Glossary

Bull and Bear Markets. A bull market is one that is rising or is expected to rise. “Bulls” refers to traders and investors who believe that the market will rise in the future—they are said to be “bullish.” A bear market is one that is falling or expected to fall. “Bears” refers to traders and investors who believe that the market will fall in the future—they are said to be “bearish.”

Capital Gains vs. Ordinary Income. Understanding the difference between capital gains and ordinary income is critical for investor performance. Capital gains refer to the price appreciation of an investment. For example, if you buy Apple stock for $100 and sell it five years later for $500, you have a capital gain of $400. Importantly, capital gains are taxed at a lower rate than ordinary income by the U.S. government. What’s more, you can have short-term capital gains, when the investment is held for less than a year, and long-term capital gains, when the investment is held for more than a year. Short-term capital gains are taxed at a lower rate than long-term capital gains. Ordinary income refers to investment income that is taxed at the investor’s normal income tax rate. Dividends earned from stocks and interest/coupon payments from bonds are considered ordinary income.

Commodities. A commodity is “a basic good used in commerce that is interchangeable with other goods of the same type.” Commodities are typically raw materials that are used as inputs for producing goods and services.1 Commodities include energy products like oil and natural gas. They also include agricultural products like cotton, coffee, lumber, corn, and cattle. Metals, like gold, silver, platinum, and copper, are also commodities. Importantly, unlike most stocks and all bonds, commodities do not have cash flows. This means the value of a commodity is entirely dependent on supply and demand. As an investor, you can only make money from a commodity by selling it to another for more than you bought it for. Gold, silver, and a few other commodities, such as platinum, have historically had values above and beyond their industrial worth. For example, gold has some intrinsic value for use in electronics and jewelry, but gold’s market value has traditionally been far greater than its intrinsic value. That’s because humans have, for millennia, thought of gold as a store of value.

Compound Interest. Compound interest is “interest on interest,” which compounds, or multiplies, the money invested. Compound interest accelerates the more compounding periods, or time, that there are, which is why compound interest really becomes impressive only after many decades of growth.

Diversification. Diversification refers to an investment strategy of holding a wide mix of investments within a portfolio. Diversification has been proven mathematically to reduce risk without sacrificing return in certain instances. It hinges on the notion that risk can be better managed by spreading it out—the adage of not “having all your eggs in one basket.” Investors can diversify across securities (i.e., by owning numerous stocks instead of a few), across asset types (i.e., by owning stocks, bonds, commodities, and real estate), by sectors (i.e., having exposure to energy, industrials, technology, healthcare, etc.), and by countries and regions (i.e., having exposure to Europe, Latin America, Asia, Africa, etc.).

Exchange Traded Funds (ETF). ETFs are like a mutual fund in that they pool investor money together to then be managed by professional managers. Unlike mutual funds, however, ETFs can be purchased on exchanges the same way that an individual security like a stock is. That means that you can trade ETFs during the trading day, unlike a mutual fund. Like mutual funds, ETFs come in many different shapes and sizes, from passively managed index funds to actively managed funds.

Factors. Factors refer to characteristics of securities that have been, or are believed to be, drivers of return. Examples include things like value, size, momentum, quality, and volatility. Financial Assets. Financial assets are those that get their value from a contractual right or ownership claim. In contrast to real assets, they do not physically exist. Examples include stocks, bonds, mutual funds, bank deposits, futures, and options.

Fundamental Security Analysis. This concept refers to determining an asset’s intrinsic, true, or real value by examining a company’s current and future financial prospects. Fundamental analysts believe they can determine a company’s true, intrinsic value and then, based upon that company’s current share price, decide whether it is a good buy or a good sell.

Hedge Funds. Hedge funds are private limited partnerships that pool investors’ money and are managed by professional managers. Most hedge funds are actively managed and seek to beat their benchmarks. Hedge funds charge more money than passive funds because they are trying to beat the market. Hedge funds typically require high minimum investments, and many are not available to you unless you already have significant wealth. Many hedge funds are quite risky, buying and selling individual assets regularly.

Index Funds. An index fund is a type of mutual fund or exchange traded fund (ETF) that is constructed to match the components and performance of a financial market index, like the S&P 500. These funds seek to track their chosen index at a low cost. Index funds allow investors to passively invest in their chosen market to receive that market’s return. Index funds typically outperform most actively managed funds (those trying to beat the market) over long time horizons.

