No question about it: investing can seem like a “high maintenance” activity. In addition to certain tasks that should be performed regularly (e.g., reviewing account statements and investment annual reports), there are tax laws to keep up with, as well as details about one’s retirement plan investment selections (e.g., reading a Value Line report to learn about the earnings and profitability of a particular company or prospectuses or Morningstar reports for mutual fund performance data). Another challenge for investors is trying to understand the jargon used by professionals in the field and the financial media. Below is a description of eight commonly used terms related to investing:
Asset Allocation- Asset allocation is the way that investors divide their portfolio by placing a certain amount of their accumulated investment capital within different types of asset classes (e.g., 50% stock, 30% bonds, 10% real estate, and 10% cash). Financial experts recommend establishing target asset allocation weights based on personal factors, such as risk tolerance, and rebalancing periodically to maintain the target weights as market performance changes the value of investments.
Capitalization- Capitalization is the market value of a company, which is calculated by multiplying the number of outstanding shares of stock by the price per share. It is often referred to by the financial press with the abbreviation “cap,” as in “small cap stock” or “large cap stock.”
Diversification- Diversification is the process of maintaining an investment portfolio that includes different asset classes (e.g., stocks, bonds, real estate, and cash equivalents) according to a planned asset allocation strategy and with different types of investments within each asset class (e.g., large, medium, and small sized companies and bonds issued by both government and corporations).
Dollar-Cost Averaging- Dollar-cost averaging is the practice of investing equal amounts of money (e.g., $50) at regular time intervals (e.g., monthly), regardless of whether the value of investments is moving up or down. A common example is the amount that workers contribute to a tax-deferred retirement plan each pay period (e.g., bi-weekly). Another is monthly deposits that are automatically debited from a bank account and transferred to a mutual fund investment plan. Investors acquire more shares in periods of declining share prices and fewer shares in periods of higher prices.
Dow Jones Industrial Average (DJIA) – The Dow Jones Industrial Average is the average of share prices of 30 specific U.S. stocks. It is widely quoted each market trading day as a barometer of stock market activity. Because the DJIA uses such a small number of stocks, it is often criticized for not representing the whole market, which is why other indexes, such as the Standard and Poor’s 500, Wilshire 5000, and Russell 3000, are also used to track stock market performance.
Ordinary Income – Ordinary income is current income from various sources that is subject to federal and state marginal income tax rates. Ordinary income includes salary/wages, net income from a business, dividends, and interest and capital gains from investments that are reported on 1099 statements. Under current tax law, ordinary income is taxed at one of six federal marginal income tax rates (10%, 15%, 25%, 28%, 33%, and 35%) based on one’s taxable income and tax filing status.
Tax-Deferred – Tax-deferred investments produce earnings that are not taxed in the current year but will be part of an investor’s taxable income at a later date, usually at the time of withdrawal in retirement. Examples of tax-deferred investments are traditional Individual Retirement Accounts (IRAs), employer 401(k), 403(b), and 457 plans, and annuities.
The Rule of 72- The Rule of 72 illustrates the impact of compound interest on the growth of investments over time. To estimate how long it will take to double a sum of money (any amount), at a given rate of return, divide 72 by the interest rate. The result is roughly the number of years before an initial sum will double. For example, money will double in eight years at 9%, nine years at 8%, and 12 years at 6%. You can also divide 72 by the number of years to determine the required interest rate.
