The investment world is full of jargon, acronyms, and all sorts of complex-sounding terms. Sometimes, these terms can make conversations about investing feel more intimidating than they need to be. The truth is that most of this language can be comprehensible to all, with just some basic explanations. And the greater your familiarity with the terminology of investing, the better equipped you will be to make decisions and fully understand our recommendations.
That’s why we’re launching our “Learn the Terms” series, providing you with brief descriptions of key investment terms. Here’s the first installment.
The price-to-earnings ratio (P/E ratio)—also known as a stock’s “multiple” or “valuation”—represents the amount you would have to invest in a company to receive one dollar of that company’s earnings, or profits. If a company is trading at a P/E of 20, you are paying $20 for $1 of current earnings. You can compute a stock’s P/E by taking the current price per share and dividing it by the earnings per share (EPS). The higher a stock’s P/E ratio, the costlier its market value, relative to its financial performance. When you hear that “the market is getting expensive,” it basically means that average P/E ratios have gotten higher. Also, P/E ratios often are used to compare the valuations of two stocks. For example, if Company A has a P/E ratio of 17 and Company B has a P/E ratio of 12, it generally means that investors are more optimistic about Company A’s future growth potential than Company B’s.
Earnings per share
Earnings per share (EPS) is a measure of how much profit a company has generated, relative to the number of shares that exist for that company. EPS is calculated by subtracting preferred dividends from net income and then dividing by the average number of shares outstanding. EPS is generally considered to be the single most important variable in determining a share’s price. As mentioned above, it’s also a major component of the price-earnings (P/E) ratio—the “E” in P/E refers to EPS. If a company is growing its EPS over time, that’s almost always a good thing because it means that the company is more profitable and has more earnings to distribute to its shareholders.
Mutual funds and exchange-traded funds
Mutual funds and exchange-traded funds (ETFs) both are commonly used instruments that provide investors exposure to a “basket” of underlying securities or an index. Professional money managers choose the investments within a mutual fund to achieve a specific goal: growth, income, or a combination of both. Some mutual funds are “actively managed,” which means they try to outperform their benchmark index, such as the S&P 500. “Passively managed” mutual funds, on the other hand, simply try to mirror their benchmark index. Most ETFs are similar to index-based mutual funds in that they are designed to track an index. One of the biggest differences between mutual funds and ETFs is in how their prices are determined. A mutual fund’s net asset value (NAV) is calculated at the end of each day. An ETF, on the other hand, trades like a common stock on a stock exchange, so its price varies throughout the day. Also, ETFs are generally considered somewhat more liquid than mutual funds.
As an investor, your time horizon is essentially the length of time you have until you need to use the money you’ve accumulated in your portfolio for a specific goal. This means that you will have different time horizons for different goals. For example, if you want to invest for college for a newborn child, your time horizon will be approximately 18 years. Or, if you are 30 years old, and you want to retire at 65, you have a 35-year time horizon for your retirement funds. Your time horizon is one of the biggest determinants in how aggressively or conservatively you should be investing. For example, as you get close to retirement, you likely will want to invest more conservatively, so that you can reduce the risk of having to sell investments whose price has dropped.
Liquidity describes the degree to which an investment can be quickly sold without affecting its price. Some investments, such as money market funds, are highly liquid—you can sell them whenever you like with very little risk of losing any value. On the other extreme, owning a house or other real estate is considered to be an illiquid investment because it would be hard to sell quickly without potentially taking a sizable loss from its current market value. As an investor, the amount of liquidity that you need in your portfolio depends on your cash flow needs, your time horizon, and other variables. But you’ll always need some liquidity in your portfolio, because you may have to generate cash quickly, either to meet short-term needs (such as a major car repair or a new furnace) or to take advantage of unexpected investment opportunities.
Risk tolerance vs. risk capacity
Risk tolerance is largely a psychology question, and risk capacity is more of a math question. Your risk tolerance is basically the amount of risk you are comfortable taking to achieve your goals. Determining your risk tolerance involves asking questions such as how would you feel if you lost 20 percent of your portfolio in a market downturn? Or, does the pain of losing 10% outweigh the reward of gaining 10%? By contrast, determining your risk capacity is essentially a math problem. Risk tolerance describes the maximum amount of risk you can afford to take without unduly jeopardizing your goals, as well as minimum amount of risk you probably should assume to generate the rate of return necessary to reach your objectives. Risk tolerance is largely a function of three things: 1) the size of your current portfolio, 2) the amount needed to fund your goals, and 3) your time horizon.
Financial advisors can be either fiduciaries or non-fiduciaries. Those financial advisors who are fiduciaries, such as Leelyn Smith, LLC, are required to act in the best interests of their clients. According to the Securities and Exchange Commission, which regulates registered investment advisors as fiduciaries, the fiduciary duty also requires providing full and fair disclosure of all material facts and avoiding conflicts of interest. Non-fiduciary advisors act under a suitability standard, which is less rigorous than that of a fiduciary. Among the differences: Non-fiduciary advisors’ duty to a client’s investments and financial situation ends once a trade is placed, and these advisors aren’t obligated to monitor client accounts or financial situations on an ongoing basis.
Performance and risk.
Market volatility often has a negative connotation, as some people incorrectly think that volatility is synonymous with downside risk. But volatility actually refers to more than just falling prices. In fact, a volatile market can exhibit both ups and downs, typically in rapid succession. As an investor, one of your best defenses against volatility is to build a diversified portfolio, which can help protect you against a market downturn that primarily affects one asset class.
Alpha vs. beta
Generally speaking, alpha refers to the portion of an investment’s performance that isn’t attributable to movements in the broader market. Conversely, beta refers to the portion of an investment’s performance that is driven by the broader market. For example, if a mutual fund that invested in large U.S. companies generated a return of 8% in a year when the S&P 500 was up 5%, the fund would have generated alpha of three percentage points. Another way to look at beta is as a measure of an investment’s volatility relative to the market as a whole. A beta of greater than 1 indicates that the investment’s price is more volatile than the market. For example, if an investment’s beta is 1.2, it’s theoretically 20% more volatile than the market. Conversely, if an investment’s beta is 0.70, it’s theoretically 30% less volatile than the market.
Interest rate risk
Interest rate risk is the degree to which changes in interest rates may reduce the value of your investments, especially bonds and other fixed-income investments. Suppose, for example, that you own a bond that pays a 4% interest rate, and market rates—the rates paid by newly issued bonds—rise to 5%. If you want to sell your bond, no one will pay full price for it, so you’ll have to offer it at a discount. Bonds with longer maturities have greater exposure to interest rate risk than shorter-term bonds. (Keep in mind, though, that if you don’t plan to sell your bond, but instead hold it until maturity, you can still redeem it for the full face value, and you won’t have to worry about interest-rate risk.)
Keep expanding your investment vocabulary.
This certainly isn’t an exhaustive list of investment terms. These are just some of the terms that we commonly get questions about from our clients. If there are other questions that you’d like us to define, email your advisor at Leelyn Smith and we’ll include it in our next edition of “Learn Your Terms.”
We know that conversations about investing can be intimidating sometimes. You shouldn’t ever feel embarrassed about not knowing what a term means. Investing is a jargon-filled industry. We don’t know all of the terminology that you use in your industry, so we don’t expect you to know all of our jargon.
At Leelyn Smith, our focus is on helping you understand the path we’ve charted to your successful retirement. So don’t ever hesitate to ask us questions about how we think—and talk—about your investments.