Common Sense Living

Basic Investment Terms

The financial markets have been a part of my life since the 3rd grade.  Investment lingo is second nature to me, and I often forget that for others, that is not the case.  In this post, I will list a series of investment terms and explain their meaning, in a simple, easy to understand format, designed for a novice.

The list is by no means comprehensive, but should cover many terms commonly used.  If there are terms you would like to know more about, please feel free to reach out and ask!

 

STOCK:  “Stock” is a term used to represent ownership of a company.  It may also be referred to as “equity”.  When you own 100% of your own business, not sharing ownership with anyone else, you own all the “stock” or “equity”.  As a 100% owner, you are entitled to 100% of the earnings, and you have full control of the business activity.

SHARES:  Not all businesses are owned 100% by one person.  Sometimes 2 people may each own 50%.  Sometimes 1000 people may own 0.1%.  Sometimes the ownership is divided among millions of people.  To manage the ownership interests, the company will divide its equity stock into ownership “shares”, and each share is apportioned a value based on the total equity.  For example, a company may initially divide it’s equity stock into 1 million shares, with each share entitled to one millionth of the total earnings, as well as one millionth of the control.  All of the share holders will elect among themselves a set of representatives who will more closely manage and direct the oversight of the company.  This group of representatives is called a “board of directors”.  Each share is usually allocated one vote for each issue or matter presented to the share holders.  Smaller matters are simply handled by the board of directors.  If you own 1000 shares, then your decision carries 1000-times more weight than the shareholder having only 1 share.

COMMON STOCK:  Not all stock shares are equal.  Common stock is typically what is meant when referring to “stock”.  Common stockholders vote on a board or directors, vote on other important matters, and are entitled to a share of the corporate earnings.

PREFERRED STOCK:  Not all stock shares are equal.  Some of the corporate equity may be set aside and divided up as “preferred” stock, or preferred shares.  Like common stock shares, preferred shares also represent an ownership interest in the company, but the “rights” of these shares are different.  Preferred shareholders do NOT have a right to vote on company matters.  In exchange for losing voting rights, preferred shares are often entitled to a higher proportion of the earnings.  The amount of earnings paid per share is usually a fixed amount.  AFTER earnings are paid out to the preferred shareholders, the remainder of the earnings is paid to the common stock holders.  In other words, these shares are given preference over the common stock when it comes to rights on the corporate earnings.

DIVIDEND:  A dividend is simply a portion of the corporate earnings that is paid to the shareholders.  Corporations can also “retain” earnings and not pay them out, and this is called “retained earnings”.  Companies will retain earnings if they want to use them to help the company grow, acquire another company, or put the retained earnings to use in such a way as to increase the overall value of the enterprise.

BOND:  A bond is a “promise”.  When it comes to investments, it is a promise to pay someone back.  So a bondholder is a “lender” (unlike a stockholder, who is an owner).  When a company borrows money, they issue a bond.  They are then bound to pay back the money, according to the terms of the loan.  Typically, bonds are issued in $1000 increments, for a term (perhaps 10 years), and a stated rate of interest (perhaps 5% annual).  The interest is typically paid quarterly (every 3 months).  In this example, 5% annual interest is $50/year.  The bondholder would get $12.50 every 3 months.  At the end of 10 years, the bondholder would receive the final interest payment of $12.50, as well as their $1000 back.  Bonds are typically “interest” only, in that they only pay interest until the bond is paid back.

NOTES AND BILLS:  Like bonds, notes and bills are also loans.  The difference is that bonds are loans having a term of 10 years or more.  Notes are loans having a term of 2 to 5 years.  And bills are loans having a term of 1 year or less.  Governments (local, state, and federal) typically issue bonds, notes, and bills to finance their operations and longer term projects.  The interest on these loans is paid with money raised from taxes.

MORTGAGE:  A mortgage is a loan, typically associated with the purchase real estate (real estate is basically a term for “land”, and the “improvements” on that land such as a home or building).  Like a bond it is a “promise” to pay.  If you break the word “mortgage” down into its components, it is comprised of “mort” and “gage”.  “Gage” is derived from the Greeks and like the word “engage”, it means to commit or promise.  Also from the Greek, the word “mort” means death.  So a “mortgage” in the old days is essentially a “death promise”.  You promised under penalty of your life that this loan would be paid back!  Thank goodness we aren’t as strict about it today!

