Top Ten Terms You Should Know About Investing

Top Ten Terms You Should Know About Investing

The goal of my FI Top Ten series of posts is to increase financial literacy.  It’s difficult to improve your financial situation if you don’t have the vocabulary.  Today I’d like to talk about investing.  

Investing

I think it is important to start by defining what investing is.  When you have any amount of money, there are essentially four things you can do with it.  The first thing that you can do is spend it.  Unfortunately, most people do far too much of this than the other three options.  The second thing you can do with money is simply save it.  This is the proverbial “hide it under your mattress” option.  When you just save the money, it isn’t working for you to generate any significant profit.  In fact, it is actually losing value because it doesn’t even keep up with inflation.  The interest rates on most standard savings accounts are so low that they fall into this category.  The third thing you can do with money is give it away.  This may be in the form of donating to a church or charity.  It could also simply be a gift to a family member, friend, or someone in need.  Finally, you can invest the money.  If you want to grow wealth and reach financial independence, the majority of the money that comes into your life must be invested.  

When you invest money you purchase some type of asset (stock, bond, real estate, business, etc.) with the expectation of a future return or profit.  Furthermore, there is usually some time component associated with investing, meaning you typically have to hold the investment for a certain period of time to achieve the hoped for or expected return.  Some forms of investing are more passive, meaning you don’t have to do much to maintain the asset.  Paper assets, such as stocks and bonds, fall into this category.   Other forms of investing are much more involved, or active.  Real estate rental property investing or small business investing would be examples of more active forms of investing because they typically require the investor to take a much more active role in maintaining the asset.  

The key point I would like to drive home is that investing is how you put your money to work for you.  Every dollar you don’t spend can be invested and start working for you.  It can make money for you 24 hours a day, 7 days a week, essentially making you money while you sleep!  And with the magic of compound interest, the dollars that those invested dollars earn can also be invested and generate you more income, and so on.  This is the secret to building wealth and becoming rich.  

Portfolio

What’s in your portfolio?  How did your portfolio perform last quarter?  

Have you ever been asked questions like these and weren’t quite sure what was being asked or how to answer?  When I was new to investing, I didn’t really know what people were talking about.

Your portfolio is simply the aggregate of all your investments.  It’s not some magical Trapper Keeper (like that blast from the past?) where you keep a record of everything you have invested your money in, although I guess it could be.  Your “investment portfolio” is a figurative term often used when looking at your investments as a whole.  It can be very helpful when trying to determine the degree of diversification of your investments, your overall asset allocation, and how your investments reflect your risk tolerance.  These are all terms we will be discussing below.  

Keeping track of how your investment portfolio performs as a whole is very useful in understanding your overall financial position.  It is much more practical than analyzing each investment individually because the number of accounts you invest in, and the number of different investments in these accounts, can get complicated and add up quickly.  For example, most people will have one or more tax advantaged accounts they invest in.  You might have a 401(k) account with your employer, a Roth IRA with Vanguard, and an HSA with Fidelity.  In each of those accounts you might own different mutual funds, index funds, individual stocks, bond funds, or other assets.  How much you own in each account and what percentage of your total investments they make up likely varies as well.  In addition, you probably have one or more checking and savings accounts where you keep cash.  You may also have a taxable brokerage account with further investments.  And maybe you are starting to invest in real estate. You can see how this can get complicated.

One of the easiest ways I have found to look at your overall investment portfolio and track how it performs over time is to use an online app like Personal Capital, which you can download for free.  Check out my review of it here.   Mint is another good option, but I think it is better for budgeting and getting out of debt, and less useful for investing.

Time Horizon

Time horizon refers to the amount of time an investment is held before it is liquidated, which is typically determined by the investor’s financial goals.  If the investor is saving for a down payment on a home in the next two years, there is a short term time horizon.  If the investor is 35 years old and saving for retirement, with a goal retirement age of 65, this would be a long term 30-year time horizon.  

An investor’s time horizon will strongly influence many factors in his or her portfolio, including risk tolerance, diversification, and asset allocation, which are discussed below.  

Risk

Some degree of risk is ALWAYS associated with investing money.  Risk is basically how likely you are to lose some or all of your money when you invest in an asset and expect a return.  Typically the more risk involved, the higher the potential return.

