Chloe’s Common Sense:
Investing Terms You Need to Know
Here are Chloe’s favorite and most commonly-used investing terms. We defined them in plain and simple English so they’re easy enough for any beginner investor – and their best friend – to understand.
Asset Allocation: The method of dividing your an investment portfolio among different asset categories, like stocks, bonds, real estate and cash. Determining which asset mix – and how much of each – to hold in your portfolio depends on your life situation. That usually hinges on two factors: what is your time horizon (the expected number of months, years, or even decades you ‘ll be investing to achieve a certain financial goal); and what’s your ability to tolerate risk. By investing in more than one asset category, you’ll reduce the risk that you’ll lose money, you’re your portfolio’s overall returns will have a smoother ride.
“Blue Chip” stock: The nickname for a stock that is thought to be safe, in excellent financial shape and considered a leader in its industry. Blue Chips usually make good profits and pay out dividends to shareholders. A good time to buy them is when the overall stock market is taking a beating, because Blue Chips usually rebound as fast as, or even quicker the market on an upswing. A few examples of Blue Chips are Coca-Cola, Johnson & Johnson, Proctor & Gamble, and Berkshire Hathaway – all favorites of renowned investor Warren Buffett.
Compounding Interest: This means that interest is calculated not only on the initial amount of money you invest with at the beginning, but also on the accumulated interest accrued over the period of time your money is invested for. Say you invest $5,000 for two years, the interest rate is 10 percent, and interest is compounded yearly. At the end of the first year, your interest would be $500 ($5,000 multiplied by 10 percent). In the second year, the interest rate of 10 percent is applied not only to the $5,000 but also to that $500 interest of the first year. So in the second year, the interest would be $5,500 multiplied by 10 percent, or $550.
Diversification: A technique for lowering your investment risk by putting a wide variety of stocks, bonds, mutual funds and other securities in your portfolio. This reduces the impact any one topsy-turvy investment will have on its overall financial performance. So along with your blue-chip stocks, you can add some safe bonds and mix them with a higher-risk small-cap stock mutual fund. Also be sure to vary your securities by industry so that not everything is linked to real estate, banks or another shaky area.
Dividend: The distribution of the post-tax profit that a public corporation makes and gives to its shareholders. This means that for every share you own of a company, you are paid a portion of its earnings, usually four times a year. If the annual dividend per share is 20 cents, you’ll receive a check for 5 cents, multiplied by the number of shares you own. That may not seem like a lot, but you can use that money to amass more shares – and money – over the years.
Dollar-Cost Averaging: The strategy of investing a fixed amount of money at regular intervals over a long period of time. Open an investment account to buy a mutual fund or individual stocks, and invest a regular amount every single month (some stock brokerage firms and fund companies let you invest as little as $50 a month). When shares of the stock or fund you’re buying fall in price, you’re actually buying more of those shares. When the shares rise in price, you are buying fewer of those shares. But over time, the number of shares that you purchase averages out.
401(k): A type of company pension plan in which your employer makes pre-defined contributions for you, but the final amount of retirement funds you receive depends on the investment’s performance. It’s the way most companies are now structuring their pension plans — putting the financial responsibility on your shoulders. However, a 401(k) is the biggest employee benefit that you should take advantage of — and learn about – especially if your company offers matching . Besides learning what type of mutual funds to place in your 401(k), you also need to know what fees you’re paying for the plan.
Index Fund: This type of investment offers instant diversification at the lowest possible cost. The fund aims to achieve the same return as a particular market index, like the S&P 500 or the Wilshire 5000 Total Market Index. While the index fund will rise or fall at the same time that the market index it’s tracking goes up or down, owning that portfolio of stocks will give you broad diversification, and you won’t need to spend a lot of money or time managing it.
IRA: An Individual Retirement Account lets you save for retirement by putting aside up to $5,000 a year, usually in a mutual find of your choice. The final amount you take from it at retirement is either tax-deferred (a traditional IRA) or tax-free (a Roth IRA). Which type you choose depends on your financial situation both now and what you expect it to be at retirement. If you’re employed and have a company 401(k), put as much money as you can in that first – especially if your company offers a financial match – and then fund your IRA.
P/E ratio: As one factor used to valuate a stock, the P/E ratio is a company’s current share price (P = price) divided by its per-share earnings (E = earnings), usually from the last 12 months. So if a company is currently trading at $20 a share and its earnings over the last 12 months were $1.50 per share, the stock’s P/E ratio is 13.33 ($20/$1.50). Usually a high P/E means investors are expecting higher earnings growth from that company compared to companies with a lower P/E. However, it’s best to compare the P/E ratios of one company to others in the same industry.
Yield: A ratio that shows how much a company pays out in dividends each year relative to its share price. To find the dividend yield, divide the annual dividends per share by the price per share. If you want a regular stream of cash from your stock portfolio, it’s best to invest in stocks that pay relatively high, stable dividend yields.
Don’t live in the doghouse! Put 90 percent of your investment money into serious investments (low risk) and only 10 percent into fun investments (high risk). I learned this tip from my friend, John Bogle.