In the past year, we’ve had several clients approach us for book recommendations or other help to convey some insights on savings and investment to their young adult or adult children. For those wanting to educate younger generations–and for those who nod their heads knowingly at terms like “passively managed mutual funds” without having any real conception of what they mean–we offer this first installment of a brief primer on financial terminology. (Please let us know if you have any topics you’d like to see covered on our blog in the future!)
Stock (Equity). A stock, sometimes referred to as equity, is a share of ownership in a particular company. The price of a stock rises and falls as perceptions of the company’s current and future value change, which impacts supply and demand for shares of the stock. Your investment return (what you gain from owning the stock) depends on capital gains (the amount that the share price increased or decreased since you bought it) as well as dividends (distributions of company profits, which some companies pay to shareholders on a quarterly basis).
Bond. A bond is a claim on the debt of a particular government or company. The original purchaser of a bond has lent money to the government or company. Federal, state, and municipal governments as well as private companies can issue bonds, which is akin to taking out a loan in which interest payments must be made, followed by a lump sum payment at the end of the loan term. The risk (and therefore the return) of bonds varies based on the credit rating of the issuer, the length of time before the bond matures, and the interest rate environment at the time. Bonds are generally viewed as less risky than stocks because a company is obligated to pay their debt to bondholders prior to any payments to stockholders in the case of bankruptcy. As a result, the expected return for bonds is significantly lower than for stocks over the long term.
Mutual Funds. While a stock gives you a share of ownership in a single company and a bond gives you a claim on the debt of a single government or corporate entity, a mutual fund allows you to use the same level of investment to buy a piece of hundreds (or thousands) of stocks or bonds. A mutual fund is like a box holding a variety of stocks and/or bonds, and instead of buying a share of ownership of a stock, you buy a share of ownership of the box. For example, the DFA U.S. Large Company mutual fund holds shares of stock for 503 different companies. When an individual buys a share of that mutual fund, they are effectively purchasing a fraction of a share in 503 companies.
Mutual funds allow investors to hold a diversified portfolio for much less than it would cost to diversify by buying individual stocks. This helps to minimize the risk that any one company will do poorly or go bankrupt over a particular period of time.
As with any familiar terms you might use on a daily basis in your own industry, we often take for granted that clients know what these terms mean. However, if you ever have questions about how we describe your investments or investing in general, please feel free to call us or bring them up at your next annual review. We believe strongly that our strategy for investing is in the best interest of our clients and having clients understand this terminology enables us to paint a clearer picture of why that is.
Stay tuned for “Investing 102” in the coming weeks!
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