9 Basic (But Essential) Finance Definitions You Need To Know Today
Edward Farthing* is an NYC-based finance professional who consults for TFD and writes about the basics of understanding capital-M Money. If you have something you’d like him to write about, send it to firstname.lastname@example.org
Over and over again, young adults are reminded that investing is essential to achieving long-term financial prosperity. We’re told that we should should take the savings we’ve squirreled away (if we have any), and construct well-balanced portfolios to harness the spectacular wealth-generating power of the stock market. We should begin early to maximize the amount of time our investments have to grow. But who even knows how to begin? Who even knows what the stock market actually is, aside from a place where money flies around? Most of the “sensible,” but rather general, advice available rarely comes with any explanation of the basics, and “introductory” guides often seem to assume you’ve taken all the necessary college-level finance pre-reqs. Even beginner investment writing can seem incredibly opaque, but so much of finance is built from extremely simple blocks.
Sure, they’re stacked together to form amazingly complex systems, but understanding those simple blocks doesn’t require some advanced degree or decades of Wall Street experience. And the more you learn, the more you’re surprised by how easily the bigger ideas come into focus. So, below are explanations of a few very basic corporate finance and investing concepts that every investor should understand. The list is far from comprehensive — you’ll hardly be transformed into Warren Buffet after reading it — but it should provide you with some useful tools and help bolster your financial literacy. Because, really: it’s your money, and you owe it to yourself to understand what to do with it.
Capital represents the financial, physical, intangible, and human resources that companies utilize to generate value for their shareholders. Think of these resources as all of the tools a business has at its disposal. Companies often start with just one or more dedicated founders equipped with an idea, some savings, and maybe a small business loan. But as they grow, companies of all sizes require additional capital to fund, power, and expand their businesses, whether it’s a designer buying a new laptop, a restaurateur opening a second location, or Facebook buying WhatsApp. A company can finance these investments with internally generated cash, but businesses often look to raise additional financing from banks and investors in the form of debt and/or equity.
Debt is borrowed money that needs to be repaid, most often with interest. Debt can take the form of bank loans or bonds, and each has different features, such as
- The order in which they are repaid (seniority)
- What rights lenders have with respect to the assets of the borrower (security)
- Whether interest is fixed or variable
- Which legal provisions are included to protect lenders from adverse changes (covenants and other terms).
Much like in the case of consumer credit, the way these securities are structured, the features included, and the interest cost depend largely on the credit quality of the borrower and on current market conditions. Debt securities come with the promise that lenders would be paid back before stockholders –should the company seek bankruptcy protection — resulting in debt securities tending to be less risky and more stable than equity. However, in exchange for that preferential treatment, lenders receive what is typically a lower but more consistent return. While investing in individual debt instruments is an option, many retail investors (that’s you!) buy mutual funds or exchange-traded funds (ETFs) that invest in a diversified basket of bonds and/or loans (more on these funds below).
Equity represents ownership interest in a company and is the value available to shareholders after all debts are settled. (You own a piece of the pie, but you can only get to it after the lenders have taken back their slices.) It tends to be the most exciting part of investing for most people (think Shark Tank!), providing investors with the opportunity for their ownership stakes to become more valuable as their company expands, but equity is also riskier than debt, exposing investors to the risk that their investments will decrease in value if the company performs below expectations or, worse yet, that a bankruptcy wipes out their shares. Because debt securities represent fixed amounts that need to be paid back in full before equity holders receive anything, fluctuations in the total value of a firm generally impact the equity value, which can be seen in real-time in the stock market as investors buy and sell shares, driving their prices up and down throughout the day. But despite these fluctuations resulting in greater risk, they also mean that equity holders, rather than lenders, can capture increases in value. Though the stock market has had its ups and downs, it really pays to take the long view – over the past 86 years, the stock market has provided a tremendous total average return of more than 9% per year.
Primary Issuance occurs when a company offers shares directly to investors, such as through an IPO or follow-on equity offering, or raises debt financing from banks or investors in the capital markets. Primary markets tend to be much more volatile than secondary markets as underwriters try to assess demand and investors try to determine an appropriate value.
Secondary Trading happens when investors buy and sell securities on an exchange or “over the counter” through a broker-dealer. The vast majority of trading in the stock market happens between investors and not between investors and the companies themselves. When a retail investor purchases shares, they do so from another investor who no longer wants them. Through her research, the buyer may have developed a favorable view, while the seller could be cashing in gains, shifting around his investments, or cutting his losses after buying at a price driven high by some exciting news that turned out not to be all that groundbreaking after all. The point is, investors buy and sell all the time, and not just because they have a negative view and want to dump the stock on some unsuspecting buyer. In fact, a good number of buyers and sellers tells us that there is a healthy, or liquid, market for a company’s shares. This liquidity is an important for an investor because it means that when it’s time to sell, there’s likely someone willing to buy at a price determined by a lively auction process.
A Mutual Fund is a type of investment fund that is managed by a professional money manager who invests the fund’s capital in a diversified portfolio according to the objectives and strategies outlined by the fund. Mutual funds allow investors to invest in diversified portfolios that could be difficult to construct with a small amount of capital, and to also benefit from professional management. There’s quite a lot of debate about whether active or passive investment management is better, but a number of mutual funds managed by the likes of Janus, Guggenheim, Fidelity, and Pimco, have posted pretty impressive returns over the past ten years.
An Exchange Traded Funds (ETF) is an investment fund that typically tracks a stock or bond index, or the value of a commodity. Investors can buy and sell ETFs like they would common stocks. They have become incredibly popular due to their high daily liquidity and low costs. Unlike actively managed funds, ETFs typically have low expense due to their passive investment strategy and low turnover of securities in the fund.
Volatility measures how much the value of a stock or other security has fluctuated over time. A security having higher volatility means there is more uncertainty about its future value and a greater likelihood that an investor could lose some or all of his original investment – in other words, a riskier option. But investing is all about the tradeoff between risk and return, and securities with greater volatility typically offer the potential for bigger gains (or bigger losses), while more stable ones are less likely to provide much more than a modest return. Your job as an investor is to determine your risk tolerance and make sure that you are being adequately compensated for taking those risks. It might seem like a vague thing to determine, but consider factors such as your timeline, financial flexibility, and investment goals, and check out online resources like these risk tolerance questionnaires (here and here) and calculators for asset allocation by age (here). Only by understanding the kind of investor you are can you make the right kind of investments for yourself.
Diversification is about not putting all of your eggs in one basket. It’s a risk management strategy that seeks to decrease the volatility of a portfolio by including a number of securities that are not perfectly correlated with one another (i.e. they don’t move in tandem). With diversification, decreases in the price of some securities will often be offset by increases in others — but that’s not to say that a diversified portfolio will always generate positive returns overall. There are times that the market as a whole will be down, along with your portfolio, but the point of diversification is to moderate unsystemic risk, or the risk that poor performance of a single company or industry, or a downturn in any one region, destroys significant value in your portfolio.
Investing is a lifelong journey, and a skill that takes years of patience and research to develop. But financial literacy and the ability to make well-informed decisions about money is an incredibly important part of being independent, and something we should all strive for.
For further reading on financial concepts, I would highly recommend Investopedia. Also, try reading the Business & Finance sections of major newspapers like the New York Times, the Wall Street Journal, and the Financial Times to become more familiar with #trending topics in the world of business and finance.
*Not his real name, but he wishes it was.
Image via Flickr