Diversification: Diversification is the financial industry’s equivalent of “don’t put all your eggs in one basket.” When you invest, you want to put your money in a few different areas to reduce risk. You don’t want to have all your money invested in tech companies, for example, only to lose all of it in another dot com crash. (Bubbles can happen in any industry, even tulip bulb-buying.)
Asset allocation: A diversification strategy in which you spread your money across different investment types, called asset classes. How much you put in each class depends on your goals, risk tolerance, and timeline. The three basic asset classes are:
Cash: Yes, we’re defining cash. But when it comes to investing it can mean not just physical money (your coins and paper bills), but also money in your savings account, a money market account, and government bonds that can easily and quickly be turned into cash.
Bonds: When you buy a bond—whether it’s a corporate, US government, or municipal bond—you’re essentially loaning money to an organization or government, with interest. Bonds come with a defined term or maturity (when the bond can be redeemed). US Treasury bonds, for example, are used by the government to pay off federal debt. They pay a fixed interest rate every six months until they mature (from 10 to 30 years). Some bonds are considered safe investments, compared to junk bonds that have higher risk but greater potential payout.
Stocks: A stock is a share of ownership in a public or private company. When you buy stock in a company, you become a shareholder and when the company does well, your investment goes up. When it does poorly, however, so does your stock investment.
Bear market and bull market: “Bear market” and “bull market” are both terms to describe the stock market and investing. They’re easy to tell apart when you consider the animals’ characteristics. In a bullish market, everything’s moving forward: investors are confident making a lot of buys, more companies are entering the stock market, and more money is being invested in the stock market overall (technically, a bull market means the market has risen in value by at least 20%). In a bear market, investors pull back (like bears hibernating). Prices start to hover and go down, and people wait and see more before investing additional money in stocks and bonds.
Why you need to know this: These are good terms to know, but not really ones to base your investment strategy on. After all, it’s often hard to tell when we’re in a bear or bull market, even for the experts. However, knowing these terms will help you understand when people are talking about market conditions or when everyone is feeling optimistic (bullish) or pessimistic (bearish)—and keep you from being swept up with the crowd.
Capital gains and losses: If you sell something for more than you spent to acquire it, that’s a capital gain. If you sell it for less than your original purchase price, it’s a capital loss. The IRS taxes capital gains but lets you deduct capital losses on your taxes. These profits and losses are usually associated with investments, such as stocks and bonds, but they also include property, such as real estate and even jewelry or art. See how capital gains tax works on How Stuff Works.
Compound interest: You know how a lie just leads to another lie and the problem just multiplies exponentially? That’s pretty much how compound interest works. Say you make a $100 investment that goes up 10% one year, or $10. Its value is now $110. The next year, it goes up another 10%—but this time, that 10% equals $11, since its value was higher. Your investment is growing at a faster rate each year because of the previous interest.
Dividends: A dividend is a portion of a company’s profits that they pay out to their shareholders. They’re usually paid quarterly. I bought one share of stock in The Walt Disney Company when my daughter was born, and every quarter we get a check for something like $1.86. It’s regular, taxable income, although we could reinvest it and buy more shares.
Dollar-cost averaging: Let’s say that every paycheck, you put $100 into your retirement account, buying the same mutual funds or stocks. This is an example of dollar-cost averaging, a strategy where you put a set amount of money towards an investment regardless of the share price. When share prices are low, you’ll buy more shares, when prices are high, you’ll buy fewer shares. Instead of trying to “buy low and sell high”, which is risky, you stick to a regular investment plan that takes emotions out of the equation. You can just set it and forget it (for the most part).
Why you need to know this: This is what most people do when they invest in their 401(k) or other retirement plan—they automatically buy however many shares of funds or stocks they can, based on their set contribution amount. It’s a smart investment strategy if you’re investing over time, though it’s not as ideal if you have a large sum of money to invest (like if you just won the lottery).
Mutual fund: A mutual fund is a collection of stocks, bonds, and/or other assets, managed by an investment company, such as Vanguard or Fidelity Investments. When you invest in a mutual fund, your money is pooled together with other investors, and the investment company buys and trades assets according to the mutual fund’s goals, such as generating income from dividends or interest (income funds are great if you’re nearing retirement). You’ll find these stated goals in the fund’s prospectus.Mutual funds let you buy shares in hundreds of different companies without having to make or monitor all those investments in your portfolio. They’re easy to buy and sell, but also come with management costs (as explained in the expense ratio section).
Index funds are a particular type of mutual fund that tries to track or match a market index, such as the Standard & Poor’s 500 Index (S&P 500), which is based on the market value of 500 large, publicly traded US companies. Index funds typically have lower expense ratios because they’re not actively managed by people trying to beat the market. Instead, they merely try to mimic the stock market.
Why you need to know this: Mutual funds might be the easiest way to get started investing in stocks and/or bonds, but they’re not the only option, and you’ll still need to choose from hundreds if not thousands of mutual funds to invest in. Know the basics of mutual funds and how they compare to similar ETFs or exchange traded funds so you know where you’re money is going. Again, for most people, index funds are the best way to go because of their lower expense ratios.
Expense ratio: This is the annual fee a mutual fund charges for things like operating costs, management fees, administrative fees, and other fees incurred by the fund. If you have $10,000 invested in a fund, for example, the fund administrators could take out 2% every year for managing the fund (or $200!). Historically, funds with lower expense ratios (such asindex funds, see below) out-perform managed funds with higher expense ratios.
Net worth: Compound interest might be the most important financial concept to know, but net worth is your most important measurement of wealth. It’s the difference between your assets (savings and investments—things that are worth money) and your liabilities (your debts).
Why you need to know this: When you focus on and track your net worth, you’ll shift towards a more realistic view of how much you really have. It’s a better yardstick for your financial progress than your income. After all, if you have a lot of debt, you could have a six-digit salary and still be living paycheck to paycheck.