If you’ve been following my blog or have read my book, you know how much I dislike fancy financial jargon. Personal finance shouldn’t be complicated and both you and I deserve to have a clear understanding of what’s happening with our hard earned money. With this in mind and the fact that April is financial literacy month, I’m taking pause and breaking down 8 important money terms you may not know (but should). In digging into these not-so-sexy money terms, you’ll find that by understanding these foundational financial topics, you’ll only equip yourself to make better financial choices for today and the future. Here are some important money terms defined:
1. Asset Allocation
It literally means your money (asset) is being allocated (assigned) to different investment classes within your portfolio: stocks, bonds, cash, and mutual funds. More specifically, asset allocation determines how your assets are distributed within your investment portfolio. It is an investment strategy that adjusts the amounts or percentages you own in certain asset classes to balance risk versus reward based on your overall risk tolerance, goals and timeframe for holding investments.
2. Net Worth
Your net worth is literally what you own minus what you owe and it’s measured in dollars. Taking stock of this number initially gives you a great starting point for measuring your financial health and progress every six to twelve months. Calculating your net worth is simple and you can learn how here.
3. Compound Interest
This is your money’s best friend! Compound interest is when you earn interest on the money you invest and then earn interest on that interest. The longer this extra interest you earn on your investment has to grow, the more money your money can earn you over your lifetime.
4. Rule of 72
The rule of 72 is something we financial planners geek out over that helps us estimate how long it will take an investment to double its worth and over what time period. It’s a simple mathematical equation by which dividing 72 by the annual rate of return equals how many years it will take for your investment to double. For example, an investor who invests $1,000 at an interest rate of 6% per year will double their money in 12 years. (72 divided by 6 = 12)..
5. Rate of Return
Rate of return is the profit your investment earns over a particular period of time and can be a positive or a negative number (meaning you’re either making money or you’re losing it). The return is expressed as a proportion of your original investment over a certain time period (mostly a year, which is why you’ll see this number sometimes referred to as an “annual rate of return”). For example, if you invest $10,000 and it grows to $10,650 over 12 months, you’ve earned $650 on your $10,000. Your annual rate of return is: $650 / $10,000 = 6.5%.
I may or may not compare diversification to the numbers and types of shoes you own in my book, Work Your Wealth. You’re not going to have just one pair of shoes to go with all your outfits. Similarly, you shouldn’t have all of your money in just one or two holdings. Having a variety of investment types in your overall portfolio is diversification. It is a popular and recommended investment technique that helps to reduce risk and can provide more stable returns. Think of it this way: If you carry all of your eggs in one basket and you drop the basket, you’re out of luck for that awesome brunch you were about to have. If you carried your eggs in multiple baskets however, dropping one basket wouldn’t have as big of an impact as you can still rely on the others to help make that omelet!
7. Expense Ratio
This is a fancy term fund managers use that means fees… that you’re paying to them. Expense ratio is an annual fee an investor is charged by funds or ETFs to operate. The simple math is that the fund will divide its operating expenses by the value of the assets it manages and what’s left is the return to the investor. As an investor, you’ll want to know what the expense ratio is for investments you select so that there are no surprises. Aim for funds with expense ratios below 1%.
Inflation is a term that tells us the rate (percentage) at which prices for goods and services are rising. It’s expressed as an annual percentage rate. Basically, inflation can detour our finances if we don’t invest and grow our money because as things get more expensive, the dollars we have today don’t go as far. For example, if the price of your morning coffee increase from $2.00 to $2.05, that’s a 2.5% increase and what your money could have bought you in coffee yesterday, now won’t go as far. Prices tend to increase over time, which is why it’s important to grow your money and take advantage of things like compound interest. By getting a clear understanding of certain financial terms, you’re equipping yourself with the knowledge you need to make informed financial decisions. You can also check out more investment terms you should know here and here. Remember, if you’re ever talking with a financial advisor and don’t know a word they use, or concept or strategy they’re recommending –don’t ever hold back your questions. You should have questions and you absolutely deserve a financial professional who will take the time to make sure you have sound understanding around your finances.
