To say investing is daunting would be a huge understatement. Jumpstart your portfolio with these 9 investment terms.
Matt Cosgriff is a Certified Financial Planner™ and personal finance expert for young professionals.
Whether you’re trying to impress that special someone’s father or just begin investing a few bucks, whatever your reason, as a young guy get the ball rolling with these nine investment terms. None of them will make you rich over night, but all of them, when understood and acted upon accordingly, can help ensure that your finances are in tip-top shape.
Compound Interest
Compound interest is any young investor’s best friend. In contrast to simple interest, compound interest is the accrual of interest on both the principal of your investment and the interest that has grown and accrued with it.
Take, a $100 investment in stock A. If that stock grows 8% to $108, compound interest says that any future growth will not just grow off of your original $100 investment, but instead off of the entire $108. Even better is that if you purchase a dividend paying stock any future dividend payment won’t be calculated off the purchase price of $100, but rather the market value of $108.
Compound interest can be so powerful for young investors that Albert Einstein once said that “compound interest” is the eighth wonder of the world. The takeaway? Start saving and investing early and let the compounding effect of money take the reins.
Exchange Traded Fund (ETF)
ETFs are like a first cousin to mutual funds in that they are generally similar, but have distinct differences. ETFs tend to be less expensive than their mutual fund relatives, are oftentimes more tax efficient, and are frequently more passively managed than many of the actively managed mutual funds.
An ETF is a type of fund that collectively owns certain assets, which in many cases are stocks or bonds, and then allows investors the opportunity to indirectly own those assets by dividing ownership of the fund’s shares among investors. This allows investors the opportunity to gain broad exposure to an asset class (i.e. large US stocks) without having to buy each individual stock.
Roth
The word “Roth” refers to a type of tax treatment applied to retirement savings vehicles such as an IRA or 401k. In both cases, “Roth” means that any contributions are done after-taxes have been paid on the income used to contribute when any money is withdrawn for retirement it is completely tax-free!
This is opposite of how a “Traditional” 401k or IRA handles contributions. In that case, those contributions are actually done on a “pre-tax” basis meaning that no taxes are paid on your income and upon withdrawing the money at retirement any and all withdrawals will be taxed as ordinary income. Generally, Roth is better for young investors who are just starting out, but many factors can impact this decision.
Diversification
Diversification is conceptually fairly simple. In fact, you’ve probably heard the age old saying “don’t put all your eggs in one basket.” In this case, the basket is what you’re investing in.
Being diversified is critical because it helps to ensure that two things will likely never happen to your portfolio: (1) you’ll never lose all your money and (2) you’ll never get filthy rich picking the next Google. Being diversified means ensuring that you are invested broadly across all of your accounts and helps to mitigate the inherent ups and downs of the market.
Expense Ratio
This one is pretty self-explanatory, but being aware of the expenses you are paying as an investor can do wonders for your portfolio. An expense ratio is simply the percentage of your investment that is paid to the fund company (i.e. Fidelity, Vanguard) to cover the administration, management and other expenses associated with running the fund.
There is a lot of work involved in managing a mutual fund or an ETF, and fund companies are in the business of making money. An expense ratio paid by an investor needs to compensate accordingly, but with that said it remains critical for investors to be very aware of the fees they are paying. The average mutual fund expense ratio is approximately 1.25% and the average ETF expense ratio is 0.44%. If you have the option, sticking with ETFs will almost always help minimize fees.
Rebalancing
Now that you understand diversification it is important to understand how to remain diversified. Let’s say you set up a 70% stock and 30% bond portfolio allocation in your 401k and all is well. You feel comfortable about your breakdown between bonds and stocks and are excited to see your portfolio begin to make some money.
Fast forward a year and the stock portion of your portfolio has gone gangbusters and is up 15%, but unfortunately your bonds lost 5%. The good news is that your portfolio has now grown from $100 to $109, but your allocation is likely a bit out of whack. What was once a 70%/30% portfolio, is now more like a 74% stock and 26% bond portfolio. This is certainly not the end of the world, but over time you can see how your original allocation can quickly get out of whack.
This is why it is usually a best practice to “rebalance,” which is a fancy way of saying update your allocation to what you originally intended it to be. Expert opinions vary on how often you should rebalance, but it’s commonly accepted to rebalance as frequently as quarterly to as infrequently as annually.
Index
If you listen to the news or occasionally peruse the Wall Street Journal you’ve probably heard the term “index” or maybe you’ve heard one specifically mentioned like the “Dow” (see below). So what exactly is an index and what does it do? Well, Investopedia.com defines an index as “a statistical measure of change in an economy or a securities market.” Got it?
A stock market index, for those who don’t hold a PhD in decoding investor speak is more simply a basket of stocks compiled together to gauge how a particular market is performing collectively. For example, an investor might be curious how large companies (think Apple) are performing relative to small companies (think company you’ve never heard of) in general so they might compare the S&P 500 Index to the S&P 600 Index, which would allow them to compare how the 500 largest US stocks are performing relative to the 600 smallest. An index can also be used to compare the performance of a particular stock. In this context an index can be commonly referred to as a “benchmark.”
The Dow
The irony of this term is that it is for all intents and purposes useless. The “Dow” or Dow Jones Industrial Average is a stock market index (see above) founded in 1896 by the co-founder of the Dow Jones & Company, Charles Dow. The “Dow” in its original form was first calculated using 12 industrial companies (only GE still remains in the Dow) to create a standard benchmark for the US industrial economy.
Okay, so how is any of that relevant to investors today? In short, it is not. The irony of the Dow is that while it is the most discussed and published index in the financial media it is also the one that carries the least weight.
Today the US stock market is comprised of well over 4,000 stocks so an index that only encapsulates 30 of them is not a fair representation of the overall US stock market performance. If you want to get a good grasp on the broad US stock market look at the S&P 500 or Russell 3000, which is comprised of the 500 and 3,000 largest US stocks, respectively.
Dollar Cost Averaging (DCA)
Dollar Cost Averaging is a fancy way to say, “systematically save money,” and it is valuable in two very distinct ways. First, DCA is valuable from the standpoint that while many of us are well intentioned when it comes to our money, our busy lives have a tendency to get in the way. DCA will hold you accountable to a savings plan. It simply means that you automatically save a set amount at set intervals. If you are contributing to a 401k you are likely DCA into your 401k plan by automatically contributing a set percentage each pay period.
The other value that DCA brings to investors is the ability to ensure we aren’t buying at the worst possible time (i.e. when the market is high). By making contributions to an investment account at set times you are guaranteed to buy some shares when the market is high, some when it is low, and many others somewhere in between. The good news is that you are ensuring that you aren’t putting a large lump-sum of money in at the worst possible time (think October 2007). If you haven’t automated your savings to take advantage of this simple concept, now would be a great time to start.