OPTION:  An option is the most basic type of “derivative” financial instrument, in that it “derives” its value from some other asset, such as a stock or bond.  An option is a “right”, but not an obligation, to buy or sell something (i.e. a stock) at a specified price (called the “strike price”), on or before some future date (called the expiration date).  A “CALL OPTION” is a right to “buy” the underlying stock.  A “PUT OPTION” is the right to “sell” the underlying stock.  Example:  A trader buys a call option (for $1) to purchase a share of stock at $100 in 45 days.  The stock currently sells for $90.  In 45 days, if the stock stays at $90, the $1 option has no intrinsic value.  Why would anyone exercise the right to purchase the stock at $100, when they can go to the market and buy it for $90?  The trader would let their $1 investment in the option expire worthless.  However, if the stock rises to $115 in 45 days, the trader would exercise their right to buy the stock at $100, and immediately sell the shares for $115 in the market, making $15, less the cost of the option.  Making a net $14 off a $1 investment is a very high return!  At the same time, the trader could have lost everything they invested.  Options are HIGHLY RISKY, and only experienced investors should use them.

FUTURE:  A future contract is another derivative instrument, similar to an option.  Where an option is a “right” to buy or sell something in the future, and futures contract is an “obligation” to buy or sell something in the future.  A future derives it’s value from some underlying asset (i.e. oil).  Futures began with farming.  A farmer’s crop takes 3 to 5 months to grow.  The prices at the end of the season may be significantly different than the prices are when the crops are planted.  A farmer needs to have assurances, that when the crop sells, he will make a profit.  He does this by selling a futures contract, that guarantees a buyer of his produce, at a predetermined price, in the future (perhaps 4 months from now).  If the market prices fall in 4 months, the farmer comes out ahead because he locked in a higher sales price.  If prices rise, the farmer lost opportunity.  He has reduced risk in exchange for a certain lower profit margin.  Futures are traded on nearly everything, including stocks, oil, gold, pork bellies, orange juice, diamonds, and even stock indexes.  Like options, futures are HIGHLY RISKY, and only experienced investors should use them.

DERIVATIVE:  A derivative is a financial security that “derives” its value from other things.  Options and futures are simple derivatives.  A more complex derivative may be created that derives its value from a combination of a stock, an option, and the price of gold, according to an agreed upon formula.  As the underlying stock, option, or gold price changes, the value of the derivative changes.  Derivatives are extremely complex financial instruments, and are often customized contracts created for a specific financial use case.  The average person will likely never use one.

MUTUAL FUND:  A mutual fund is a mechanism where multiple investors (sometimes millions) can pool their money to mutually purchase securities.  A stock mutual fund purchases stock.  A bond mutual fund purchases bonds.  Mutual funds can invest broadly, or focus on just one type of asset such as tech stocks, utility stocks, or federal government bonds.  The mutual fund is run by a manager who makes the investment decisions on behalf of the investors, and allocates the fund’s earnings (or losses) according to the amount of money each investor has contributed to the fund.  Mutual funds are commonly found in retirement portfolios, and are often used by investors who do not wish to spend time researching securities, opting instead to allow the experienced mutual fund manager to make the decisions.  It is important that the investor trust the mutual fund manager!  Investors buy or sell shares in the fund, and the share price is calculated once at the end of each trading day.

ETF:  “ETF” stands for “Exchange Traded Fund”.  An ETF is similar to a mutual fund.  When an investor buys an ETF, they pool their money with other investors, and place it under the control of a fund manager.  The main difference between a mutual fund and an ETF is that the ETF is traded on stock exchanges, and similarly has a stock symbol.  It’s price therefore fluctuates throughout the trading day, and fund shares can be bought and sold throughout the day.  ETFs are useful in creating a diversified portfolio, with just a single purchase, thereby saving the investor on commissions.  An investor wishing to buy the 500 stocks in the S&P 500 index can either make 500 purchases and pay 500 commissions, or they can make one purchase of the “SPY” S&P 500 ETF fund, and pay one commission.

CAPITAL GAIN (or LOSS):  When a stock pays dividends, that is considered investment income.  When a stock price rises from where you purchased it, that is known as a “capital gain”.  The capital (money) you invested, gained in value, and is now worth more money.  If stock you bought at $10 rises to $15, you have an “unrealized” capital gain.  If you then sell the stock at $15, you have a “realized” capital gain.  A capital loss occurs when the reverse happens, and the value of the stock (or bond) declines.  Capital gains are often given special treatment under the tax laws, particularly if they are “long term” capital gains, meaning the gain occurred over a period greater than 1 year.  In 2017, the top capital gain tax rate in the United States was 20%, whereas the top income tax rate was 39.6%.

