Investing terms: Important terms every investor must know
Investing can seem intimidating, especially when you’re just starting out. Well, you’re not alone. We have made a list of investing terms for you, as you embark on your investment journey. Here is an introduction to the world of investing and the important investing terms.
General investing terms
Investing: Investing is the act of committing capital to an asset, expecting a profit. The profit could either be through capital appreciation; the increase in value of the asset with time, or it can be through active income from the asset; dividends (stocks), rental income (real estate), etc. In the stock market, investing is generally considered as buying and holding stocks over a period of time, at least 5 years.
Stock: An asset class that represents the partial ownership of a company. When you own a stock, you are owning a portion of the company. It is also known as equity. In investing, the stock is used synonymously with the underlying company. However, it is important to look into the underlying company, which will determine everything about the stock in the long run. For example, Amazon is the company, and the Amazon stock you own represents your ownership in the company.
Share: It is a portion of an asset or security like a stock. When you are buying a stock, you are buying a specific number of shares of the stock, it could be one, a hundred, a thousand, or whatever you want. Let’s take Amazon as an example; you can buy one or a hundred shares of Amazon stock (AMZN).
Ticker: A ticker symbol is an abbreviation used to identify publicly listed stocks on a stock exchange. Remember AMZN? That’s the ticker symbol for Amazon stock.
Portfolio: A portfolio is a collection of investments like stocks, bonds, funds, etc. Every asset you have currently invested in is a part of your portfolio, the investments constitute your portfolio.
Stock exchange: It is the place where stocks are bought and sold. Stock exchanges are institutions that host a marketplace for both buyers and sellers to come together to trade shares with one another. The transactions can only take place during business hours. Each country has its own stock exchange. The largest stock exchange, in terms of the value of companies listed, is the NYSE (New York Stock Exchange). A company must meet a certain set of requirements to be listed on a stock exchange.
Liquidity: The liquidity of an asset is the ease with which it can be converted into readily available cash. The most liquid asset is cash itself, as it can be exchanged for cash or any asset easily. Stocks on major exchanges are generally liquid in nature, so you can buy and sell them, at your time and price. You can also cash it, whenever you want. An example of an illiquid asset is a house, as you cannot easily convert it into cash. You would need to find a buyer who is ready to buy the house at your price, and the whole transaction could take a while to complete.
Market index: It is a hypothetical portfolio of stocks, that represents a section of the stock market. If you’ve heard people talking about how the ‘market’ is performing, they are talking about the index. Because often people see indexes as a representation of the stock market as a whole. The index tracks the prices of a set of stocks. The stocks might be selected based on their market cap, industry, or revenue. S&P 500 is the most followed index in the world. It tracks the largest 500 companies in the US, by market capitalization. The Dow Jones industrial average (DJIA) is another popular index in the US.
Bull market: A bull market is a market that is moving upward, that is rising in value. When someone says they are ‘bullish’ about a stock, it means they expect the stock price to rise.
Bear market: A bear market is a market that is declining 20% or greater. But investors generally use the term to describe a market that is declining in value. Also, when someone says they are ‘bearish’ about a particular stock, it means they think the stock will go down. A bear market generally occurs every six years or so.
Initial public offering (IPO): You might have heard of a company going public. That’s an IPO. It is when the shares of a company are made available for the public to buy for the first time. Once a private company becomes a publicly listed company through IPO, the shares will be available in the public market for investors to trade.
Capital gains: There are two ways by which investors hope to make a profit out of their investments. Capital gain is one of them. Also known as capital appreciation, it is the rise in the value of an asset (stocks) over a period of time. This allows investors to sell the stocks for a price that is higher than the price they bought the stocks for.
Dividend: This is the second way through which investors make a profit out of their investments. Dividends are cash payouts by companies at specific intervals, quarterly or annually (mostly quarterly). This is a way for companies to show their appreciation towards their shareholders (anyone who holds at least a stock share of the company). Shareholders will be paid a certain amount for each share they own. Dividends are an important part of investing as it provides an active income from your investments; you’re being paid just for holding the stocks. It is important to note that not all companies pay a dividend, particularly, younger and fast-growing companies.
Trading: Trading is the process of buying and selling stocks. Mostly, it is used synonymously with day trading. Day trading is the process of buying and selling stocks within a day. Day traders buy huge quantities of shares and hope to sell them within the day for a higher price than they bought them for, and pocket the difference. Day trading is a high-risk option, mainly due to the limited time frame, as they must sell the shares by the end of market hours.
