With obvious exceptions like brain surgery and rocket science, concepts we might think are incredibly complicated from a distance are actually relatively straightforward once you understand the basic vocabulary. While investing can get extraordinarily complex, the principles that underpin modern investing are much simpler than you realize once a few common words and phrases are explained in layman’s terms.
Most people are familiar with stocks and bonds and generally what they involve, but when even slightly more complex instruments are used, the average person might quickly lose interest. Unfortunately, mutual funds often fall into that category even though they are, by far, the most popular form of investing for the typical American.
Simply put, when you purchase a mutual fund, the money you invest – along with the money from all of the other investors within that particular fund – is placed into a reservoir of sorts where the fund manager scoops up all the money and invests it in several different positions. According to that fund’s prospectus, those positions can be stocks, bonds, commodities, or virtually anything else the fund manager is allowed to invest in.
In short, mutual funds are a convenient way for an investor to achieve significantly more diversification without individually purchasing all of those positions on their own.
Exchange-Traded Funds (ETFs)
The newest investment instrument is the Exchange-Traded Fund or ETF. An exchange-traded fund, or ETF, is a type of security that involves a collection of securities—such as stocks—that often tracks an underlying index. However, they can invest in any number of industry sectors or use various strategies. ETFs are in many ways similar to mutual funds; however, they are listed on exchanges, and ETF shares trade throughout the day just like an ordinary stock does.
Typically associated with stocks, beta is simply a measurement of volatility. The greater a stock’s beta, the wider its prices will swing, both up and down. Since, generally speaking, volatility and long-term growth work in conjunction with each other, stocks with higher betas will exhibit wider price swings but also superior long-term growth. Furthermore, the stocks of smaller companies tend to have higher betas than those of large companies.
Short for market capitalization, market cap is the total amount of equity owned by a company’s stockholders. If the amount of outstanding stock stays fixed, a company’s market cap will rise when their stock price rises because each share is now worth more. Likewise, when a stock price falls, a company’s market cap will fall along with it.
Most commonly associated with taxes, capital gains are often thought to be far more complex than they actually are. In a nutshell, capital gains are the proceeds from the sale of an investment, less the purchase price.
Let’s say, for instance, you buy 10 shares of stock at $10 per share and sell that stock six months later at $15 per share. Your capital gain would be $5 per share or $50 for the entire transaction. If you sold that stock at $5 per share rather than $15 per share, you would have a total capital loss of $50.
Capital gains and losses are often divided by short-term and long-term positions to add one slight wrinkle to the equation. Short-term positions are those you’ve owned for less than one year, whereas long-term positions are held for greater than one year.
Of course, the vocabulary behind investing is vast, and we’ve hardly scratched the surface with these examples. We will help define more terminology in the future but, for now, this is an excellent first step in demystifying the investment vernacular.
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