401k: A 401k is a special tax advantaged account available to employees in the United States.  It’s rules were established by section 26, sub-section 401(k) of the US Internal Revenue Code.  It allows certain employees in the United States to set aside a portion of their income for retirement purposes, and defer taxes on such income until retirement.  During your working years, your tax rate is likely to be higher (i.e. 28%) than during your retirement years (i.e. 15%).  Not only will the 401k contributor save on taxes, the full amount can grow over the years free of capital gains taxes.  In 2017, employees (under most conditions) can contribute up to $18,000 annually to their 401k accounts, and employees aged 50 or older can contribute an extra $6000, for a total of $24,000.  Certain restrictions exist under certain conditions for “Highly Compensated Employees”, or HCEs, which are those employees earning more than $120,000 per year. 401k money is usually invested in a mutual fund or set of mutual funds, as directed by the employee.  It is therefore known as a “self directed retirement plan”.  401k plans also encourage employers to “match” employee contributions, to further benefit the ability of workers to retire with a sense of financial security.

Roth 401k: A Roth 401k is similar to a 401k EXCEPT the money employees put into the account is AFTER income taxes are taken out.  The money can then grow tax free until retirement, at which time the withdrawals of the employee contributions are tax free.  Any employer match, as well as any earnings on the money in the plan will incur taxes upon withdrawal.  There are limitations on who can contribute to a Roth 401k based on income levels.

IRA:  An IRA is an “Individual Retirement Account”.  Like a 401k, these are special, tax advantaged accounts established by the United States for the purposes of encouraging those with earned income to save for retirement.  An IRA account can invest in a number of different instruments including stocks, bonds, mutual funds, annuities, cash, gold, real estate, etc.  Because they are retirement accounts, the government limits the investments to lower risk assets.  IRAs cannot be used to purchase options for instance.  In 2017, an IRA investor can defer taxes on up to $5,500 ($6,500 for those 50 and older).  They will be taxed on the money when it is withdrawn from the plan at retirement.

Roth IRA:  Similar to an IRA, a Roth IRA is a special “Individual Retirement Account” where the investor can grow capital tax free.  However, their contributions to the plan are AFTER taxes.  When the investor retires, withdrawals from the plan are tax free (subject to certain limitations).

COMMODITY:  A commodity is something that has value, and is so common no one producer can influence the price.  Examples include soybeans, gold, silver, copper, pork bellies, corn, orange juice, natural gas, cotton, coffee, cattle, and oil.  Certain investors “speculate” on the prices of various commodities.  If they think gold will go higher, they will buy gold, wait for the price to rise, then sell the gold they bought.  Since the gold does not produce an income, this type of investment is called a “speculation” in that there is no underlying earnings to assess the value of the gold.  It is pure speculation that the price will move in one direction or the other.

EXCHANGE:  An “exchange” is a place where securities are traded.  A stock exchange is where stocks are traded.  A commodities exchange is where commodities are traded.  In the United States, there are 3 main stock exchanges including, the New York Stock Exchange (NYSE), the American Stock Exchange (ASE), and the NASDAQ (National Association of Securities Dealers Automated Quotation system).  The NASDAQ is a virtual exchange in that it is really just a bunch of computers, with no physical location.  The Chicago Mercantile Exchange and the Chicago Board of Trade are the two main commodities exchanges in the United States.  Exchanges exist in one form or another throughout most of the capitalist world.

SHORT (or LONG):  When an investor buys an asset such as a stock with the expectation that it’s price will rise, they are considered a “long” investor, or an investor who “went long”.  The investor bought low, and sold high.  A short is a special kind of investment where an investor can sell high, then buy low.  They do this by “borrowing” shares from another investor (perhaps at $100 each), and selling immediately into the market.  So the investor now has $100.  If the price of the share drops (perhaps to $70), the investor can then use $70 of the $100 they have to repurchase the share.  They then return the share to the original investor, keeping the $30 they have left over.  Fortunately, short investors don’t have to go find share lenders, as brokerage houses make these arrangements for them.  All the investor has to do is tell their broker they want to short a stock, and the broker finds the shares to short (usually by borrowing the shares from a long investor, per their agreement with the broker).

 

 

 

 

 

 

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