Investing is a broad subject. Not everyone takes an interest in it, and yet few other topics play such an important role in one’s quality of life. Someone can practice superb habits when it comes to personal finance — making much more than they spend each year, retiring high-interest debt, establishing a sufficient emergency fund and so on — and still find themselves without enough money to retire if they never invest their savings.
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And so it’s only practical that everyone develops a basic fluency in the language of investing. While, like other domains, there’s more jargon in the field than you’d ever want to encounter, some terms are more important than others.
Here’s a rundown of 12 finance and investing terms that every investor should know. For a more comprehensive list of important investing and financial terms, see the U.S. News Investing Dictionary.
— Equity.
— Beta.
Compounding. The principle of compounding is hands-down one of the most important concepts in finance. With the exception of lottery winners, heirs and others who are independently wealthy, it’s the basic formula everyone must use to build wealth.
Compounding is what happens when you invest money, earn a return, and then reinvest both your principal and your return. In essence, it’s the principle of earning returns on previous returns, over and over again.
The powerful nature of compounding is perhaps best illustrated by way of example. Let’s say you have $1,000 that you invest in the stock market. In reality, returns aren’t the same every year, but the long-term average annual return is about 10.5%. If you earn 10.5% on your $1,000 every year for 40 years, without taking money out, you’ll have $54,261.42 at the end of that period. If, on the other hand, you’d taken your 10.5% out at the end of each year and not reinvested it, you’d finish with $5,200. That’s a compound annual growth rate of just 4.21%, barely good enough to keep up with inflation, which has averaged 3.2% over the long term.
Equity. There are tons of assets for investors to choose from, including stocks, bonds, real estate, commodities, cryptocurrencies and so on. But over many decades, the most rewarding asset class has been stocks, which are also known as equities.
The reason stocks are synonymous with equities is because owning a share of a particular company means you own equity in that company. And equity, in turn, simply means you have a certain ownership interest in a certain asset after all other claims are paid.
The term takes the same meaning in the phrase “home equity” — this is the homeowner’s real ownership stake in their home after liabilities like the mortgage are paid off.
Opportunity cost. Arguably one of the most important and underappreciated concepts in finance is the concept of opportunity cost. Simply put, this is the highest benefit that you miss out on by making one decision over another.
[READ: How to Invest in Stocks for Beginners]
In this broad sense, life is flooded with opportunity costs: The cost of choosing to go rafting, for example, is that you have to forgo time you could’ve spend studying, or spending time with your family or learning to cook.
In finance, however, opportunity cost is more quantifiable, and can be used to make better strategic decisions. Suppose you buy a 10-year Treasury yielding 3%, instead of an S&P 500 index fund, which averages about 10.5% returns over time. You’re deciding to pay a 7.5% annual fee, in some sense, for more certainty and less volatility.
Price-earnings ratio. One of the most prominently used investment metrics in the stock market is the price-earnings ratio, or P/E ratio. As with any ratio, it’s calculated by simple division: The company’s current price per share is divided by its earnings per share over the past year, or four quarters, of financial reports. (You can also calculate a forward-looking P/E ratio using estimates of a companies’ earnings in the next four quarters.)
But P/E ratios are almost worthless without context. Certain sectors and industries may tend to have higher P/E ratios, also known as “earnings multiples,” than others. A high multiple means investors are willing to pay more for each dollar of trailing earnings. This is often because such companies are growing more quickly than companies with lower multiples.
It’s also important to note that sometimes P/E ratios can occasionally be absurdly high if a company is just turning profitable, or had one very bad quarter recently. The P/E can also be very low if an earnings aberration causes a massive one-time profit and earnings are expected to dramatically decline.
Companies that are losing money do not have P/E ratios, because the ratio loses all meaning when the denominator is negative.
Competitive advantage. In investing, there’s the quantitative side — this one is full of ratios, growth rates, financial statement analysis and the like — and the qualitative side.
Qualitative considerations in investing can include things like the strength of a company’s brand, the experience of its leadership, its company culture and so on. A competitive advantage is a business advantage one company has over its rivals. Brand is a good example, which is why Coca-Cola Co. (ticker: KO) can sell its soda for meaningfully more than generic soda companies can.
Legendary investor Warren Buffett refers to sustainable competitive advantages as “moats” that keep competitors from chipping away at your business. Buffett’s Berkshire Hathaway Inc. (BRK.B, BRK.A) is a major owner of Coca-Cola stock.
Other examples of competitive advantages include things like network effects (the product or service becomes better as more and more people use it), natural monopolies with high barriers to entry, companies with cost advantages due to huge economies of scale or geographic advantages, and patents that give companies protected legal monopolies for a given length of time.
