An annuity is a contract between an insurance company and a buyer. The buyer pays a premium, in one or several payments, and the insurance company agrees to pay the buyer a regular return for a specified period of time, usually the remainder of the buyer’s lifetime. The insurance company invests the money to earn interest, receive dividend income, or collect capital gains distributions. The insurance company then pays the buyer an income based on the terms of the contract. Annuities can be variable or fixed, deferred or immediate. A fixed annuity ensures that the insurance company will pay a set principal plus a set interest rate. Returns on a variable annuity, however, fluctuate based on the performance of the investments. With a deferred annuity, the premium gathers interest for a certain set period of time, tax-free, before payments to the buyer begin. Immediate annuities, on the other hand, establish a return for the buyer based on the buyer’s age, part of which is considered principal and part of which is considered taxable interest. Thus, age, wealth, and risk tolerance will heavily influence the type of annuity an individual buyer selects.
Assets include any of an individual’s possessions that have economic value. The sum of one’s assets is considered to be the individual’s net worth. Assets include stocks, bonds, cash, real estate, jewelry, investments, and other properties.
Asset allocation refers to the specific distribution of funds among a number of different asset classes within an investment portfolio; it is diversification put into practice. Funds may be distributed among a number of different asset classes, such as stocks, bonds, and cash funds, each of which has unique types of expected risk and return. Within each asset class are several variations of the asset, meaning that there are levels of risk within each asset class. Asset allocation involves determining what percentage of funds will be invested in each asset. Determining how to allocate funds depends on the individual investor. The investor’s goals, time frame, and risk tolerance will all affect how an investor wishes to allocate funds based on the investor’s desired return and acceptable risk.
A back-end load is a sales charge or fee charged when funds are withdrawn from an investment, particularly mutual funds and annuities. In many cases, the fee is reduced over the years of investment, or holding period, and eventually is reduced to zero.
Someone who believes or speculates that a particular security or the securities in a market will decline in value is referred to as a bear.
A bear market is a market in which a group of securities falls in price or loses value over a period of time. A prolonged bear market may result in a decrease in market prices by 20% or more. A bear market in stocks may be due to investor’s expectations of economic trends; in bonds a bear market results from rising interest rates.
Blue Chip refers to companies that have become well established and reliable over time, demonstrating sound management and quality products and services. Such companies have shown an ability to function throughout both good and bad economic times, usually paying dividends to investors even during lean years.
A bond is essentially a loan made by an investor to a division of the government, a government agency, or a corporation. The bond is a promissory note to repay the loan in full at the end of a fixed time period. The date on which the principal must be repaid is the called the maturity date, or maturity. In addition, the issuer of the bond, that is, the agency or corporation receiving the loan and issuing the promissory note, agrees to make regular payments of interest at a rate initially stated on the bond. Interest from bonds is taxable based on the type of bond. Corporate bonds issued by state or local government agencies are free from federal income tax and usually free from taxes of the issuing jurisdiction, and Treasury bonds are subject to federal taxes but not state and local taxes. Bonds are rated according to many factors, including cost, degree of risk, and rate of income.
Someone who believes that a particular security or the securities in a market will increase in value is known as a bull.
A bull market is a long period of rising prices of securities, usually by 20% or more. Bull markets generally involve heavy trading and are marked by a general upward trend in the market, independent of daily fluctuations.
A capital gain is the appreciation in value of an asset, that is, when the selling price is greater than the original price at which the security was bought. The tax rate on capital gain depends on how long the security was held.
Certificate of Deposit
A Certificate of Deposit (CD) is a note issued by a bank for a savings deposit that the individual agrees to leave invested in the bank for a certain term. At the end of this term, on the maturity date, the principal may either be repaid to the individual or rolled over into another CD. The bank pays interest to the individual, and interest rates between banks are competitive. Monies deposited into a Certificate of Deposit are insured by the bank, thus they are a low-risk investment and a good way of maintaining a principal. Maturities may be as short as a few weeks or as long as several years. Most banks set heavy penalties for premature withdrawal of monies from a Certificate of Deposit.
Certified Financial Planner (CFP)
A professional financial planner who has completed a series of correspondence courses and has passed examinations in subject areas such as insurance, securities and taxes. The Institute of Certified Financial Planners awards the designation.
