Basic Terms To Improve Your Investment IQ
Strategically investing your money can be a great way to build wealth over time. However, it comes with some inherent risks. To help you make smart investing decisions, we put together a list of 23 investment terms you should understand before getting started on your wealth building journey for 2023.
The investment world can be a tricky arena to navigate, especially in a bear market environment, but understanding these concepts can help you avoid unnecessary losses or expensive mistakes. This goes for any type of investing, whether in the bond, stock, or cryptocurrency market. Being an educated investor armed with the basics goes a long way in predicting possible market shifts and understanding how to maneuver when they do happen.
Let's jump in and take a look at these terms!
This first list of terms will set the foundation for your investment journey!
Cash is one of several investment vehicles available to savvy investors. It may refer to cash investment instruments such as bank notes, Federal Reserve notes, treasury bills, checkable deposits, and money market accounts; or it can refer to certificates of deposit (CDs) that represent a specific sum of money required on deposit for a fixed period of time in exchange for a fixed interest rate.
Cash gives the investor buying power along with the additional benefit of liquidity, meaning that investment funds can be accessed within a relatively short time frame without significant penalty. While some investment strategies focus on generating returns through investment instruments more than not, cash provides an important tool in any investment portfolio.
Investing involves the use of money to purchase some type of investment asset and the expectation of an income or profit from that investment. It is important for potential investors to understand their investment objectives, investment timeframe, and risk profile before making any decisions.
Financial education is critical for potential investors, as it helps them form a foundation on which they can become educated investors. The more informed an investor is about a chosen investment product, the better chance they have at achieving investment success. Better financial understanding can lead to sound investments that are tailored to meet individual investor needs and desires.
Being an educated investor is key to successful investing, and understanding Assets is an important part of that financial education.
An Asset is anything that has measurable value and can be converted into cash through buying or selling. These could include stocks, bonds, mutual funds, cryptocurrency, real estate investment trusts (REITs), foreign exchange rates, gold, and commodities. Investing in these Assets can help generate income, preserve capital or invest for growth over the long run.
To become a successful investor it's important to understand the risks and returns associated with each Asset class so you can build out a well-diversified investment portfolio tailored to your investment goals.
A prospectus is an important financial document that all investors should familiarize themselves with before making investment decisions. It is a type of offering statement that provides details about an investment, so having a thorough understanding is integral to investing wisely.
Educating yourself on the specifics of a discovery and investment opportunity outlined in the prospectus enables you to become an informed and educated investor who is best equipped to make sound investment choices. An investment advisor can help you understand the information presented in the prospectus to enable you to confidently proceed with your investment plan.
Investing exchanges represent a method of investing that provides the stock market, bond market, and commodities access for investors.
Through the stock market, one can purchase shares of stock in a company; through the bond market, an investor can take on a loan to an entity such as a government or corporation with the promise of interest payments; and through commodity markets, individual investors can participate in buying and selling contracts on commodities ranging from crude oil to gold and silver.
All these forms of investment provide potential diversification within any individual’s portfolio while offering different kinds of risk exposure. Investing exchanges are best utilized by taking advantage of their everyday operations, which makes stock trading fast, efficient, and cost-effective.
A well-rounded investment portfolio is the result of careful planning and a strategy built around your financial goals. It typically contains a mix of assets including stocks, bonds, commodities, real estate, and even cryptocurrency offerings.
The value of assets can fluctuate with market conditions and other external factors, so diversifying across different asset classes helps to reduce risk and increase the strength of your portfolio. The right stock mix and asset allocation for your portfolio can help you maximize returns, while also ensuring that you're prepared for any market downturn (such as a recession or down market).
Stocks can offer capital gains and dividends, and Commodities such as gold also provide a hedge against inflation. Cryptocurrencies have become popular for their potential for long-term capital gains if deemed right for your portfolio (Note: Cryptocurrency markets are currently unregulated). Bonds are fixed-income investments that offer more guaranteed returns with varying degrees of risk depending on the individual bond structure. Real Estate can offer assets with cash flow income. By taking stock of these options and forming an investment portfolio based on what works best for you, you will be poised to weather today's tough investment climate.
One of the most important terms to be familiar with as an investor is compound interest. Investing in a long-term portfolio can potentially generate returns that are compounded over time as your capital grows.