Inflation. Inflation is the change, over a specified period, in the price of goods and services. Inflation is typically measured by government agencies, which look at the average price of a defined basket of goods and services over time. When goods and services inflate over time, that means the same amount of money will not buy the same amount of goods and services, on average. Not all goods and services inflate at the same rate; and some may deflate, or go down, over time. For example, the average price of things like televisions and computers has deflated over time, while the average price of things like healthcare, education, and housing has inflated over time. While inflation might sound like a negative, it is a crucial component of modern, capitalist economies. Indeed, the U.S. government, along with most others, mandates that their central banks try to create about 2 percent inflation every year. This is because the government wants people to do two things with their money: (1) spend it in the economy, since one person’s spendings are another person’s income, or (2) invest it with someone else who can put the funds to more productive use. Inflation running at 2 percent is seen as the sweet spot for giving people enough time to either spend the money or invest. Because inflation erodes the value of the currency, it means that people should not hoard cash, which is bad for the economy. High inflation is negative for an economy, however, because it can cause a runaway spiral that is hard to contain, where people’s incomes are no longer sufficient to buy the goods and services they need. But deflation is likely even worse since nobody will want to spend or invest if their cash is worth more in the future.

Markets. A market is a place—whether physical or digital—where buyers and sellers come together to buy and sell goods, services, information, currency, and the like. In accordance with supply and demand, the number of buyers and sellers for a particular asset in a market will determine the price of that asset. So, if there are more buyers than sellers, the price of the asset will go up, which should attract more sellers. And if there are more sellers than buyers, the price of the asset will go down, which should attract more buyers. When most people hear the word “market” they typically think of the stock market, but there are markets for almost everything you can think of, including bonds, commodities, houses, and cryptocurrencies.

Mutual Funds. Mutual funds broadly refer to funds that take investors’ money, pool them together, and invest them. They are managed by professional managers. Mutual funds have many different styles, strategies, and investment mandates. An index fund is a type of mutual fund, but so are actively managed funds that try to beat their index benchmark. You can invest in many different types of mutual funds, such as those focusing on replicating a particular market, sector, region, or country, or those that are actively managed—for example, a technology growth fund. Mutual funds do not have daily liquidity, like many publicly traded assets and ETFs, and can only be traded once a day after the market closes.

Opportunity Costs. Opportunity costs are all the benefits an investor misses out on when choosing one investment over another—the “road not taken.” As investors, we only have a finite amount of money with which to invest. We must make choices and live with them. But blindly ignoring opportunity costs gets investors into trouble. Keeping in mind what you could have done with your money, or what you will give up when choosing one investment over all the others, is a crucial skill to develop as an investor. For example, many investors like purchasing rental properties, fixing them up, and renting them out. They relish the monthly cash flows and expect the property to appreciate nicely over time. But few take the time to compare whether the opportunity costs were worth it. Did your investment do well because of something unique to you or the property, or did the entire housing market appreciate? And what if the entire housing market appreciated more than your rental house? What if you could have taken less risk and earned more return by investing in the entire housing market through a low-cost, publicly traded single-family housing real estate fund? What if you could have done this without any work, like making repairs, paying taxes, and collecting rent? Were the opportunity costs you gave up worth it?

Passive vs. Active Investing. Passive investing means the investor looks to mimic the return of a certain market. This is usually accomplished by purchasing a low-cost index fund that replicates that market. For example, if an investor wants to match the return of the S&P 500, which is a well-known market index in the United States that tracks the stocks of the largest five hundred public companies in the country, the investor will buy an S&P 500 index fund. By investing in that fund, the investor is guaranteed to receive the return provided by the S&P 500, less any fees, costs, and taxes. On the other hand, an active investor looks to outperform the return of a certain market. Therefore, taking the S&P 500 example, an active investor will buy and sell one or more stocks, trying to pick stocks that do better than the S&P 500 index. Further, if an investor purchases an individual stock—say Amazon, for example—that investor is implicitly betting, whether they know it or not, that Amazon will do better than the S&P 500 index. Because, if they didn’t believe that, why not just buy the index? Market timing strategies are also an attempt to outperform the index whereby investors try to be in the market for the good times and out for the bad. It’s important to keep the difference between active and passive in mind when looking at funds, since a fund will either be active or passive in style. Active funds will charge investors more money, sometimes a lot more, for the chance to outperform. Passive investing is simple and low cost, while active investing is expensive, typically requiring many smart analysts and managers who are constantly trying to outperform.

