Beginners guide to investing part 1:Useful definitions

Introduction

Today, we start a 14-part series that will aim to educate investors that don’t know where to begin investing their spare cash. For a new investor, it can be intimidating to invest money. A lot of the intimidation comes simply from the terminology. Financial advisers like to use jargon that can appear difficult to understand. The number one rule of investing is to not invest in something you don’t understand (well, that and make money!) Not understanding only leaves two options: not investing at all or paying someone a high cost to do it for you. This is a shame because the best financial gains can be made from investing.

My aim in this series is to use language that is simple to follow. Not use flash fancypants language to show off.

Most of the series will focus specifically on the stockmarket. This is because it has proven to be one of the best investments we can make to grow our money.

My personal investment philosophy is to invest in low cost index funds. When starting out, I do not believe in an investment philosophy of trying to beat the market. I believe in betting on the market, not the components within. I also believe in a long term buy and hold strategy. They have proven to provide the best returns for the lowest risk. I will explain more on these strategies later in the series. If you are interested in investing in individual stocks or looking for a quick buck then this series is probably not for you. This strategy should be for more experienced investors, if at all.

We will break down a few key words used in the investing world. These terms may sound scary at first, but the concepts are really not that difficult to understand. By taking the time to understand the terms, we are removing the largest barrier that is stopping many of us from investing our money – understanding the terminology.  

 

BROAD MARKETPLACE TERMS

Market – A place where securities such as bonds and stocks are bought and sold. Also known as an exchange. Most trades (buy and sell) these days are executed electronically with a money manager acting as the middle man between buyer and seller.

Index – A tool used to statistically measure the progress of a group of stocks, bonds, commodities, and other assets. The NZX50 is a well-known index tracking the 50 largest companies in New Zealand.

Investing – Putting our money someplace with the intention of a higher payback over time.

Volatility – How much a particular asset can swing from high to low and vice versa. High risk investments tend to have higher highs and lower lows. Lower risk investments tend to have a smaller range of returns, hence less volatility.

Inflation – The rate at which the cost of general goods and services are increasing. Generally in New Zealand this is about 2.5-3%. At 3% this means that the price of goods and services will double every 24 years, although some costs tend to rise at rates much higher or lower than average.

 

TYPES OF INVESTMENTS

Securities – Investments that can be traded in a market. Securities allow us to own the asset without taking physical possession. There are 3 types of securities. Equity, debt and derivative securities. I will not be discussing derivatives in this beginner series..

Equity securities – Shares of a corporation. Also known as stocks. By purchasing a share, we own a part of the company. The price of the stock will fluctuate depending on what people thing the company is worth and what they are willing to pay. We can also purchase shares that form part of a mutual or exchange traded fund (ETF).

Debt securities – An IOU made to a company or a country. Commonly called bonds. Here we are loaning a company or the government money, in the hope that we will have our money returned (with interest) on the date of the loan expiry. Rating companies evaluate how likely the bond is to be repaid. We will receive higher returns from companies and countries that are at higher risk of defaulting on their repayment to us. Government/treasury bonds are considered the safest, but also lowest returning. Bonds can also be purchased as part of a mutual or exchange trade fund. Unlike treasury bills, government bonds are typically for periods of longer than 1 year.

Treasury bills – Commonly referred to as T-Bills. Money that is sold by the NZ government to the investor so that the government can pay off maturing debt and to raise cash needed to run the office. We are basically lending money to the government and receiving your money (plus interest) at the end of the loan term. For T bills, this is typically 3 months, 6 months or 1 year.

 

TYPES OF INVESTING

Mutual fund – Also known as a managed fund. A bunch of money that comes from a group of investors just like you is invested in a group of assets like stocks or bonds. With a mutual fund, our money can be spread across more investments than if we bought an investment directly. A mutual fund could hold hundreds of stocks/assets, or less than 10. Some funds cover geographic areas, while others hold companies of a certain size (small, mid or large cap). Most mutual funds are managed by a money manager who makes buy and sell decisions for the whole group of investors invested in the fund.

Exchange Traded Fund (ETF)/Index fund – Similar to a mutual fund in that the money is pooled together from a group of investors. The differences being that it tends to track the performance of an entire index, such as the NZX50. Whereas, A mutual fund will tend to select parts of the index. Because it traces the entire index it does not require as much management. Therefore, ETF’s have much lower management fees. Every ETF is different: Some focus on a broad range of assets in a wide range of industries, whereas others focus on just one type of asset or sector.

Index funds are very similar to ETF's. In fact, ETF's are a type of index fund. The only real difference is the way they are traded. ETF's are slightly more flexible. An ETF is able to be traded like stocks. You can trade them immediately and easily. Whereas index funds can only be sold at the end of each day based on the Net Asset Value (NAV) of the fund. 

 

PORTFOLIO MANAGEMENT

Asset allocation – This just means how our investments are divided up in our portfolio,.For example, out of your entire investments you own 20% in bonds and 80% in stocks. The idea is that different assets perform opposite to each other in the same economic conditions. This way we can limit our risk by allocating our portfolio according to the type of asset we have and how well they complement each other – shares, bonds, gold, property, treasury bills, etc.

Portfolio – The sum of our investment holdings. All the investments we hold make up our portfolio.