Compounding occurs when the amount of money you have invested earns its own return on top of what was already generated from your initial investment. This means that, over time, the value of your investment portfolio grows exponentially, delivering returns that can be significantly greater than if you had invested a single lump sum. Investing in low-risk assets with compounding interest may help guarantee steady and consistent returns over time.
» Did you know: At 30 years old Warren Buffet's net worth was only $1 Million
If you have not yet begun your investment journey, there is no time like the present to do so, no matter how small. This powerful tool can help you begin to create that nest egg.
Moving along from the basic terms above, let's move into Investing 101. Investing is making a bet on the future success of an asset, typically with the goal of achieving long-term capital gains or income from dividends. Investing requires careful analysis and a solid understanding of the risks associated with different investment products and strategies, so it is important to educate yourself before taking on any investments.
Bonds & Stock
When it comes to investing, stocks and bonds are two of the most common asset classes available.
Stocks are investment instruments that represent part ownership in a company and allow investors to benefit from stock market appreciation. On the other hand, bonds are debt instruments issued by companies, governments, and other organizations to borrow money.
When it comes to stock investing, there’s no one type of stock—tech stocks continue to have an edge, especially with Tesla dominating headlines these days and offering investors multiple growth opportunities. Bonds on the other hand provide security as they come with regular coupon payments and participants can set up a laddering strategy for long-term capital appreciation.
As investors decide which stock or bond to add to their portfolio, they should pay close attention to management performance, interest rates, financial trends & industry outlooks before committing any significant amount of capital.
Securities & Equities
Securities and equities are two other key terms to know when it comes to investing. Generally speaking, securities refer to financial assets, such as stocks and bonds, that may be traded on securities exchanges or in private transactions. Equities, on the other hand, represent ownership interests in a company, entitling investors to a part of any profits made by the business.
In addition to providing potential financial gains (or losses) through the value of the asset itself, securities can also provide individuals with periodic payments based on interest rates and/or dividends associated with them. It is important for prospective investors to research securities before making any investments to understand both their potential risks and rewards.
Price to earnings Ratio
The price-to-earning ratio is another important tool to use when investing. This ratio is a valuation metric that compares the relative value of a particular security or company, relative to the company’s earnings per share.
The formula to calculate P/E Ratio is;
P/E Ratio = Market Value Per Share/Earnings Per Share
There are two types of P/E ratio; Trailing P/E and Forward P/E. Trailing PE is calculated with the company’s most recent earnings, while Forward PE takes estimated earnings from the future.
Investors can use P/E ratio to compare various companies and determine whether investing in a particular company is a good idea. The higher the P/E ratio, the more expensive the company is relative to its expected earnings — and this could be an indication of an overvalued stock.
Cryptocurrency is an ever-evolving and rapidly growing new asset class. As its popularity has skyrocketed over the past decade, it is now one of the most widely discussed markets in the world.
The cryptocurrency market is significantly different than traditional investing, mainly due to its lack of regulation and comparable decentralization. Cryptocurrency prices are subject to extreme volatility so investors should be aware of the risks associated with cryptocurrency investing, including the potential for losses in a "bear" market, as the sector is now experiencing.
The brief history of the global cryptocurrency market shows growth from a measly $5+ billion in January of 2015 to a peak market capitalization of $3 trillion only 6 years later in November 2021, but has since fallen in the current bear market by over 70% down to $800 billion, as of January 2023.
Understanding the different types of cryptocurrencies, their use cases, and types of transactions is also important before entering this market. Experienced investors may consider capitalizing on this unique & wildly profitable market by researching cryptocurrency coins & understanding current & future market trends while managing risk appropriately.
Asset Allocation is the process of intelligently dividing investment funds between different asset classes, so as to find a balance between risk and return. Stocks are typically the most volatile investments, while real estate and commodities offer more diversification.
For investors looking to push the boundaries even further, Bitcoin and other cryptocurrencies are increasingly becoming viable options within a diversified portfolio. It's important to keep in mind that no two portfolios are identical – by assessing a range of factors such as time horizon, risk profile, financial objectives, and lifestyle preferences, investors can tailor their asset allocation accordingly.
An asset class refers to a group of investments that have similar characteristics and responses to economic factors. Stocks, real estate, cash, and even cryptocurrency are all part of different asset classes.