At one end of the spectrum you have a basic savings account at a bank or credit union.  Contrary to popular belief, there is some risk you could lose your money in such an account.  This risk, however, is extremely low since these accounts are insured by the federal government (FDIC insured), typically up to $250,000.  Given the extremely low risk, the return is also quite low.  At brick and mortar banks, most savings accounts yield 0.1 to 1% interest annually.  Higher yield online savings accounts are available, usually from banks that don’t have the costs of maintaining the physical location of a traditional bank.  However, they still only currently yield about 2.3 to 2.4% interest annually.  This is barely enough to keep up with the average rate of inflation.  

At the other end of the spectrum are stocks, which are an asset that would be considered much riskier.  The value of stocks can fluctuate greatly.  We’ve all seen pictures of graphs that look like an EKG with ups and downs from day to day.  This up and down variation is known as volatility.  Due to the volatility risk associated with stocks, there is the possibility of a greater return.  

The amount of risk you take on in your portfolio can be mitigated by a number of factors.  For example, the length of time you hold the investment can decrease the risk.  If you hold shares of a stock for a very long time, despite short term fluctuations in the market, you are much more likely to have a higher return and decrease your risk of losing money.  Other strategies to reduce risk in your portfolio include diversification and asset allocation, both to be discussed below.  

When the risk of investing becomes excessive or wreckless, you cross the line into speculation. 

Risk Tolerance

Risk tolerance is how much risk you are willing to accept in your investment portfolio.  There can be a significant amount of variation in risk tolerance from one investor to another.  Risk tolerance is dependent on a large number of variables including personality, income, age, financial goals, stage of life, etc.  

I believe there are two components to risk tolerance.  The first is psychological.  This really is whether or not you will lose your cool when the market goes south.  If you can’t stomach the ups and downs of the market, you have a lower risk tolerance.  Conversely, if watching your portfolio drop by 50% in a financial crisis doesn’t cause you to break a sweat, you have a higher risk tolerance.  

The second component is practical.  This varies based on what stage of life you are in and when you plan to use the invested money.  If you are young with a very long time horizon until retirement, meaning it will be decades until you actually need your nest egg, then you have a higher risk tolerance because there is ample time for your portfolio to recover from multiple significant downturns in the market.  On the other hand, if you are only five years from retirement, a major market crash could really hurt your portfolio if it is aggressively invested and you have a lower practical risk tolerance.  

Diversification

You’ve probably heard the saying “don’t put all of your eggs in one basket.”  Well, with investing there is a term for that: diversification.  Diversification is a strategy to minimize risk within your portfolio by holding multiple different investments.  

One way to diversify is to hold multiple different investments within a given asset class.  For example, if all of your money was invested in the stock of a single company, this could be quite risky.  If that company went out of business, you could lose everything.  If instead, you purchased stock shares of ten different companies, you would have more diversification within the stock asset class and would be at less risk of losing your money.  Investing in 100 different companies would be even more diversification and less risk.  

Another way to diversify is by investing across multiple different asset classes.  Rather than putting all of your money in the stock market, you could diversify by investing in bonds.  This is a common strategy because the stock market and bond market are usually (but not always) inversely correlated, meaning that when stocks go down, bonds tend to go up.  Branching out into real estate or small businesses could provide even more diversification.  

While there are many positives to diversification, too much diversification can bring problems as well.  The more things you are invested in, the more complicated the portfolio becomes, making it harder to keep track of and manage your investments.  Holding many different investments can also increase associated costs and fees.  It is important to weigh the positives and negative when diversifying your portfolio.  

Asset Allocation

Asset allocation refers to the strategy of dividing your portfolio among different asset classes, which can provide diversification and reflect an investor’s risk tolerance.  Classically this refers to what percentage of a portfolio is held in stocks and bonds.  It is common to hear phrases like “I have an 80/20 portfolio,” which would mean the portfolio consists of 80% stocks and 20% bonds.  Asset allocation could also refer to other asset classes such as cash or real estate.  An investor might say “I have 50 percent of my portfolio in stocks, 25% in real estate, 20% in bonds, and keep 5% in cash.”

Many investment advisors consider your asset allocation the most important investment decision you will make.  When determining asset allocation, it is critical to make sure it reflects your time horizon and risk tolerance.  If you have a longer time horizon and higher risk tolerance, the asset allocation can be much more aggressive and weighted more heavily towards stocks.  On the other hand, if you have a shorter time horizon and lower risk tolerance, your asset allocation will likely be more conservative with a more balanced portfolio, such as a 50/50 mix.  