Volatility: It is the degree to which the market fluctuates up and down. When someone says the market is moving up and down, they’re most likely referring to the rise and fall of the market index. The increase and decrease in stock prices are what cause these fluctuations. A volatile market will see constant fluctuations, as the stock prices will move up and down. The more frequent the fluctuations, the more volatile the market. It is to be noted that volatility is a short-term element and in the long term, the market tends to rise in value.
Stockbrokers: A stockbroker is an individual that buys and sells stocks on your behalf. They act as an intermediary between you and the buyer or seller. They often charge a commission for their services.
Full-service brokerages: Full-service brokerages are institutions that act as an intermediary between buyers and sellers and facilitate the transactions of stocks. They also provide services such as financial planning and money management. They often charge comparatively high fees.
Discount brokerages: These are generally online trading platforms that facilitate the buying and selling of shares. Unlike traditional brokerages, they only charge a small amount as commission. Some discount brokers provide zero-commission trades which means you don’t need to pay anything to buy or sell shares. Popular discount brokers include TD Ameritrade, Charles Schwab, E-Trade, etc.
Brokerage Account: You need a brokerage account to buy and sell stocks, bonds, funds, etc. It works similarly to a bank account. This is an account you open either with a full-service brokerage or a discount brokerage. This account will hold all your current investments. On opening a brokerage account, you can electronically transfer funds to the brokerage account, and use the fund to buy stocks. On placing orders to buy stocks, the brokerage will execute the order on your behalf, and deliver the stocks to your account.
Rate of return: It is the net gain or loss of an investment over a period of time that is expressed as a percentage of the initial investment. In other words, it is a measure of the profit or loss you have made relative to the money you invested. If you bought a stock at $50 a share and held it for a year, and the price rises to $80 in that time, you would have made a profit of $30 a share. If you divide the profit, by the initial investment, and multiply by 100 you get the rate of return of your investment. In this case that would be 30/50 multiplied by 100, which is 60. Hence for an investment of $50, you had a rate of return of 60% in a year.
Intrinsic value: Intrinsic value is a measure of how much an asset is worth. Intrinsic value takes into account tangible and intangible factors of the assets, to determine a value that accurately reflects its worth. In the case of stocks, investors study the fundamentals of the company; financial statements, corporate performance, management, industry, etc. to determine its intrinsic value. More often, it is different from its market value, as market value is more about how the stock market perceives the stock, which might take into account factors such as supply and demand from investors.
Ways of investing; terms you should know
Apart from individual stocks, you have plenty of ways you can invest in the stock market. From a low-cost index fund to a financial derivative, here’s everything you need to know.
ETFs: Exchange-traded funds (ETFs) are funds that track a market index, sector, commodity, or asset. But you can buy a share of an ETF, just like you buy a stock. Let’s say you want to invest in marijuana companies because you know they will make a lot of money. But you don’t know which marijuana company to buy nor have the time to research and study marijuana companies. So you can buy an ETF that holds shares of marijuana companies. Now, instead of one company, you have invested in several different marijuana companies.
Index fund: An Index fund is how you buy an index. Similar to ETFs, they track a particular index and attempt to mirror the performance of the underlying index (the index that it tracks), by buying shares of all the stocks in an index. Index funds are passively managed, which means there are no fund managers actively changing the holdings according to market conditions. Instead, the fund merely adopts the changes in the underlying index.
Mutual fund: Mutual fund is a fund that pools money from individual investors and invests in different assets like stocks, bonds, commodities, etc. A mutual fund is managed by finance professionals (generally referred to as Fund managers or Portfolio managers), who actively make changes in the investments in order to ‘beat’ the market. However, mutual funds tend to underperform the market in the long run. A 2018 report from S&P Dow Jones Indices suggests that more than 92 percent of active mutual fund managers in large companies were unable to beat the market over a 15-year period.
Hedge fund: Hedge funds pool money from rich investors. I say rich because there is a minimum investment amount, that is comparatively higher. Hedge funds use the pooled money to engage in a wide range of investment activities. They often use borrowed money to amplify their returns. Besides, the fund managers charge huge amounts of money in management fees. Due to the risky nature of hedge funds, the government has put in a number of regulations, which makes it hard for a regular investor to invest in hedge funds.
