If you’ve ever scanned the paper’s finance section, you’ve probably come across terms like S&P 500, ETFs and bull markets. But do you actually know what they mean?
If you haven’t a clue, don’t worry – you’re not alone. A recent survey by Bankrate revealed that the second most common reason cited by millennials for not investing is that they don’t know enough about stocks. And, in a recent Harris Poll, 69% of adults, 35 and younger, said that they found investing, and the accompanying jargon, complex and confusing.
Well, we’re about to change that. We want you to become an informed and confident investor, so we’ve taken it upon ourselves to explain some key investment terms in the simplest way possible.
Stocks and bonds
A stock represents part ownership in a public company. When you purchase a stock, you own a share of the issuing company’s earnings and assets, in other words you’re a ‘shareholder’.
A bond is a loan that you (the lender) give to the issuer – a company or the government. Normally, the bond issuer promises to repay you the full amount of the initial loan on an agreed future date, known as the maturity date. Plus, interest on the loan amount in the meantime, which is based on a coupon rate.
Bear and bull stock markets
A bear market is characterized by stock price drops of more than 20% and a pessimistic outlook. There can be bear markets for a market as a whole, such as in the Dow Jones Industrial Average, as well as individual stocks.
A bull market is the opposite of a bear market. Investors are optimistic and reward even moderately good news with higher stock prices, fueling an upward spiral. In a bull market, the value of the market increases by 20% or more. Bull markets also tend to last much longer than bear markets.
Fun fact! The descriptions ‘bear’ and ‘bull’ are thought to come from the way in which each animal attacks its opponents. For example, a bull thrust its horns up into the air, while a bear swipes down with its paws.
Indexes
An index is a small sample of a market, which is used to represent the whole stock market. It’s used by investors to track and measure changes in a portfolio of stocks.
Here are the three major players:
S&P 500
The S&P 500 refers to the Standard & Poor’s 500 index, which includes 500 of the largest US, publicly traded companies. It’s often used as a benchmark for the stock market because it includes a significant portion of the market’s total value.
Dow Jones Industrial Average
Also known as ‘the Dow’. It’s an index that tracks 30 of the largest and most influential companies in the US, and is widely viewed as a proxy for general stock market conditions and even the US economy.
NASDAQ Composite
When people talk about “The Nasdaq,” they’re most likely referring to the Nasdaq Composite — a price-weighted index of the stocks listed on the exchange of the same name.
Because it’s so much bigger than the Dow, a glance at the day’s Nasdaq can give a broader view of the economy; even though most are technology and Internet-related, but there are financial, consumer, bio-tech and industrial companies as well.
ETF
Stands for exchange-traded fund. It’s a basket of securities — stocks, bonds, commodities or some combination of these — that you can buy and sell through a broker, just like a stock. ETFs usually track an index.
Mutual fund
Pools money from a bunch of different investors, in order to invest in a large group of assets – stocks, bonds or other securities. The cost of each share – each unit of the mutual fund – is calculated as the fund’s per-share Net Asset Value (NAV) and sometimes includes purchasing costs (be sure to ask beforehand).
Risk and beta
Risk
It refers to the probability an investment’s actual return will differ from the expected return. It’s calculated: (a) from company specific factors such as loss of a major customer, a legal battle, any major regulatory action, etc. and (b) from broad economy-wide shocks such as a change in central bank policy rate, change in taxes, war, etc.
Risk that results from company-specific factors is called unique risk while the risk that affects the whole stock market is called systematic risk.
Beta
Beta measures the volatility or systematic risk of a portfolio against the stock market as a whole. It’s perfect for evaluating a stock’s trading pattern since it includes the risk that that investors can do nothing about.
A beta of 1 indicates that the security’s price moves with the market. A beta of less than 1 means that the security is theoretically less volatile than the market, for example, a Treasury Bill. On the other hand, a beta greater than 1 indicates that the security’s price is theoretically more volatile than the market.
Keep in mind that beta only measures systematic risk.
Passive vs. active investors
Passive investors have a long-term buy-and-hold mentality. They limit the amount of trading within their portfolios.
Active investors, on the other hand, take a hands-on approach. They attempt to beat the stock market’s average returns and take full advantage of short-term price fluctuations.
Investing vs. trading
Investing in stocks means buying and holding shares for an extended period. When you invest, your money is intended to increase the company’s value.
On the other hand, trading refers to buying and then quickly selling for a profit (kind of like gambling). Sometimes, traders have a gut feeling, or have heard a rumor, but ultimately, they are not thinking about long term investments.
EPS vs. P/E ratio
Earnings per share (EPS)
Earnings per share (EPS) indicates the company’s ability to produce net profit for common shareholders. It’s calculated by taking the company’s profit and dividing it by its number of common shares outstanding. This measure is useful when comparing two companies in the same industry, with the same number of shares outstanding.
A higher EPS indicates better profitability. However, keep in mind that it doesn’t tell you how — or how efficiently — the company uses its capital. Some companies take those earnings and reinvest them in the business. Others pay them out to shareholders in the form of dividends.
Price-to-earnings ratio (P/E)
P/E ratio is the measure of a stock’s value, and tells you how much investors are willing to pay to receive $1 of the company’s current earnings. It’s calculated by dividing a company’s current stock price by its earnings per share — usually over the last 12 months.
Expense ratio
An annual fee (expressed as a percentage of total assets) that funds charge their shareholders. It includes management fees, administrative fees, operating costs, and all other asset-based costs incurred by the fund. However, it doesn’t include the brokerage commissions.
In other words, if you invest in a mutual fund with a 1% expense ratio, you’ll pay the fund $10 per year for every $1,000 invested. When you invest with FlexInvest, the expense ratio is already baked into the price, not charged separately.
Margin
A loan that allows you to buy more stock than you’d be able to buy normally, by borrowing from brokers. The amount of credit loaned is based upon the amount of assets held by the borrower, which are pledged as collateral on the loan.
Selling short
This is when an investor or speculator believes that the stock price is plunging, so he sells it and repurchases it once the price declines. His profits consist of the difference between the buying and selling price.