Exchange-traded fund (ETF). Exchange-traded funds, or ETFs, are a financial product that trades on a stock exchange that holds a bundle of securities. They’re similar to mutual funds, except they trade throughout the day, like stocks. Mutual fund trades, by contrast, can only be executed once daily, at the end of the trading day.
ETFs have become more popular over the years because they’re easy to trade and they offer a simple way to gain instant diversification. ETFs are themed and often follow a certain benchmark, sector or investing strategy. So instead of going out and buying every stock in the S&P 500 in different proportions, you can now just buy one of many different S&P 500 ETFs that will give you instant exposure to the S&P 500 for as much or as little money as you want.
[See: 7 Best ETFs to Buy Now.]
ETFs almost always charge “expense ratios” for this convenience. For benchmark-tracking ETFs, these fees are extremely minimal and have declined over time, with many charging 0.1% or less per year. In recent years, some companies like Fidelity have begun offering zero-fee ETFs if you hold your assets with them.
Debt-to-equity ratio. Another investment metric, the debt-to-equity ratio, is measured by dividing a company’s outstanding debt by the value of its shareholder equity.
This gives investors a loose idea of the financial condition of a given company and how that company would fare if business were to worsen. As with most investment ratios, a company’s debt-to-equity ratio is more useful when considered alongside industry and historical averages.
In general, lower debt-to-equity ratios indicate financial health, with a ratio below 1 considered a good guideline. That said, companies can juice return on equity by taking on more debt, which can often be one reason to use more debt financing.
Beta. Beta is a measure of how volatile a given stock is compared to the stock market at large. The stock market in this case is considered to be the S&P 500.
A beta of 1 means the stock moves perfectly in lockstep with the S&P 500; it’s quite rare for a stock to have this beta, although S&P 500 ETFs would be expected to have betas of very close to 1. Stocks that are less volatile than the market have betas between zero and 1, while stocks that are more volatile than the market have betas higher than 1.
Generally speaking, lower-beta stocks are preferable when investors are defensive or preparing for a bear market, while higher-beta stocks are preferable to own in bull markets, as gains for these more volatile stocks will often be greater than the index’s gain.
One weakness of this metric is that it uses previous price movements in its calculation, which is not always indicative of how prices will move in comparison to the market in the future.
Interest rate. Interest rates are the costs charged to a borrower for taking out a loan. Homeowners will be all too familiar with interest rates, as mortgage statements show how much of each monthly payment is being applied to interest versus the principal amount of the loan.
Banks have to charge interest rates to make money, and to compensate for the time value of money and for the risk of making a loan. Riskier loans tend to carry higher interest rates.
The most commonly cited interest rate is probably the federal funds rate, which is set by the U.S. Federal Reserve and influences almost all other interest rates. By raising interest rates, the Federal Reserve can make it more expensive for banks, businesses and individuals to borrow, thereby slowing economic expansion. Conversely, lowering interest rates can help boost loans, investment and economic activity.
Federal Reserve Bank. This is the central bank of the United States, responsible for monetary policy.
Not only does the Fed regulate large banks, but it also sets benchmark interest rates and can buy and sell huge amounts of U.S. Treasurys to increase or decrease the money supply. It can create money out of thin air.
The Federal Reserve was formed by an act of Congress in 1913 and operates independently from other government agencies. Members of the Federal Reserve Board of Governors are appointed by the president and confirmed by the Senate.
The Fed was given two broad mandates: to maximize employment and to achieve stable prices. Understanding which way the Fed is taking monetary policy is very important for all kinds of investors, as it can affect where the economy is going next and the future cost of debt.
Index fund. An index fund is an ETF or mutual fund that tracks the performance of a particular market index.
Low-cost index funds are a favorite of passive investors, and long-term buy-and-hold investors. Decades of research has routinely shown that most folks who actively invest in an attempt to beat the market fail to do so.
Reaching that realization, Jack Bogle, the founder of Vanguard, created the first index fund in 1976. The fund still exists, and is known as the Vanguard 500 Index Fund (VFINX).
Capital gain. Capital gains are simply the amount by which capital assets — including stocks, real estate, bonds and other collectible items — advance over time. Capital gains are important because when you sell one of these assets for a gain, Uncle Sam will be there with his hand out, looking for a cut.
The capital gains tax rate itself will depend on your tax bracket, but the rate on long-term capital gains is advantageous, in that it will be lower than your tax rate on your ordinary income. Long-term capital gains are incurred on holding that are sold for a profit after holding them for at least a year.
Short-term capital gains are typically taxed as ordinary income.
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12 Terms Every Investor Needs to Know originally appeared on usnews.com