Expense ratio: It is a measure of how much of a fund’s assets will be used for administrative and operating expenses. Basically, it is the percentage of your money you need to pay when you choose to invest in a fund. For example, if you invest $10,000 in a fund with an expense ratio of 0.5%, you would need to pay $50 annually for the associated expenses. Generally, index funds and ETFs have a lower expense ratio compared to mutual funds, as index funds are passively managed. Remember, the higher the expense ratio, the less the returns.
Bonds: A bond is similar to a loan. When you invest in a bond, you’re lending money to the government or a company, with a promise that you’ll be returned the principal amount along with interest. The time period for which you’re lending money is the maturity date, on which the bond is matured and the borrower should give you back the money with interest. There are different types of bonds including Treasury bonds issued by the government and bonds issued by companies, known as corporate bonds. Bonds are generally considered to be a ‘safe’ investment as it promises a fixed rate of return.
Commodities: A commodity is a raw material that can be bought and sold. Commodities are generally categorized into two; hard and soft. Hard commodities are those which are mined or extracted; gold, oil, rubber, etc. Soft commodities are agricultural products such as coffee, wheat, sugar, etc. Investing in commodities can be done either through buying shares of companies that are directly involved in the commodities or by investing in commodity futures contracts.
Derivatives: A derivative is a financial security that derives its value from an underlying asset. The underlying asset could be stocks, bonds, commodities, etc. Derivatives are generally used to mitigate risk. Derivatives derive their price from fluctuations in the underlying asset. Consider an oil company that agrees to buy 100 barrels of oil at $50 a barrel from a supplier. Here the oil, a commodity, is the underlying asset and the futures contract between the oil company and the supplier is the derivative.
Asset management company (AMC): It is an institution that invests capital on behalf of its clients. They generally manage everything from high-net-worth individual portfolios to hedge funds and pension funds. They often create mutual funds and ETFs to cater to individual investors. Some famous asset management companies in the US include Vanguard Group and Fidelity Investments. AMCs charge their client a percentage of the assets the company manages for the client – assets under management (AUM).
Alternative assets: These are assets that do not come under the traditional asset classes like stocks, bonds, or commodities. It could be collectibles, antiques, rare stamps, or coins. These assets are traded infrequently and hence are illiquid. However, cryptocurrencies are another alternative asset that has high liquidity. These are digital currencies that can be used to make purchases. Bitcoin, the most popular cryptocurrency, is currently traded at $60,792.00 per coin.
Risk Management: It is the process of understanding, analyzing, and mitigating potential risks to your investment portfolio. As every investment involves a certain amount of risk, investors perform risk management to reduce risk as per their level of tolerance. Generally, investors do this by diversifying their assets, choosing stocks that are less volatile (blue-chip stocks), etc.
Asset allocation: It is the process of allocating your assets according to your risk tolerance (a measure of how much risk you can take on), investment goals, and time horizon (how long do you plan to stay invested). This is done to balance risk and reward by focusing on the overall portfolio. Diversifying assets across different asset classes, different geographies, companies of different scales (smallcap, mid-cap, and large-cap) is a method that is commonly used in asset allocation.
Financial advisor: A financial advisor is a professional who provides financial advisory services to their clients for compensation. Their services generally include financial planning, investment management, and tax planning. After understanding the client’s financial situation and goals, a financial advisor devises an investment strategy for their client that is tailored to their investment goals and horizon. Basically, they tell their clients what, when, and where to invest.
Investment terminology; companies
These are investment terms that are associated with a company and its business. Having a basic understanding of these terms will help you in finding the best company (stock) to invest in.
Outstanding shares: These are stock shares of a company that is currently held by all shareholders, including shares held by institutional investors and company insiders. Outstanding shares are used to calculate the market value of a company referred to as market capitalization.
Market capitalization: Commonly referred to as a market cap, it is a measure of how valuable a company is, according to the stock market. Market cap is the price of one share multiplied by the number of outstanding shares. Consider a company whose stock price is $100 per share, and it has 10 million shares outstanding, which means the company has a market cap of $1 billion. As per the market cap, companies are categorized into small-cap ($300 million to $2 billion), mid-cap ($2 billion to $20 billion), and large-cap ($20 billion to $200 billion), mega-cap ($200 billion or more).