Risk profile – The percentage we allocate to different asset classes depends on our risk profile. If we are an aggressive investor with a high tolerance for risk, we are more likely to invest a higher percentage of our money in riskier assets such as international shares and value companies. This type of investor is willing to pay the price for extra risk and volatility in anticipation of higher returns in the long run. A defensive investor on the other hand, is more likely to allocate a higher percentage of their money to lower risk asset classes including cash and fixed assets such as bonds and treasury bills.

Diversification – A form of risk management that seeks to reduce the volatility of an investor’s portfolio, by holding a wide variety of different investments that have low co-relations with one another. In a well diversified portfolio, when one investment goes down, anther investment will go up. If we only have one type of investment we run the risk of losing more.

Rebalancing – Another form of risk management to minimise losses. Periodically buying or selling the assets in our portfolio to maintain our original desired level of asset allocation. If stocks have a stellar run for example, we may end up with an asset allocation of 85% stocks and 15% bonds. Our original target though was 80% stocks and 20% bonds. To reduce the risk of our portfolio back to our desired levels we would need to either sell some stocks or buy some more bonds. How often we rebalance depends on our investment strategy and goals.

Expense ratio – Basically, how much it costs for the fund manager to manage our investments. If it costs 2% to manage our portfolio and our return is 6%, after management costs our return is only approximately 4% (6 - 2). See the definition below for real returns for the exact calculation.

 

MARKET RETURNS

Dividends – Many companies in the sharemarket will divide up some of its income amongst all the shareholders. The payment we receive from the company is known as a dividend and are most commonly received bi-annually. The payment is a percentage of each share in the company we own. A common form of investing is dividend investing, where the investor focuses on companies that pay good dividends. Take care if adopting this strategy, as some companies pay high dividends because they have run out of ideas for re-investing the money into the company. Once growth stalls, the dividend pay-outs can then reduce, further reducing the stock value. Dividends are useful as cash in the hand for retirees. If we are a long term investor however, dividends are best reinvested back into your fund. Our fund manager can make this automatic for us - very easy.

Share returns – There are two ways to get returns from shares. An increase in the price of what people are willing to pay for the share. And the dividends we receive each year. In general, high dividend paying companies have lower increases in share prices. The returns on share price increases are not realised until we sell, whereas dividend returns are realised only if we hold the share.  

Bond returns – Bonds typically return more than bank deposits, but less than stocks. Much like bank deposits, the return we receive is a pre-determined interest rate set by the bond issuer. Whether that is a bank, the government, or some other agency. Our return is paid on maturity (expiry) of the bond. We may wish to sell the bond early if we need the cash or if the interest rate has gone down. If rates have gone down we will get a higher return than we would have at maturity because the bond we hold at the higher rate is much more valuable to a new investor than the new bonds at the lower rate. If we sell when interest rates have gone up however, we will likely lose money on our investment. This is only a risk if we sell. If we hold on until maturity we will get the agreed rate regardless of whether interest rates have increased or decreased.

Real returns – Percentage return on our money invested, after inflation. Formula is (1+stock or bond return)/(1+inflation)-1. For example, say we purchase $10,000 in bonds on 1 Jan. We sell these bonds for $11,000 (10% return) on Dec 31. Inflation during this period was 2%. The real return = (1+10%)/(1+2%)-1 = (1.1/1.02) – 1 = 7.84%. We can’t just subtract 2% inflation from 10% returns (8%) because inflation and returns compound, hence the need for the formula. If we had 1% in management costs we would just subtract 1% from the 10% returns in the first bracket, making it 1+9% or 1.09. We need to be careful which return the investment advisers are quoting us. There is a big difference between 7.84% and 10%. No more maths today, I promise.

Compounded annual growth rate (CAGR) – The rate of return of an investment over time, expressed as a percentage. It is similar to the average, but vitally different. More on this in part 12 of the series.

 

SHARE MARKET ECONOMY

Bear market – This is a market that is falling at a sharp decline in a short space of time. Typically referred to a fall in value of greater than 20%. A small, less sharp decline is just known as a correction.

Bull market – A market that is rising at a rapid rate. Typically, a rise in value of 20%. A bull market is a market that is extremely confident. People that expect prices to keep rising are said to be bullish.

NZX50 – Also known as a stock exchange. The main stock market index in New Zealand. It comprises the 50 largest publicly listed companies (ranked by capitalisation) trading on the New Zealand Stock Market (NZSX).

Small, mid and large cap – Cap is short for capitalisation. Capitalisation refers to the size of a company. How much it is worth. It is calculated by multiplying its current share price by the number of shares. Small cap companies have either a lower share price, a lower number of shares, or a combination of both. Small cap companies offer investors more room for growth, but also incur greater risk and volatility than large cap companies. Large cap companies tend to be more established. Less room for growth but more reliable.

 

FINAL THOUGHTS

One of the toughest parts of starting a new journey as an investor is understanding the terminology. It can seem daunting but once you get the hang of it, you will realise there was no reason to be so intimidated.

I hope you have found it useful having these terms all on one page. I have tried to keep the explanations as simple as possible. Do keep reading. In my next article, I will debunk some common myths about investing to help you get over any barriers that may be preventing you from getting started.

 

 

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my

 

Are there any other definitions you are unsure of?  Comment below