Portfolio. An investment portfolio is simply a collection of different kinds of investments, which could include stocks, bonds, real estate, cash, and commodities. Many investors refer to all their investments as a singular portfolio, while others may split up their investments into different portfolios depending on their investment strategy and organization preferences.

Private Equity. Generally, this refers to investments made into privately held companies. Therefore, investing in a startup or into a friend’s new company can technically be thought of as private equity. However, the term is usually used in reference to investing into a fund managed by a private equity firm. Private equity firms generally buy an equity stake in a portfolio of private companies, typically with debt, to effect positive change in the companies. These are called leveraged buyouts. Venture capital is technically a type of private equity but is usually thought of as a separate type of investment.

Real Assets. Real assets are tangible, physical assets that get their value from their physical properties. Examples include raw land, developed real estate, and commodities.

Real Estate Investment Trusts (REITs). A REIT is a corporation that owns, operates, or finances real estate. REITs are similar to mutual funds in that they pool investor money to be managed by professional managers. Most REITs are publicly traded like stocks, which makes them very liquid. You can buy REITs for many different types of real estate assets, like single family housing, multi-family housing, industrial, medical, and hotels.

Securities. Securities refer to fungible, negotiable financial instruments that can be freely bought and sold in private or public markets. Securities include stocks and bonds, as well as other instruments that derive their value from another asset, like futures and options.

Stocks. Stocks, also called “equities” or “shares,” are pieces of ownership in a corporation. When you own a piece of stock, you are a part owner of that company. That means you get to participate in the company’s growth or decline. Stocks will typically pay the stockholder a dividend from the company’s profits. A dividend is a cash payment to the stockholder on a per-share basis. So, a company may pay a $1 per-share dividend per quarter. If you owned one hundred shares of that company’s stock, you’d receive $100 in cash in your account every quarter. You can then choose to reinvest that dividend back into the company by purchasing more stock or to take the cash. Some companies, particularly companies that are growing quickly, will not pay a dividend, and will instead reinvest any profits back into the company to catalyze growth. In that case, the company’s share price should hopefully increase if such growth is realized. To the stock investor, the only thing that matters is the “total return” with Total Return = Dividends + Share Price Appreciation. It does not matter, therefore, whether the company pays a dividend if the price of the stock appreciates equal to or greater than what the dividend would have been. Importantly, stocks offer no promise of return. The investor gets to participate in any upside, but if the company goes bankrupt, the stock could become worthless. That’s because, in bankruptcy, the company’s bondholders are paid out before any stockholders.

Systematic vs. Idiosyncratic Risk. Systematic risk refers to risks that affect most, if not all, assets and which largely cannot be diversified away. They include things like recessions, pandemics, war, and inflation. Idiosyncratic risks are those that affect individual assets and sectors, and which can be diversified away, in whole or in part, through sufficient diversification. They include things like a CEO making a bad decision, an employee defrauding the company, or a major lawsuit. It is key to understand that, pre-investment, investors should only expect to be compensated (i.e., to receive positive investment returns) for the systematic risks they take. That is because if you can diversify a risk away, you should not expect to be compensated for taking the risk. For example, if you invest in ExxonMobil and they perform poorly, other energy companies will take Exxon’s business and market share. You could have received the energy sector’s return by diversifying and owning the entire energy market, including ExxonMobil. You suffered idiosyncratic risk by choosing just Exxon. This does not mean, however, that you cannot get lucky and earn an outsized return by investing in a single company. In that case, the idiosyncratic risk that could have occurred did not, and the company you chose outperformed the market for that time period. The more diversified your portfolio, the less idiosyncratic risk it should have, leaving you only with systematic risk. Because you should not expect to be compensated for taking idiosyncratic risk, you should try to have maximum diversification to mostly eliminate it.

Tax-Deferred Accounts. Tax-deferred accounts are those that are given special tax treatment by the U.S. government. Some accounts, like many retirement accounts, are funded with “pre-tax” money, meaning that whatever money you put into such accounts will be subtracted from your income that year. For example, if you make $100,000 a year and put $20,000 into a tax-deferred 401(k) account, you will only be taxed by the U.S. government as if you were making $80,000 that year—a significant savings.

Technical Security Analysis. This concept refers to determining whether an asset will go up or down in price based on historical movements, like price, and historical market data, like trading volume. Those utilizing this technique call themselves “chartists.” They look primarily at the past movements of stock prices to decide whether to buy or sell.

Venture Capital. Generally, this refers to investments made into privately held, early-stage companies, typically referred to as startup companies. Venture capital firms will invest in a basket of startups with the hopes that a few strike it big.