The top five asset class types are:
Equities (stocks): Equities represent ownership in a company, and their value is based on the performance of the company. A risk is that the company fails and investors lose their investments.
Fixed-income (bonds and debt instruments): Fixed-income investments represent borrowed money that is repaid with interest. A risk is that the borrower fails to repay the loan at maturity.
Cash equivalents: Investing in cash instruments such as money market funds provide an additional layer of safety, but often returns are low compared to other asset classes. A risk is inflation—when prices rise, the purchasing power of cash decreases.
Real estate: Investing in real estate can provide steady cash flow income and offers investors the ability to take advantage of potential tax savings. A risk is the lack of liquidity—it can take a long time to liquidate real estate assets.
Alternative investments: Investing in alternative asset classes such as commodities, cryptocurrency, and derivatives can help diversify a portfolio, but also carries greater risk than traditional investments.
» Important Note: Commodities and Real Estate are among the tangible assets that perform well during inflation and interest rate hikes.
Return on Investment
Return on Investment, or ROI, is a measure of how much profit an investment generates compared to the total cost of the investment. Investing in higher-yielding asset classes such as real estate and cryptocurrency typically provides a higher ROI than investing in lower-yielding assets like cash or fixed-income investments, but with additional risk.
Return On Investment = (Final value of investment (FVI) - Initial value of investment (IVI)/Cost of investment) x 100
ROI = (FVI - IVI/Cost of investment) x 100
It’s important to note that ROI is not only determined by the rate-of-return on an investment, but also by how long you hold the investment and whether or not it increases in value.
Capital Gains are a type of income that can be earned when investing in Stocks, Real Estate, or Bitcoin. It's defined as any profits made when the proceeds of an asset sale exceed its original purchase price.
Capital Gains can occur when an investor sells Stocks or cryptocurrency on the market at more money than they had paid initially to buy it. Similarly, selling property such as real estate at a higher price than the initial purchase would also generate Capital Gains for the seller. This is why many investors turn to Stocks and real estate for long-term growth or to speculate on potential rises in their value over time.
The largest drawback to capital gains is that the profits are subject to taxation. In Real Estate, for example, taxes paid on short-term capital gains could be as high as 37 percent (Owned less than 1 year), and long-term capital gains are taxed at 15 to 20 percent (Owned more than 1 year).
Generally speaking, diversification involves spreading assets across various sectors or markets and asset classes, such as stocks, commodities, real estate, and bitcoin. By having investments in a variety of different types of assets and services, you can help manage your risk by ensuring that you are not overly dependent on any single sector.
This can help to protect you from large drops associated with a market downturn or recession across a specific sector. Staying diversified is one way to take a more prudent approach to investing for maximum potential return on investment.
A dividend is a sum of money paid out by a company to shareholders on a regular basis, either quarterly or annually. It is essentially a portion of the profits that the company has earned over the course of the year and provides investors with an extra source of income in addition to any potential gains they might receive from selling stocks or shares.
It often serves as an incentive for individuals to invest in certain companies, as continuous dividend payments show that the business is profitable and stable - two key factors that are always taken into consideration by potential investors.
Exchange-Traded Fund (ETF)
Exchange-traded funds (ETFs) are index funds or baskets of stocks that track indexes, like the S&P 500. For those interested in getting more bang for their buck in terms of investing, ETFs can be an advantageous approach.
As opposed to holding stock in one single company, holders of ETFs get exposure to a wide range of company shares within particular sectors. This makes it easier financially to diversify risk and hedge your bets against volatility within the market – which can be especially beneficial if you’re starting out with limited capital and resources but have some knowledge on where to place investments.
Whether it's blue chips, tech stocks, or a diverse spectrum of startup companies through venture capital funds, ETFs are likely the best place to start if you’re looking for a simple way to invest and strategize long-term returns on your portfolio.
Risk Tolerance is an essential factor for any investor to consider when entering the market. It refers to the amount of financial loss an individual is willing and able to withstand for a potential return on investment-- the higher the risk, usually, the higher the gain, but with that comes increased odds of costlier failures.
Certain investments carry more risk than others: stocks are an example of a high-risk venture while owning cryptocurrency and commodities can be extremely volatile in comparison to safe-haven assets like real estate or bonds.
