A recent global financial literacy study by Standard and Poor’s reveals that only 57 percent of US adults are financially literate. Since April is Financial Literacy Month, we put together a word-list to help our readers become more familiar with common financial terms. Having a better understanding of the jargon from the financial world is a step towards greater financial literacy.
Equity– A type of investment, another term for stocks or ownership. Owning stock gives a person equity, which makes them a part-owner of that business. Returns from this investment vehicle are unpredictable.
Fixed income– A type of investment that comes from lending rather than ownership, where a stated return or interest rate is received for a certain period of time. The returns from this type of investment are designed to be rather stable.
A balance of both equity and fixed income in a portfolio is important and the key differentiator for anyone is how much of their assets should be in either equity or fixed income, which varies based on individual goals and risk tolerance.
Financial planning– The study of putting all aspects of someone’s financial life together and coming up with a concrete direction or goal. This covers everything from asset allocation to how much is being saved to reach specific financial milestones: i.e. retirement, college education.
Net Worth– The total value of assets owned, less any outstanding liabilities; what is owed subtracted from what is owned. It’s a measuring tool to find out if you’re on track with financial objectives.
If you have any liabilities (a car loan, mortgage, credit card debt), you subtract that from any real assets owned (money in the bank, investments, house, car) which equals net worth. If you plan to retire at a certain age, you need your net worth to be high enough so you can draw upon the assets during retirement.
Liquidity– Refers to how quickly the money an investment represents can be turned to cash. It’s necessary to have a certain amount of liquidity because emergencies happen and having a fund or cash cushion to pay for those things is important. All assets have varying degrees of liquidity.
The most liquid asset is cash or what is in a checking and savings account. Equities are also fairly liquid, it’s typically easy to sell a stock. Although it might not be the most appropriate time, if you need the money you can usually get it. Fixed income tends to be less liquid because they aren’t as easy to sell.
Principal– The original amount invested or the current value of a portfolio.
People, mostly in retirement, want to make sure principal stays where it is and that it doesn’t change. They then want to live off the earnings of their portfolio. If principal goes down, then they have less assets to draw from. For people that are not yet retired, their goal is to keep adding money to their portfolio to see the principal increase.
Dividend– Cash payments from equities owned; cash earned by a company paid out to shareholders.
Some stocks will pay out high dividends because they have a lot of cash flow they return to shareholders. Other companies will use their cash flow to fund the operations of the business and they don’t pay a dividend to shareholders. A company’s dividend policy is based on cash flow needs of the business and how much cash that they earn.
Risk Tolerance– How much portfolio volatility someone can withstand; how much of a loss someone can accept in his or her portfolio.
People that have a high risk tolerance are able to withstand more fluctuations within their portfolio. If someone has a low risk tolerance they want a portfolio that is more stable with less price volatility. The key is trying to figure out what someone’s risk tolerance is and matching that with a portfolio that will guide them to their goal.
Time value of money– A dollar today is worth more than a dollar tomorrow, or a year from now. The key here is keeping up with inflation. Inflation has caused prices to go up over time.
If you want a dollar to be worth as much a year from now as it is today, you need to get some sort of return on that dollar. If you get a return, then that dollar will be more in the future. If you get no return, it will be worth less in the future. That’s why we recommend being invested in equities. They are the only asset class that has historically demonstrated success keeping pace with inflation.
Total return– The amount an investment increases in cash received in both price appreciation and any interest or dividends from an investment.
Some investors look for high dividend-paying stocks to get cash. Some are less concerned with that so total return becomes important. Investors unlock the return of equities that don’t pay a dividend by selling shares to get a return from price appreciation. If someone invests $10,000 and $1,000 is earned in dividends and the value goes from $10,000 to $12,000, the total return on investment would be $3,000, or 30 percent.