Your asset allocation need not be a fixed number or a one time decision.  Most investors adjust their asset allocation over time as their investment time horizon and risk tolerance changes.  Asset allocation can be a complex decision and whole books have been written about it.  In future posts I will discuss some common strategies for asset allocation.  

Liquidity

Liquidity refers to how easily an asset can be bought or sold on the open market.  Cash is the most liquid asset and what all other assets are compared to.  So essentially, liquidity translates to how easily the asset can be converted to cash.   

Some assets are much more liquid than others.  Paper assets, such as stocks and bonds, are traded frequently every day on the open market and are thus, quite liquid.  With online brokerages today, you can usually sell a share of stock in a matter of minutes, seconds even, and have cash readily available.  Real estate holdings, however, are much more illiquid.  It is usually more difficult to find a buyer for real estate and the transaction takes time.  

As you plan for the future and eventual financial independence, the liquidity of your assets becomes more important.  You need assets that either produce cash flow, such as rental income or dividends from stocks, or you have to sell some assets in order to have liquid cash to pay for your expenses.  If all of your invested money is tied up in your home equity it is quite illiquid and doesn’t do you much good.  You can’t pay for groceries or the electric bill directly with a paid off home.  

Inflation

Inflation is a key factor to consider when investing.  Inflation, put simply, is the increase in price of goods and services over time.  A loaf of bread costs a lot more in 2019 than it did 50 years ago in 1969.  This is inflation.  

As the prices of goods and services goes up over time, the spending power of money decreases.  One dollar in 1969 could buy a lot more than one dollar in 2019.  This is one reason why it is important to invest your money rather than just stuff it under your mattress or let it sit in a low interest savings account.  

Let’s say you were planning to retire in 25 years and had $500,000.  If you just put it in a safe and kept it locked for 25 years, when you opened it up there would still be $500,000.  But that same $500,000 could buy far less goods and services than when you initially put it in the safe.  In order to keep the spending power of your money, you MUST invest it in assets that at least keep up with the rate of inflation, and hopefully outpace it.  Historically in the United States the rate of inflation has been around 1-4% per year.  

Inflation is also very important to take into consideration when looking at investment returns over time, especially with longer time horizons.  For example, if you are trying to calculate how much you need to retire, you will need a few variables.  This includes an initial investment principal, how many years the money will compound and grow, how much money you will add each year, and at what interest rate the money will grow.  If you decide to use the average stock market rate of return over the 40 year period from 1975-2015 with dividends reinvested as used by J.L. Collins in his book, The Simple Path to Wealth, you would plug in 11.9% into your calculation.  This number, however, is NOT adjusted for inflation.  When taking inflation into account, the rate of return drops to 7.8%.  You can see how much of a difference this can make on your long term plans.  

Dollar Cost Averaging

Dollar cost averaging is a common investment strategy to mitigate risk.  When dollar cost averaging you buy the same dollar amount of a given investment at a repeated regular interval of time.  Let me give you an illustration to demonstrate the rationale behind this.

Let’s say an investor had $120,000 dollars and wanted to invest it in the stock market.  She decides to buy shares of a low cost, passive, total stock market index fund.  However, she is worried that if she invests all of this money at once, the market could crash soon thereafter causing her to lose a significant portion of her investment.  Dollar cost averaging is a strategy to mitigate this risk.  Rather than invest all of the money at once, with dollar cost averaging she could invest $10,000 per month over the next year spreading out her risk over time.   This way, if the market drops she can buy some of those shares at the discounted price and lose less of the money that is already invested.  In the end, the same amount is invested, but it is spread out over time.  

Opponents of this philosophy would argue that the market is just as likely to go up as it is to go down.  If this were to happen, dollar cost averaging could cause you to potentially miss out on some major gains and end up buying shares at higher prices over time.  

I think the bottom line is that no on can predict what the market will do.  You need to do what you feel comfortable doing based on your own risk tolerance.  If dollar cost averaging seems like a good strategy to you, then by all means give it a try.  You may already be dollar cost averaging and not even know it.  For example, if you have a regular amount withheld from your paycheck and invested in your 401(k) each month, this is essentially dollar cost averaging.  

Conclusion

These basic terms form a foundation for understanding investing.  It is in no way comprehensive, but it includes ten terms that I think are key in understanding investing principles, and terms I see regularly used in books and articles on investing.  Hopefully this may answer some questions you have had about investing and will spur you on to gain more knowledge. 

Good luck as you continue to work towards Freedom Through FI!