Stock options are a form of trading in which investors purchase the right to buy or sell a specific number of shares at an agreed upon price. By doing this, stock options give the investor the potential to take advantage of underlying assets with relatively low amounts of capital so they can speculate on its future price or hedge their portfolio against losses.
Market Capitalization, or Market Cap, is a critical factor to consider when investing. Market Cap is the total market value of a company’s outstanding shares and is calculated by multiplying the company’s share price by the number of its outstanding shares. Market Cap size can give investors an indication of how established and economically powerful a company is.
For example, Tesla's Market Cap as of January 2023 is $340 billion, making it the world’s largest car company in terms of Market Cap. Market cap analysis has increasingly become important for maintaining an efficient portfolio due to its ability to quickly provide information about a company’s economic health and success.
Liquidity is an important concept when it comes to investing. It refers to the ability of an asset or cash equivalent to be quickly converted into cash without a significant decrease in value. Generally, cash is considered the most liquid asset since it does not need to be converted and can be used for purchases immediately.
Stocks may become less liquid in times of market volatility as prices fluctuate, along with Real Estate, as it can become more difficult for investors to find buyers for their assets.
In order for an investor to maximize returns and minimize losses, understanding liquidity is essential as it can help create cash reserves for emergency scenarios and provide quick access to cash when opportunities arise.
Volatility measures the variation, or change in price over time in investment vehicles such as cash, fixed-income assets, stocks, cryptocurrency, and commodities. It reflects the degree of risk associated with investing in any given asset—volatile assets tend to carry more risk than less volatile ones.
A low-volatility example is cash; its stability over time has made cash a popular fixed-income asset because investors know they will not lose much (if any) money on cash investments. On the other hand, high-volatility assets such as cryptocurrency, stocks, and commodities are known for their potential to generate higher returns but come with a lot more risk.
5 other important market terms to Understand
The following terms relate to macro trends that can have an effect on multiple markets, and pitfalls to look out for.
A recession is defined as a period of significant economic contraction that lasts at least two quarters. It is a phenomenon that can lead to decreased demand, unemployment, and falling asset prices.
The effect a recession has on a portfolio will depend on the investment mix, but typically it is beneficial to have some exposure to safe-haven assets like bonds that can help cushion any losses.
Bull & Bear Markets
A down market is often referred to as a "Bear Market" while an up market is known as a "Bull Market". These terms can be used to indicate the overall performance of a stock or industry, but they also allude to change. A Bear Market suggests that investments are decreasing in value due to inflation, recession, or overall market volatility; while a Bull Market indicates that investments are increasing due to positive market sentiment.
Knowing these terms helps keep investors informed and on top of their portfolio's performance so they can either take advantage of a Bull Market or prepare for a Bear down.
Investment Psychology is an integral and often overlooked part of the investing process. It describes how investors react emotionally to down markets, economic recessions, and other sources of market volatility.
This emotional response can have tangible impacts on investment decisions over time, as it can lead to irrational decisions such as buying high and selling low. It's important for any investor with a long-term strategy to keep a close eye on their Investment Psychology and make sure it does not override financial logic when making important investing decisions.
Margin refers to a loan that allows an investor to purchase stocks and cryptocurrency without having the full amount of money required for the investment. The use of this kind of leverage with borrowed money can significantly increase profits, but it also magnifies potential losses due to volatility and downside risk.
Margin is taboo among legendary investors like Warren Buffet who advise against using leverage, due to the high risk. Investing with borrowed money should be avoided by beginning investors as it can lead to devastating losses in a down market.
Understanding these investment concepts is critical if you want to make informed decisions with your money. Investing can be lucrative, but it is important to understand the potential risks and how to navigate them in order to protect yourself.
With these 23 investment terms, you will have a better understanding of what to look for when evaluating investments and making decisions about where your hard-earned money should go. Investing doesn't have to be intimidating when you know the basics. Invest in yourself, and start smart investing today!
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Disclaimer: The information in this article is for educational and informational purposes only. It should not be considered financial or investment advice. The author cannot be held responsible for any losses. Please consult a licensed financial advisor before making any financial decisions. Follow me on social for more business content and Insights! Note: This article was originally published on my blog Assorted World on 01/03/23