Investing Definitions
#4 AdviceBy_
Welcome to the investing section of the Personal Finance Series! Investing can provide good returns, increasing your overall wealth. I had a ~30% gain in 2020. However, it is confusing and intimidating (or at least it was for me). So, I’m going to do my best to simplify it for you. Make sure you’re signed up above to get the super actionable follow-up part delivered straight to your inbox. It will cover multiple items, such as when, how much, and what to invest in, and discuss robo and cryptocurrency investing. Disclaimer: nothing here is financial advice, just my personal thoughts.
Part 1: Savings vs. Checkings Account (read here)
Part 2.1: Investing - Definitions (this one!!)
Part 2.2: Investing - Start Now (read here)
Part 3.1: Retirement Accounts - Roth IRA (read here)
Part 3.2: Retirement Accounts - 401k (read here)
Part 3.3: Education Accounts - 529 & Coverdell (read here)
Part 4: Credit Cards
📋 Overview
Before you start investing (subscribe above for Part 2.2), it’s essential to understand the variety of assets you can invest in and the technical terms you’ll encounter. Understanding these terms upfront is critical and will make you a smarter, more knowledgeable investor. After reading this guide, you should have a basic understanding of the following:
Stock • Dividend • Market Order • Buy Limit Order • Sell Limit Order • S&P 500 • Dow • Nasdaq • ETF • Mutual Fund • Expense Ratio • Transaction Fee • Active Management • Passive Management • Bond • Coupon • Face Value • Option
Let’s dig into it …
📚 Definitions
What is a stock? Owning a stock of a company allows you to have fractional ownership in the corporation. You purchase a stock hoping the price will go up so that you can make a profit when you eventually sell. Demand and supply dynamics determine stock prices. If there's more demand, the price will go up, and if less, the price will go down. Some companies may also offer dividends to reward their stockholders.
What is a dividend? It's a quarterly payment that some companies make to stockholders (eg. you) based on their performance. It's a small reward for investing in the company's stock. To get the dividend, you have to purchase the stock by a specific date (ex-dividend date). Note that a company's stock price decreases by the dividend amount on the day dividends get paid.
What is a market order? When you place a market order, the security (stock, etf, etc.) will be bought or sold immediately at the current price. Suppose you want to buy Apple and place a buy market order at 2:38 pm. Your trading platform will buy the Apple stock at the 2:38 pm price.
What is a limit order? When you place a limit order, you are stating a specific price you would be willing to buy or sell the security. You can place a buy or sell limit order and choose how long you want the order to last (one day, until a specified date, etc).
What is a buy limit order? Suppose Apple stock is trading at $130. If you think the price will drop and want to buy the stock at a lower price (but not monitor the price constantly), you can place a buy limit order of $125 (or any amount below the current stock price). If the stock price falls to or below $125, your trading platform will execute your order.
What is a sell limit order? Suppose Apple is trading at $130, and you think the stock price will rise. If you want to sell the stock at a higher price, you can place a sell limit order of $135 (or any amount above the current stock price). If the stock price rises to or above $135, your trading platform will execute your order.
What are the major market indices?
What is an ETF? An ETF (exchange-traded fund) gives you access to a basket of assets (could be stocks, bonds, etc.) rather than only one particular investment. This decreases your risk of investing in a single asset, which could fluctuate a lot more. ETFs mirror an index (eg. S&P 500) rather than having someone choose the composition. For example, VOO (Vanguard S&P 500 ETF) mirrors the S&P 500 and comprises several stocks, including Apple, Microsoft, Amazon, Alphabet, etc. For this reason, ETFs are generally passively managed. There are several different types of ETFs, including stocks, bonds, international, etc. You can buy an ETF throughout the day at its market price. Check out ARK ETFs focused on disruptive innovation and actively managed (plus point that is not typical of ETFs).
What is a mutual fund? A mutual fund is similar to an ETF. It also gives you access to a basket of assets. For example, MSEGX holds Zoom, Square, Shopify, Amazon, etc. However, an individual or team actively manages mutual funds. So, mutual funds aim to realize higher gains than ETFs (usually passively managed). For this reason, they typically have a higher expense ratio as well. You can place a buy/sell order for a mutual fund at any time throughout the day, but the purchase/selling price will be that at market close.
