In order to reach your financial goals, you don’t have to be an investing sesquipedalian. The term sesquipedalian can describe someone or something that excessively uses big words. A philosophy professor, for example. Or, much to our dismay, the financial news.
Finance experts and pundits on TV or in the newspaper often freely throw out industry jargon with little clarification. What is a “dead cat bounce” anyway? Does it matter? That type of language can make a situation seem better or worse than it really is, which in turn can cause investors to make costly mistakes.
If you don’t quite have a strong investment vocabulary, that’s okay. You don’t necessarily need one, unless you plan to work in the industry or want to become a full-time trader. For those investing primarily for retirement (i.e., those not trying to run a hedge fund), there are only a handful of terms that you should really know. Here’s a brief glossary of important investing terms for retirement investors.
Asset Allocation
These are the 6 A’s of investing: asset allocation, asset allocation, asset allocation.
Asset allocation is a term frequently used because of its importance. It is the foundation of anyone’s investment portfolio. In fact, research suggests that asset allocation can explain more than 90% of a portfolio’s long-term performance, which is important for someone saving and investing for retirement. That means what individual investments you choose and when you buy or sell them don’t account for much. Instead, it’s all about asset allocation.
So, what does this critical term mean?
Asset allocation is how your portfolio is invested among different investments – stocks, bonds, alternative investments, etc. It is often expressed as a ratio between stocks and bonds. For example, a 60/40 portfolio is one that holds 60% of stock investments (funds or individual shares) and 40% of bond investments (funds or individual bonds).
What asset allocation is right for you depends on personal factors such as your objectives, age, savings and income, current assets and attitudes toward risk. This highlights the importance of working with a professional to build an investment plan with an appropriate asset allocation for your specific needs.
Bull and Bear Markets
Bulls, bears, oh my! Most people have a general understanding of bull and bear markets. Bull is when the market is going up; bear is when the market is going down. Bull is optimistic; bear is pessimistic. Bull is good; bear is bad. But, knowing a little more can provide some needed reassurance when things go south.
First of all, the technical definition of a bull market is when stock prices rise by 20%, often after a 20% drop and before another 20% decline. It’s why the market is commonly described as cyclical. Meanwhile, a bear market occurs when the market falls 20% or more from its peak.
Perhaps, the most important thing to know is that the stock market has historically gone up more than it has gone down. According to one report, bear markets have lasted 14 months, on average, since World War II. Bull markets, on average, have lasted 4.5 years. Something to keep in mind whenever a bear market occurs and the airwaves are flooded with “the sky is falling” narratives: bulls don’t run forever, and bears don’t leave hibernation for long.
Compounding
Albert Einstein once said: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn't … pays it.” Compound interest is when the interest you earn on an amount of money in turn earns interest itself. Then the money earned from that money earns money and the money earned from that money earns money and the money earned from that money earns money and…so on and so on.
Since retirement accounts such as 401(k)s and IRAs are investment vehicles rather than just savings accounts, they have the potential to provide accountholders the benefit of compounding. This can have an incredible impact on your retirement savings. It is why you should start saving for retirement as early as possible.
Diversification
Diversification is the investing strategy equivalent of “don’t put all your eggs in one basket.” A diversified portfolio holds several different investments with prices that typically move independently of each other. A simple example is stocks versus bonds.
The purpose of diversification is to take on less risk than you would investing in any individual investment, yet potentially earn higher returns. Instead of trying to pick the best performing investments, which change frequently, you can invest in a mix of them, with your positive performers negating the losses of your negative performers.
Fiduciary
Not all financial advisers, financial planners and investment managers are registered the same way. Registered investment advisors, such as Advance Capital Management, are regulated under the Investment Advisors Act of 1940. This act bounds RIAs to the fiduciary, or “trust,” standard, which is the highest legal standard.
A fiduciary adviser is someone who manages a person’s assets on their behalf and solely in their best interest. That means acting in utmost good faith, avoiding conflicts of interest when possible and fully disclose and mitigate any potential conflicts, and disclose all material facts.
Meanwhile, registered representatives, such as stockbrokers and advisers working for insurance firms, follow the “suitability” standard. The suitability standard does not require advisers to put their clients’ interests first, nor must they disclose conflicts of interest. It’s possible that they recommend investments from which they receive the highest commissions. Therefore, it’s important to be aware that the advice you receive from one adviser to the next can differ depending on how they are registered.
Rebalancing
Over time, the market can change your asset allocation. Rebalancing – generally, selling what’s up to buy what’s down – helps you do two things. One, it allows you to reap your earnings. Two, and most importantly, it helps you reduce risk and return your portfolio back to your desired asset allocation.
It may sound counterintuitive. You want me to sell what’s doing well to buy what’s not? But, consider it this way: you’re selling high and buying low.
Or, think of your portfolio like a garden. A garden’s appearance greatly depends on the weather -- the rain, the sun, the wind, etc. But, also the gardener. It’s up to you to keep things from becoming overgrown. And, with all fruits and vegetables, you get to reap the rewards. Rebalancing keeps your investment garden in balance and healthy for the long term.
Risk Tolerance
Essentially, your risk tolerance is a realistic assessment of the level of risk you’re comfortable with in your portfolio. How much you have invested in stocks is typically a representation of your risk tolerance. Stocks are generally riskier than bonds. Therefore, the more you have allocated to stocks, the higher your level of risk.
Your emotions are difficult to quantify. Therefore, you may not know how much risk you can handle until you experience a market downturn. The goal is to avoid exposing yourself to a level of risk that causes you to abandon your investment plan, which can reduce the chances of achieving your financial goals.
Time Horizon
Time horizon is another essential piece of the retirement puzzle. But it could be easily argued that time horizon is a useless term. That’s because its definition is straight to the point.
Essentially, your time horizon is the amount of time you have before you need to start selling your investments. So, a 22-year-old right out of college who is saving and investing for retirement and wants to retire at age 62 has a time horizon of 40 years.
It plays an important role in determining your asset allocation. Generally, the longer you have before you need the money, the more aggressive you invest.
Volatility
Simply put: volatility is the dramatic rise and fall of a particular market or investment return. For example, when the stock market moves up and down by more than 1%, it’s labeled a volatile market. Generally, the more volatile an investment, the riskier it is.
However, what’s really confusing about volatility is the way it is discussed. It is often talked about in the news as an exceptional event, when in fact market volatility is normal over short periods of time. Over the long-term, the difference between the average high and average low becomes much smaller. Which is why retirement investors must build an investment plan with the long term in mind. And, when things get rocky, stick with that plan.
