Like most fields, investing has a vocabulary all its own. This can be pretty intimidating when you first start looking at investing, so I’m going to try to define and explain some of the more common jargon.
What’s a Stock?
When a company needs money, one way they can raise it is by selling a piece of the company. But they want to keep using that piece of the company, so they give out receipts for the pieces of the company that they sell. These receipts are called shares of stock.
So owning a share of stock means that you own a piece of a company. And all the shares of stock that a company has represent the entire company. So if there are 100 shares of stock for a company, then each share is worth (1/100) 1% of the company.
Owning a piece of the company entitles you to certain rights. The most important is that you are entitled to receive dividends (see below) if the company decides to pay out dividends. A second right is that you can often cast one vote per share of stock at the company meetings like in the elections for the company officers. At the small investor level this doesn’t mean much, but if you are able to get 50% of the stock, then you can vote whatever decision you want and control the company.
What’s a Dividend?
A company’s sole purpose is to create value. In practical terms this means to make money by doing whatever business it does. And someone who invests in a company is hoping that the company will do well, create a lot of value, and pay the investor some of that money.
A good analogy would be a rental house as the company, and you the owner as the investor. So you buy or invest in the rental house by putting down some money. Then the rental house conducts its business of being rented out. And each month it generates some rent. Most of that rent needs to go to paying the mortgage, insurance, and other monthly bills, and maybe some of it is saved for an unexpected expense or maybe for improvements like new siding or solar panels. But there will hopefully be a little bit left over that the rental house doesn’t need and that you the owner/investor will get to keep. This little bit of money would be the dividend that you the investor receive from that rental house company.
So ideally, when a company’s management decides that they have some extra money, and that they don’t have anything better to do with it in the company, they pay it out to the investors and it’s called a dividend. Usually the payment is made every 3 months, which is once a quarter. And the person that owns the stock when the stock market opens on the ex dividend date is the person that will be receiving the money when it is paid out.
What’s a Mutual Fund?
Lets say you wanted to invest your money in stocks, but you didn’t know which companies were the best to buy. Lets say you didn’t want to learn which companies were the best to buy and just wanted to hire someone to invest the money for you. But you don’t have a whole lot of money and you don’t want to have to pay this person a whole lot. Mutual funds are supposed to fill that role.
So a mutual fund manager lets many, many people make deposits into his fund. Then the mutual fund manager takes that combined money and buys stocks, making decisions on what to buy based on his experience and knowledge. Because so many people make deposits to the mutual fund, the manager has a large sum of money to buy stocks with, so the manager can buy many different stocks, where as one of the investors alone could not buy that wide variety of stocks.
So by investing (making a deposit) in the mutual fund the investors are able to buy many different stocks that they couldn’t otherwise have bought. This means that if any one of the stocks goes down, then the investor doesn’t lose very much money. Whereas if that was the only stock they owned, then they might lose a lot of money. This spreading out of money to avoid losing a lot of money if one investment goes bad is called diversification (see below).
Then generally each year, the mutual fund manager takes some where around 1-3% of the money in the fund as payment for investing the money in the fund.
Because they are easy to invest in and provide the benefits of diversification, mutual funds have been touted as the perfect investment for small investors. This is one reason that you find them so prevalent in the 401ks that many companies offer their employees.
What’s an Index or Stock Index?
An index is a collection of stocks. Sometimes they are all added up together as equals. Sometimes some stocks are given more importance than others in the adding. The idea is that any individual stock might be suffering from some problem specific to itself or benefiting from some lucky gain specific to itself, but if you look at all the stocks at the same time by adding them up, then that will cancel out the problems and the gains and give a more accurate picture of the state of the whole group.
Many different indexes exist. There are indexes for the entire market, so the idea in this case would be to see how the entire market is doing. There are indexes for just the energy companies, and gold miners, and airlines, and on and on.
One that may sound familiar is the S&P 500 index. This is a list of 500 stocks that the company Standard and Poors thinks are most representative of the market. So in their opinion, looking at the combination of these 500 stocks should give you a good idea of how the market over all is acting.