Chartered Financial Analyst (CFA)
A professional designation offered by the CFA Institute (formerly known as AIMR) to financial analysts who complete a series of three examinations and work for at least four years in the investment decision making process. CFA charter holders are also obliged to adhere to a strict Code of Ethics and Standards governing their professional conduct.
Commission is a fee charged by an agent making transactions of buying or selling securities for another individual. This fee is generally a percentage based on either the number of stocks bought or sold or the value of the stocks bought or sold.
Credit risk refers primarily to the risk involved with debt investments, such as bonds. Credit risk is essentially the risk that the principal will not be repaid by the issuer. If the issuer fails to repay the principal, the issuer is said to default.
To default is to fail to repay the principal or make timely payments on a bond or other debt investment security issued. Also, a default is a breach of or failure to fulfill the terms of a note or contract.
Diversification is the process of optimizing an investment portfolio by allocating funds to a number of different assets. Diversification minimizes risks while maximizing returns by spreading out risk across a number of investments. Different types of assets, such as stocks, bonds, and cash funds, carry different types of risk. It is important to diversify among assets with dissimilar risk levels for an optimal portfolio. Investing in a number of assets allows for unexpected negative performances to balance out with or be superseded by positive performances.
A dividend is a payment made by a company to its shareholders that is a portion of the profits of the company. The amount to be paid is determined by the board of directors, and dividends may be paid even during a time when the company is not performing profitably. Mutual funds also pay dividends. These monies are paid from the income earned on the investments of the mutual fund. Dividends are paid on a schedule, such as quarterly, semi-annually, or annually. Dividends may be paid directly to the investor or reinvested into more shares of the company’s stock. Even if dividends are reinvested, the individual is responsible for paying taxes on the dividends. Unfortunately, dividends are not guaranteed and may vary each time they are paid.
Dow Jones Industrial Average
The Dow Jones Industrial Average is an index to which the performance of individual stocks can be compared; it is a means of measuring the change in stock prices. This index is a composite of 30 Blue Chip companies ranging from AT&T and Hewlett Packard to Kodak and Johnson & Johnson. These 30 companies represent not just the United States; rather, they are companies involved with commerce on a global scale. The DJIA is computed by adding the prices of these 30 stocks and dividing by an adjusted number which takes into account stock splits and other divisions that would interfere with the average. Stocks represented on the Dow Jones Industrial Average make up between 15% and 20% of the market.
A 401k plan is a retirement plan sponsored by employers. Employees may choose to have a portion of their salary deferred to any of the 401k investment choices selected by the employer. The employer may also contribute to the employee’s 401k by matching a portion of the investment (for example, $.50 for every $1.00 the employee invests). The investments to which money is deferred may include stocks, bonds, money market funds, and company stocks. Monies deferred into the 401k are allowed to grow tax-free, and these monies are subtracted from the employee’s taxable income. The maximum amount allowed to be contributed to a 401k changes annually. If money is withdrawn from the 401k before the employee turns 59, the individual may have to pay penalties. If the individual changes jobs, the monies in the 401k may be rolled over to a 401k of the new employer or to an Individual Retirement Account (IRA).
A 401k plan is a retirement plan sponsored by employers. Employees may choose to have a portion of their salary deferred to any of the 401k investment choices selected by the employer. The employer may also contribute to the employee’s 401k by matching a portion of the investment (for example, $.50 for every $1.00 the employee invests). The investments to which money is deferred may include stocks, bonds, money market funds, and company stocks. Monies deferred into the 401k are allowed to grow tax-free, and these monies are subtracted from the employee’s taxable income. The maximum amount allowed to be contributed to a 401k changes annually. If money is withdrawn from the 401k before the employee turns 59 , the individual may have to pay penalties. If the individual changes jobs, the monies in the 401k may be rolled over to a 401k of the new employer or to an Individual Retirement Account (IRA).
A front-end load is a commission or fee that is charged when an investment is initially purchased. Investments that require a front-end load include mutual funds, annuities, and life insurance policies. Typically, the fee amount is a percentage of the net asset value of the investment.
A company that has previously been privately owned is said to be ‘going public’ the first time the company’s stock is offered up for public sale.
Hedging is a strategy of reducing risk by offsetting investments with investments of opposite risk. Risks must be negatively correlated in order to hedge each other; for example, an investment with high inflation risk and low immediate returns with investments with low inflation risk and high immediate returns. Long hedges protect against a short-term position and short hedges protect against a long-term position. Hedging is not the same as diversification, as it aims to protect against risk by counterbalancing a specific area of risk.