The investment world can be a complicated and overwhelming place to those on the outside, and it doesn’t matter where you fall on the GenY to Boomer spectrum. Not only are there a variety of account types to consider when stashing away cash for the long term (think 401(k)s, Individual Retirement Accounts, Roth IRAs, SEP IRAs, 403(b)s, etc.), but on top of that there’s a slew of investment terms and types to be aware of too! The terminology alone can make someone’s eyes glaze over if there’s no context behind it. One of the big “no no’s” in the financial planning profession is throwing around industry lingo and using schmancy words in front of clients to make them think you’re smart. That doesn’t fly for me. I took Spanish in high school and Italian in college. I know that learning a new language is tough. And I know that understanding your investments shouldn’t make you feel like you have to break out the books and start studying. That’s why I’ll be taking the next two weeks to break down some basic investment terminology for you. Part One will cover basic investment terms and Part 2 will cover account types and considerations. If you’re already finance savvy – consider the below a recap (but feel free to review and share) and if you’re new to the investment world, you’re in the right spot. Read on for a GenYer’s mini-financial dictionary.
One share of stock represents a single share of ownership (equity) in a company. When you purchase a share of stock, you become a part owner in the company (proportionally to the number of shares owned by others) and you can even vote on how the company operates. The price of the stock will fluctuate up and down over time depending on how much an investor is willing to pay for it (or think it will be worth). Fun homework assignment: Visit www.yahoofinance.com and look up the stock prices for some of your favorite companies. You can track the movement in price throughout the day and overtime.
A bond is a debt investment where as the investor, you loan your money to an issuer (a corporation or government) for a set period of time. In exchange for the loan, the issuer promises to repay the principal and a set interest amount over the life of the bond, which is a predetermined time. Think of this as an IOU where you loan a company money and in exchange they agree to a set of terms for repayment. The value of a bond will increase or decrease based on changes in interest rates (increase when interest rates fall and decrease when interest rates increase). They tend to offer more moderate returns and risk when compared to stocks and can sometimes work in a portfolio to even out risk.
A mutual fund pools together money from a group of investors and purchases stocks, bonds and other securities. The fund acts as one investment and as the underlying securities increase or decrease in value, so does the overall value of the fund. Mutual funds help individuals to take advantage of diversification, asset allocation and professional money management when they’re unsure or don’t have the time to do it themselves. Each mutual fund has a manager and a strategy for the fund’s overall objective, which can be found in the fund’s prospectus. Some may be geared towards growth or capital appreciation and others may be geared towards income generation or stability. Even though a mutual fund may own stocks, bonds and other securities, its price does not fluctuate throughout the day, but instead is set at the end of each trading day. This means that if you want to purchase or sell a mutual fund, you will do so at the end of the day after its price has been set based on the value of its underlying securities. Note: You’ll likely see a variety of mutual fund offerings for you to choose from in your employer’s 401(k), 403(b) or TSP plan. Among these options you may see a Target Date Fund, which is a type of mutual fund whose asset allocation is set according to a selected time frame. The allocation becomes more conservative as the “target date” approaches.
Exchange Traded Funds (ETF):
An exchange traded fund (ETF) is similar to a mutual fund in that it pools together funds to purchase a set of stocks, bonds or securities. However it trades throughout the day instead of at the end of the day. The price of an ETF is determined throughout the day and they trade just like stocks. Note: Most ETFs are passive in nature and therefore tend to come with lower internal expense ratios than similar mutual funds. Be sure to check the expense ratios of any mutual funds or ETFs you’re investing in.
Asset Allocation: This is a strategy that adjusts the amounts or percentages you own in certain asset classes in order to balance risk versus reward based on your overall risk tolerance, goals and timeframe for holding investments.
Risk Tolerance: As an investor, this describes your comfort level with certain levels of uncertainty when it comes to fluctuations (large and small) in the value of your portfolio.
The key to understanding your investments is to start off as you would with any other goal. Break it down into smaller goals and conquer one piece at a time. Start by getting clear on key terms, then account types and then work your way up to how they relate to each other and most importantly – to your life. And if you’re ever feeling like your Advisor is talking above you, using words you don’t know or just plain isn’t making things easy to understand – call them out on it. You deserve to have an understanding and education about these things. Make sure to ask for it.