What’s an Index Fund?
An index fund is a type of mutual fund, but it doesn’t have an active manager. It probably has a manager, but the manager doesn’t need to make any decisions. The reason the manager doesn’t need to make any decisions is because an index fund’s purpose is to match the performance of a given index (see above). To do this, the manager just uses the index like a shopping list and buys all of the stocks on the list. So if the index fund is an S&P 500 index fund, then the index fund will own all 500 stocks.
Since the manager is not active, index funds normally have much lower fees than the actively managed mutual funds. That is the manager is not entitled to as high a paycheck because the manager doesn’t need to have any particular expertise to buy all the stocks on a list.
What is Diversification?
Lets say all the money you had to invest was $1000. You buy 10 shares at $50 each of Stock ABC (so $500 total), and 10 shares at $50 each of Stock XYZ (so the other $500) for a total of ($500 + $500) $1000. And then you head off to Aruba on vacation.
Then lets say that some bad news about XYZ comes out. For example, let say they were developing a drug that looked promising and now it looks like its causing heart attacks in patients that have taken it. Since investors were expecting the new drug to do well and add more income to the company they are disappointed.
Some of the investors decide they are so disappointed they don’t want to own the stock any more and try to sell their shares. But to sell a stock you have to sell it to someone else. And after hearing about the problems with the new drug, no one else is willing to buy the stock at $50 per share. So the investors looking to sell offer the to sell the shares at a lower price. And they keep lowering the price looking for a price where someone will be willing to buy the stock.
Lets say someone steps in when they see the stock being offered for $40 per share and decides to buy it. Since actual sale prices are the ones that get reported on the stock charts, everyone else now sees that the stock was at $50 and is now at $40. That means that the initial $500 invested in XYZ is now probably worth $400. This is kind of scary to some investors, so even if they weren’t that disappointed by the news about the drug, they decide to sell their shares of stock incase the price goes even lower. But when they go to offer their shares for sale, no one is willing to buy the shares unless the investors drop the price to $30. So the investors sell their shares at $30 each and jump for joy that they didn’t lose more.
This new drop in price from $40 to $30 causes more investors to sell at lower and lower prices in a chain reaction until the stock has fallen all the way to $10 per share.
Coming back from your nice beach vacation you check your stock account and notice that your balance is 10 shares at $10 and 10 shares at $50 for a total of (10*$10 + 10*$50) $600. Since you initially had $1000, you just lost 40% of your investment money. And not only that, but if you want to get it back you have to earn a 66% gain on the $600 that you have left just to break even.
But if you had bought 1 share of 20 different stocks at $50 per share for a total of (1*20*$50) $1000, and XYZ was only one of those 20 stocks, then what would have happened? You would have had 19 stocks at $50 per share, and 1 stock at $10 per share. So your account balance would have been (19*$50 + 1*$10) $960. So you would have only lost $40 or 4% of your total portfolio. That’s what diversification is.
By diversifying you are able to spread out your investments so that no single investment can seriously damage your whole portfolio. But it should also be noted that by diversifying you are also making sure that no single investment can seriously benefit your whole portfolio. So if ABC had doubled in the first scenario where you had 50% of your money in it, you would have made $500, or a 50% gain. But in the second scenario, you would have made only $50, or a 5% gain.
Just the Tip of the Iceberg
The small sampling of definitions above will probably get you started with more questions than it answers. But that’s the way with most new things we try to learn about, so feel free to send me any questions that you have at contact us and I’ll be sure to answer them.
I’d also like to point out that you don’t need to know everything about a subject to be successful in it. Consider that you use your car to get to work every day, but you don’t need to know anything about combustion, carburetor design, or wheel balance. You just need to know enough to get you to where you want to go. And even if you did know those things, it wouldn’t help you get to work any faster or better than someone that didn’t know those things.
So don’t be intimidated by the seemingly large field of knowledge about investing. Some of the knowledge is useless and lots of the rest is redundant because once you know a particular subset of investing well, you often don’t need to know the other stuff because that subset will meet all your investing needs.