Individual Retirement Account (IRA)
An Individual Retirement Account allows individuals who are earning income to contribute to a tax-deferred investment fund. An individual can contribute up to $2,000 per year or $4,000 if married to an unemployed spouse. Contributions to an IRA are tax-deductible based on the individual’s marriage status and income level. Monies contributed to an IRA may be invested in stocks, bonds, mutual funds, annuities, bank savings accounts, Certificates of Deposit, government bonds, and investment trusts but not more personal and immediate investments such as a home or collectibles. The individual may contribute to the Individual Retirement Account until age 70 , but if money is withdrawn before age 50 , penalties will be incurred.
Inflation risk is the risk that rising prices of goods and services over time, or, generally the cost of living, will decrease the value of the return on investments. Inflation risk is also known as ‘purchasing-power risk’ since it refers to increased prices of goods and services and a decreased value of cash.
Junk bonds are bonds that are considered high yield but also have a high credit risk. They are generally low rated bonds and are usually bought on speculation, with the investor hoping for the yield, rather than the default. An investor with high risk tolerance may choose to invest in junk bonds.
The Keogh Plan is a type of tax-deductible retirement plan, similar to Individual Retirement Accounts, for self-employed individuals. It is also known as a self-employed pension plan. The individual may contribute up to $30,000 or 15% of total earned income per year, whichever is less.
Liquidity refers to the ease with which investments can be converted to cash at their present market value. Additionally, liquidity is a condition of an investment that shows how greatly the investment price is affected by trading. An investment that is highly liquid is composed of enough units (such as shares) that many transactions can take place without greatly affecting the market price. High liquidity is associated with a high number of buyers and sellers trading investments at a high volume.
Market risk is the risk that investments will lose money based on the daily fluctuations of the market. Bond market risk results from fluctuations in interest. Stock prices, on the other hand, are influenced by factors ranging from company performance to economic factors to political news and events of national importance. Time is a stabilizing element in the stock market, as returns tend to outweigh risks over long periods of time. Market risk cannot be systematically diversified away.
Market value is the value of an investment if it were to be resold, or the current price of a security being sold on the market.
Modern Portfolio Theory
Aims to minimize the risks of investing while maximizing returns through the diversification of a portfolio. Diversification is the process of allocating funds among a number of different asset classes. Modern portfolio theory looks at three main factors in determining appropriate investments for an investor’s portfolio: the investor’s goals and objectives for investing, the time frame of investment, and the investor’s risk tolerance, or how comfortable the investor is with taking certain risks. Optimizing a portfolio according to modern portfolio theory involves matching the statistics of expected risk and return for a number of different assets with the individual’s terms of investment.
Mutual funds are investment companies whose job it is to handle their investors’ money by reinvesting it into stocks, bonds, or a combination of both. Mutual funds are divided into shares and can be bought much like stocks, allowing mutual funds to have a high liquidity. Mutual funds are convenient, particularly for small investors, because they diversify an individual’s monies among a number of investments. Investors share in the profits of a mutual fund, and mutual fund shares can be sold back to the company on any business day at the net asset value price. Mutual funds may or may not have a load, or fee; however, funds with a load will provide advice from a specialist, which may help the investor in choosing a mutual fund.
NASDAQ (National Association of Securities Dealers Automated Quotation)
The National Association of Securities Dealers Automated Quotation is a global automated computer system that provides up-to-the-minute information on approximately 5,500 over-the-counter stocks. Whereas on the New York Stock Exchange (NYSE) securities are bought and sold on the trading floor, securities on the NASDAQ are traded via computer.
NASD (National Association of Securities Dealers)
The National Association of Securities Dealers is an organization of broker/dealers who trade over-the-counter securities. The NASD is self-regulated. The largest self-regulated securities organization. This organization operates and regulates both the NASDAQ and over-the-counter markets, ensuring that securities are traded fairly and ethically.
NAV (Net Asset Value)
Net Asset Value is the price of a share in a mutual fund or investment company. This price is calculated once or twice daily. Net asset value is the amount by which the assets’ value exceeds the company’s liabilities. It is calculated by adding up the market value of all securities owned by the company, subtracting the company’s liabilities, and dividing this value by the number of shares of the company outstanding. Thus, the NAV indicates the current buying or selling price of a share in an investment company.
