When it comes to investing, you want to make sure that you are as informed as possible about any investments you are making. You also want to make sure that you fully understand what you are investing in. Understanding how investing works begins with learning the basic and most commonly used investment terms. Good thing you are here - you're about to learn all about the most common terms in this article!
1. Brokerage firm
A brokerage firm is a financial institution that manages or facilitates the buying and selling of securities between buyers and sellers. These securities include different kinds of investments like stocks, bonds, funds, etc.
They typically charge commission fees on trades. They can provide you with up-to-date research, market analysis, and pricing information on various securities. Examples of brokerage firms in the US include Vanguard, Fidelity, Charles Schwab, etc.
A stock is part ownership of a company. Yup, even if you only own one a stock, you are a part-owner of the company! Stocks are also called shares or equities and the more you own the bigger your ownership stake is in a company. This is probably the most common investment term!
In simple terms, a bond is when you loan money to a company or the government who in turn pay you back in full with interest. For example, the government may sell bonds to raise money for a specific initiative.
You can then purchase the bond and the government will pay you back over a fixed period of time with interest.
4. Mutual Fund
A mutual fund is a pool of funds from a group of investors set up for the purpose of buying securities like stock, bonds, etc.
Mutual funds are typically managed by a fund manager or a money manager associated with a brokerage firm. Their job is to make investment decisions for the fund and set the funds objectives.
5. Index Fund
An index fund is another common investment term you probably hear about all the time. By Investopedia's definition, an index fund is "a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index".
In plain English, this means, an index fund can be set up to buy all the same stocks within a specific index like say the S&P 500. This means you will be invested in every single one of the 500 companies that make up the S&P 500.
Or you can purchase a total market index fund that invests your money in equal ratios across the entire stock market. This index fund is based on a total market index that measures the investment return of the overall stock market.
Here are Clever Girl Finance, we are fans of index fund investing!
Wondering about ETFs?
They are similar to index funds however they can actively be traded throughout the day at the current market price. This is unlike mutual funds and index funds that are traded at the end of the day, and at the market's closing price. You will however pay commission fees as a result.
Other key differences revolve around brokerage fees and tax efficiencies with ETFs and Index funds. They are typically more tax-efficient than mutual funds. (An investment advisor can help you break down your best option).
6. Asset Allocation
Asset allocation basically allows you to balance risk by allocating your assets in stocks, bonds, and cash according to your goals risk tolerance and investment timeline. It's pretty much your personalized investment plan based on your financial goals.
7. Capital Gains
This is the increase in the value of your investment that makes is higher than your original purchase price. The gains are not realized until the asset is sold though. Once assets are sold, capital gain tax (tax on your profits) comes into play.
8. Expense Ratio
These are the annual fees that funds e.g. mutual funds charge their shareholders. These fees include fund management fees, administrative fees, and other fees related to operating the fund on your behalf.
9. Price to Earnings Ratio (P/E)
This is a company's market value per share and a way by which companies are valued. It's calculated by taking the current stock price and dividing it by the company's earnings per share.
Dummies.com further breaks it down as "The price-to-earnings ratio or P/E indicates how much investors are willing to pay for each dollar of profit they stand to earn per year.
For example, if an investor buys a stock with a P/E of 15, he’s willing to pay $15 for each dollar of profit, or 15 times the earnings for one share of stock. Another way to look at it is that it will take 15 years to earn back your investment in company profits".
In simple terms, this is not putting all your eggs in one basket. It's putting your money in a mix of investments to minimize your overall risk.
A prospectus is a legal document filed with the SEC (Securities and Exchange Commission). It provides details of an investment that is publicly made available for sale. You can review details in a prospectus to see how a company is performing or to learn more about their operations.
Investing in the stock market might seem and sound complex but it doesn't have to be. If you make the effort to learn these core investment terms and how they work, you'll be surprised at how quickly it all starts to make sense!
To learn more about exactly how investing works, check out our free investing courses!