What is an expense ratio? It is an annual fee that the fund uses to cover its expenses. For example, VOO has an expense ratio of 0.03%, and MSEGX has an expense ratio of 0.83%. If you invested $1000 in each, you would be paying $0.30 and $8.3 annually in fees, respectively. Last year, VOO had a year-to-date return of 17% and MSEGX 118%, so the higher expense ratio could be worth it depending on the fund you choose and its performance.
What is a transaction fee? It's a fee you may have to pay to buy or sell an asset in the market. Today, this will likely only be applicable for trading cryptocurrency and not stocks, bonds, ETFs, etc. For example, a 0.5% transaction fee means that if you buy or sell $100 worth of Bitcoin, you will have to pay a fee of $0.50.
Active vs. passive management?
What is a bond? A bond is essentially a loan made by an investor (eg. you) to a borrower (eg. corporation or government). When you invest in a bond, you are lending your money to the borrower. You can hold a bond until its maturity date to receive its face/par value (usually $100 or $1000) and get interest payments (called coupons) usually twice a year. You can also try to sell the bond in the market at a higher price than what you paid.
What are interest (aka coupon) payments? It is the amount of money the borrower (eg. corporation or government) will give you for lending them your money. If a bond has a 5% coupon rate and $1000 face (aka par) value, you will receive $50 annually for investing in the bond regardless of how much you paid for the bond (could be at, above, or below $1000).
What is face/par value? It's the amount you will get for holding the bond until it matures (usually $100 or $1000). The face/par value may be different from the amount you actually pay for the bond set by the market. You could buy a bond for $980 (trading at a discount) or $1020 (trading at a premium), but you will still receive the face value ($1000 in this case) if you hold the bond until it matures. People may buy a bond at a premium because the coupon (aka interest) rate is high.
Bond safety and returns? Bonds are safer investments than stocks because you are very likely to receive the face value (usually $100 or $1000) of the bond at maturity along with semi-annual interest payments. For this reason, bonds have comparatively lower returns than stocks (which don't guarantee returns). Lower risk means lower reward potential. You could invest more money into stocks (less if any into bonds) when you're younger and change this over time.
What is an option? In simple terms, options allow you to buy or sell an asset (stock, bond, etc.) at a specific price by a certain date. Options are riskier than the other assets mentioned above, so I don't recommend using them if you're a beginner. I've never traded options personally but have a good understanding of them. If it's helpful, I could write an in-depth article on them. Email me if this would interest you!
Now that you've got the basics down, you're ready for Part 2.2 (Investing - Start Now)! If you haven't already, make sure you and your friends subscribe above to get it delivered straight to your inbox. We will cover multiple items that will help you open your account and start investing immediately. I hope you're as excited as I am!!
💡 Knowledge Check
Fill in the blanks using the options in brackets after each question! Answers below.
You can place a ____ order if you think a stock's price is going to drop in the future. [market | buy limit | sell limit]
The ____ is known as the 'technology' stock exchange. [S&P 500 | Dow | Nasdaq]
If you want access to a basket of assets to decrease your risk, you can purchase a ____ or ____. [stock | ETF | mutual fund]
The ____ market index is generally a good indication of the US market movement as a whole. [S&P 500 | Dow | Nasdaq]
If you bought a bond at $1100, you have bought it at a ____ to its face value. [premium | discount]
____ funds have a higher expense ratio because they are ____ managed. [exchange traded | mutual || actively | passively]
You will receive an annual interest of ____ if a bond has a 3% coupon rate and a $1000 face value.
Investing in options is ____ risky than investing in stocks or bonds. [more | less]
A quarterly payment some companies may give you as a reward for investing in them is a ____. [stock | dividend | bond]
The ____ consists of 30 of the largest US companies. [S&P 500 | Dow | Nasdaq]
✔️ Answers
buy limit
Nasdaq
ETF & mutual fund
S&P 500
premium
mutual & actively
$30
more
dividend
Dow