Investing is a bit like navigating medical care, where the experts are often spouting terms that are as understandable as a foreign language.
In the case of investing, deciphering a few key terms is all it takes to become a successful and confident investor. We’ve compiled important key terms for you to become familiar with so you can better understand your investments.
There are three main types of assets. Stocks, bonds and cash. Asset allocation is the pie chart: how much you have in stocks, how much in bonds and how much in cash. Stocks historically provide the biggest gains over time, but that includes periods when they lose value. That’s where bonds and cash come in handy: they don’t earn as much as stocks over the long-term, but they also don’t suffer big losses. They will help you –and your portfolio—live through stock bear markets.
There is no single “right” allocation for investments. If your investing goal is decades away, you might want to keep as much as 80 percent in stocks and the rest in bonds and cash. As a general rule, as retirement nears, having 50 percent or more in bonds can make sense. There are free online “asset allocation” tools that can help you explore the right mix.
Asset allocation is one type of diversification; rather than having all your money in stocks or all your money in bonds/cash you are spreading your money among different assets. The next level of diversification is equally important: how many stocks and bonds you own. More is better. If you own just a handful of stocks, if one blows up, your portfolio is going to take a big hit.
If you own hundreds or thousands of stocks, that diversification will protect you from any single stock wreaking havoc. Mutual funds and Exchange Traded Funds (ETFs) make diversification easy. Each fund or ETF owns hundreds, and often thousands of individual stocks or bonds. For example a fund that tracks the S&P 500 stock index, will own shares in all 500 stocks. If you save for retirement through a workplace plan, you are no doubt investing in diversified fund portfolios.
You might also want to consider adding additional layers of diversification, such as investing in international markets, or mixing the size of the companies you invest in. Large multinational firms tend to get plenty of investor attention, but smaller companies have, over the long-term delivered stronger gains, though with a bumpier ride.
The expense ratio is the annual fee every fund and ETF charges you so you can be a shareholder. It is expressed as a percentage. Low-cost funds and ETFs can have expense ratios of 0.20 percent or lower. Others may charge more than one percent a year. Granted, that sounds like very small potatoes versus kind-of small potatoes. It is anything but! Investing in funds with lower expense ratios can give you tens of thousands of dollars more come retirement.
You won’t see the expense ratio deducted on your statements. It is a fee the fund and ETF shaves off from its gross return. For instance, if a fund has a 10 percent gross return, and the expense ratio is 0.50 percent, the return you will see in your statement, or reported online, will be 9.5 percent.
That said, it is easy to fund the expense ratio online. You can do a quick search of a specific fund or ETF and the “quote” page will likely report the expense ratio.
Index Fund vs. Active Fund
Mutual funds and ETFs come in two main flavors. Index funds, also referred to as passive funds, track the holdings of a target benchmark index, such as the S&P 500 stock index or the Bloomberg Barclays U.S. Aggregate bond index. Active funds have managers at the helm deciding what to own, buy and sell. An active fund may often look very different from an index fund; the manager may choose to own fewer stocks or bonds than the index, or own more/less of a certain type of stock or bond depending on the manager’s outlook.
Theoretically, investing with a talented manager would seem like a smart move, on the assumption that the manager knows how to pull the levers to earn more than an index fund that invests in the same sorts of assets.
Alas, numerous studies, covering decades, shows that most actively managed funds do worse than index funds. Moreover, an actively managed fund that has a great year, or two, or three, is typically not able to sustain its outperformance over the long term.
The big factor in why active investing tends to underperform passive index investing is fees. Namely, the expense ratio. It is common for many index funds to charge less than 0.10%, while active funds often charge 0.50% to 0.80% or more. That difference, compounded over time, adds up. Low costs are the secret sauce in investing. Index funds and ETFs typically have the lowest costs.
There are plenty more arcane investing terms. But if you nail asset allocation, diversification, expense ratios, and indexing you will have put in place the essential building blocks for investing success.
Disclaimer: the content presented in this article are for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.