Enterprise value: While market cap is the value of a company as seen by the stock market, enterprise value is the total value of all assets and liabilities of the company. It is basically what you need to pay if you wanted to buy the company in whole and have 100% ownership. Apart from the market cap, it also takes preferred stock (a special class of stock that offers benefits such as larger dividends), debt, and cash reserves into the account. To calculate the enterprise value, add a market cap, preferred stock, and outstanding debt together and subtract cash and cash equivalents found on the balance sheet. You subtract the cash because once you acquire the company, the cash is yours.
P/E ratio: Price-to-earnings (P/E) ratio is the ratio of the company’s share price to its earnings per share (EPS). Earnings per share is the total profit of a company (earnings) divided by the number of shares outstanding. If a stock trades at $50 per share, and its EPS is $5, then its P/E ratio is 10.
P/B ratio: Price-to-book (P/B) ratio is the ratio of a company’s share price to its book value – which is the total value of all assets of the company. Typically, a ratio less than one is ideal. However, many newer companies (especially software/technology companies) have a higher P/B ratio, as more of their value derives from intangible assets which cannot be quantified on their balance sheet. Because if the stock price is lower than the book value of the company, the stock might be undervalued.
Free cash flow: Free cash flow is the cash left after paying for all the expenses including operating expenses and capital expenditures – which are used to purchase, maintain, or upgrade physical assets. If a company is generating free cash flow, it means the company has plenty of cash to invest in future business, pay off debts, or pay dividends to shareholders.
EBITDA: EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a measure of the overall profitability of a company and often used as an alternative for net income. EBITDA can be calculated by adding net income, interests, taxes together with depreciation and amortization expenses.
Dividend yield: Dividend yield is a measure of how much a company pays its shareholders in dividends each year, relative to its stock price. If a company’s stock trades at $100, and they pay a dividend of $5 per share, then the dividend yield would be 5%. It is important to note that a higher dividend yield is not always ideal, as it might be a result of a decline in the stock price. While looking at dividend yield, you should ideally check whether the company has consistently paid dividends in the past.
EV/EBITDA: EV/EBITDA ratio is enterprise value (EV) divided by earnings before interests, taxes, depreciation, and amortization (EBITDA). It is also known as EV multiple. The ratio is used to compare the value of a company including money it owes, to its earnings less non-cash expenses.
Income statement: An income statement is a financial statement that shows you the financial performance of a company over a period of time – a quarter or a year. It is one of the three most commonly used financial statements (the other two being balance sheet and cash flow statement) that conveys the financial position of the company. The income statement shows you how profitable the company was during the reporting period. It shows the revenue, expenses, and profit of the company during the period.
Balance sheet: A balance sheet is a financial statement that basically shows what the company owns and owes, along with the amount invested by shareholders. The balance sheet reports the company’s assets, liabilities, and shareholders’ equities at a given point in time. Investors look at balance sheets to derive various financial ratios to understand the financial position of the company.
Cash flow statement: A cash flow statement is a financial statement that reports the movement of cash into and out of the company during a given period of time. It gives you an idea, of where the money comes from and how it is being used. Free cash flow in the cash flow statement, is a measure you can use to determine the profitability of a company. Because the more free cash the company has left, that can be used to expand the business, or return to shareholders, after paying dividends and paying off debt.
Form 10-K: It is a detailed report published annually by every public company. The Securities and Exchange Commission (SEC) requires every publicly listed company to publicly disclose all the information that surrounds the company, including the recent financial performance and the risks faced by the business. It is much more detailed than an annual report, which is a report that is sent to all the shareholders before the annual meeting. You can find all the information about the company in a Form 10-K; from how the company makes and spends money to the risks they currently face, everything you need to know about the company can be found in Form 10-K.
Fundamental analysis: Fundamental analysis is the process of studying business fundamentals and financial statements to determine the intrinsic value or ‘fair market value’ of a company. This is done to understand whether the stock is undervalued or overpriced. Investors and analysts look at the financial position of the company and other business fundamentals like overall industry, competitive advantage, management of the company, business model, etc. for fundamental analysis.
Brokerage terminology: buying a stock
These are investment terms you should know before you buy your first stock. It starts with the type of order you should choose when you buy a stock. Generally, there are two options; market and limit order.
Market order: A market order is selected when you want to get the stock as soon as possible for the current price. Market order puts no parameters on the share price, so the order will be fulfilled immediately. Since price fluctuations happen all the time, there might be a slight difference between the price you saw when you selected the stocks, and the price you paid. This price difference is negligible for an investor who plans to buy and hold these stocks for a long time. Investors generally use market orders as their priority is the completion of the trade.