NYSE (New York Stock Exchange)
Established in 1792, the New York Stock Exchange in the largest securities exchange in the United States. Securities are traded by brokers and dealers for customers on the trading floor at 11 Wall Street in New York City. The exchange is headed by a board of directors that includes a chairman and 20 representatives who represent both the public and the members of the exchange. This board approves applicants as newNYSE dealers, sets policies for exchange, oversees the exchange, regulates member activities, and lists securities.
An option is a security that can be bought as a contract to fix the price on another, underlying security. The buyer can pay the issuer of the option a premium that fixes the price on an investment, including stocks, bonds, real estate, and others, for a specified period of time. The holder of the option can then choose to buy or sell the underlying security at the fixed price during this time period; however, the holder is under no obligation to buy. For example, if the holder purchases an option to buy a stock at $30, the individual may not wish to buy the stock during the time period of the option if the shares are being sold for $27. However, if the shares are being sold for $33, the holder will save $3 per share with the option. Thus, options may or may not prove advantageous to the holder.
The price-earnings ratio is a measure of how much buyers are willing to pay for shares in a company, based on that company’s earnings. Price earnings ratio is calculated by dividing the current price of a share in a company by the most recent year’s earnings per share of the company. This ratio is a useful way of comparing the value of stocks and helps to indicate expectations for the company’s growth in earnings. It is important, however, to compare the P/E ratios of companies in similar industries. Price-earnings ratio is sometimes also called the ‘multiple'.
A quotation, or quote, refers to the current price of a security, be it either the highest bid price for that security or the lowest ask price.
Real Rate of Return
The Real Rate of Return refers to the annual return on an investment after being adjusted for inflation and taxes.
Reinvestment is the use of capital gains, including interest, dividends, or profit, to buy more of the same investment. For example, the dividends received from stock holdings may be reinvested by buying more shares of the same stock.
SEC (Securities and Exchange Commission)
The Securities and Exchange Commission is a federal government agency comprised of 5 commissioners appointed by the president and approved by the Senate. The SEC was established to protect the individual investor from fraud and malpractice in the marketplace. The commission oversees and regulates the activities of registered investment advisors, stock and bond markets, broker/dealers, and mutual funds.
A security is any investment purchased with the expectation of making a profit. Securities include total or partial ownership of an asset, rights to ownership of an asset, and certificates of debt from an institution. Examples of securities include stocks, bonds, certificates of deposit, and options.
S&P (Standard and Poor’s) 500 Index
The Standard and Poor’s 500 Index is a market index of 500 of the top-performing United States corporations. This index is a broader measure of the domestic market than the Dow Jones Industrial Average, indicating broad market changes. The S&P 500 index includes 400 industrial firms, 20 transportation firms, 40 utilities, and 40 financial firms.
A split is when a company’s board of directors and the shareholders agree to increase the number of shares outstanding. The shareholders’ equity does not change; instead, the number of shares increases while the value of each share decreases proportionally. For example, in a 2-for-1 split, a shareholder with 100 shares prior to the split would now own 200 shares. The price of the shares, however, would be cut in half; shares that cost $40 before the split would be worth $20 after the split.
The ticker displays information on a moveable tape or, in modern times, as a scrolling electronic display on a screen. The symbols and numbers shown on the ticker indicate the security being traded, the latest sale price of the security, and the volume of the last transaction.
An underwriter is an individual distributing securities as an intermediary between the issuer of the security and the buyer. For example, an underwriter may be the agent selling insurance policies or the person distributing shares of a mutual fund to broker/dealers or investors. Generally, the underwriter agrees to purchase the remaining units of the security from the issuer, such as remaining shares of stocks or bonds, if the public does not buy all specified units. An underwriter may also be a company that backs the issue of a contract, agreeing to accept responsibility for fulfilling the contract in return for a premium.
Volatility is an indicator of expected risk. It demonstrates the degree to which the market price of an asset, rate, or index fluctuates from average. Volatility is calculated by finding the standard deviation from the mean, or average, return.
A warrant is similar to an option, giving the holder the right to purchase securities at a set price for a specific period of time. Warrant certificates last longer than options, typically holding value for a few years or indefinitely. Warrants are often traded as securities at a price that reflects the underlying security.
Yield is the return, or profit, on an investment. Yield refers to the interest gained on a bond or the rate of return on an investment, such as dividends paid on a mutual fund. Yield does not include capital gains.