intangibles in the internet age has led companies such as Apple, Microsoft, Google, and Facebook to rise to the top. Most of their assets lie in the software that drives their platforms, not the factories of yesterday.
Learning how to invest is similar to learning a new language; there are new terms and jargon you need to get a handle on, and once you learn that language, investing becomes easier.
And like learning a new language, the more you use the new terms, the more familiar they will become to you. As I mentioned earlier, it is similar to eating a pizza; you need to work piece by piece.
The more you use the terms and read through investment documents, the more familiar you will find yourself. And the more you learn, the more knowledge will compound on itself, like any monetary investment.
The above is a sampling of the terms you need to learn, and as you branch out from this base, you will learn more and more. You can do this; it just takes a little time and effort. A good practice is to try to go to bed a little smarter than you woke up, one of my favorite Charlie Munger quotes.
With that, we will wrap up our discussion on investment terms every investor should know.
As always, thank you for taking the time to read today’s post, and I hope you find some value in your investing journey. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,