Limit order: Limit order focuses on the price at which the trade should be executed. You have more control over the price with this order. Let’s say the stock Brookfield Asset Management (BAM) is trading at $50 per share. But you want to buy the shares at $48. With a limit order, you can set the price at $48, and the order will only be completed, once the price drops to $48 from $50. If you’re selling, you can set the price above the current price, say $52, and the trade will only complete once the price climbs to $52. Limit orders are mainly used by day traders, for whom even the slight fluctuations in the share price matter a lot.
Stop order: This is an order to buy or sell a stock, where you can specify a price, and on reaching the price, the trade will be executed at the next available price. The price you specify is referred to as the ‘stop price’. Consider Dell (DELL) trading at $100. If you think DELL is going to go up, but you want to buy it only, if and when it crosses $105, you can set the stop price to $105. Once it crosses $105, the order will be executed as a market order, which means the order will be fulfilled immediately at the available price. If you’re selling a stock, the same can be done, only you’ll set a price lower than the last traded price, and on crossing the price, the stock will be sold immediately. This is often used by investors to mitigate loss, hence it is referred to as a stop-loss order.
Trailing stop order: Similar to a stop-loss order, this type of order can be used to buy or sell a stock, the difference is the stop price moves when the stock price moves in your favor, and it stays at the stop price when the stock price moves against you. To explain this better, imagine you’re selling Dell (DELL) trading at $100, and you set trailing stop at $99. If the stock price goes up to 101, the trailing stop would move to $100. However, if the stock price lowers to $100.50, the trailing stop won’t move. If the price drops again to $100, the order will be converted to a market order and fulfilled immediately. A trailing stop order is mainly used by day traders as it helps them to lock in the profits while protecting them from any losses.
Bid and ask: Every time you want to buy or sell a stock, you can find the bid and ask the price for that particular stock. The bid price is the maximum amount a buyer is willing to pay for the stock share. The ask price is the lowest price at which a seller is willing to sell the stock share.
Margin: Margin refers to the amount of money you borrow from your brokerage firm to buy an asset. It is similar to availing a bank loan, only here, your investment portfolio will be the collateral, and your brokerage is the lender. Just like a bank loan, you’ll need to pay interest for the borrowed money. Leverage incurred from margin can amplify your losses and could lead to the brokerage acquiring your portfolio, without prior notification.
Here you have terms that are related to investing for retirement.
Traditional IRA: It is a traditional Individual retirement account where you can save money for retirement. Anyone over the age of 18 with a job can open a retirement account, however, some retirement accounts have specific requirements. IRA offers tax advantages, and traditional IRAs are tax-deductible. That means the contributions you make to these accounts won’t be considered as your taxable income. If you earn $100,000 a year and contribute $20,000 to your IRA, you’ll only be taxed for $80,000. With a traditional IRA, you’ll only be taxed when you start withdrawing money from your IRA account.
401(k): This is a common retirement account offered by many employers to their employees. Similar to traditional IRA, contributions to 401(k) are also tax-deductible. Also, it allows you to invest money in stocks or mutual funds. Employers often match contributions, with up to 50%. The money is only taxed when you start withdrawing it, which you can only access when you are 59.5 years old.
Roth IRA: Roth IRA is a type of retirement account that offers some great tax benefits. Unlike traditional retirement accounts, you need not pay taxes on the money you withdraw from the Roth IRA. Also, the profit you make from the investments held within the Roth IRA, is tax-free, even when you withdraw those profits. You can invest in stocks, bonds, and other securities within the Roth IRA. Note that the contributions you make to the IRA are post-tax, which means you are already paying taxes for that money.
You’re right. Investing can be quite complicated at times. But we’ve got you. Understand all these terms, and you’re off to a great start. Even if you don’t understand everything in the beginning, it’s fine. Start small, buy your first stock, learn a little every day, and you’ll be good.
If you’re still not sure, whether or not should you start, it might be because you’re missing an investment strategy. Maybe you should try value investing. It is an approach where you buy stocks that are currently trading for less than their intrinsic value. Legendary investors like Warren Buffett used the value investing strategy that made him one of the richest men in the world. Learn more about value investing with our Amazon Bestseller The 8-Step Beginner’s Guide to Value Investing.
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