It happens to all of us across all disciplines. We follow the news regularly, yet there are some things when, if asked point blank, we falter to explain, despite encountering them daily. To ensure you’re not left stammering when the conversation shifts to finance, here’s an outline of everything you need to know to help you keep up with financiers at your next dinner party!
The term security has nothing to do with safety or riskiness of a financial asset. If there ever was a deceiving term, this is it. This broad term the covers the following types of tradeable assets:
- Equities: Another word for stocks
- Debt: Think CDs and bonds
- Derivatives: Contracts between parties to buy/sell assets at a certain time and price
You have likely heard about the importance of diversifying an investment portfolio to protect against financial risks. Unfortunately, diversification can be cost-prohibitive for new investors who may only have a few hundred dollars to start. This is where mutual funds come in handy. Mutual funds allow many investors to combine their resources into a managed fund of securities. There are mutual funds that can meet the tastes of all types of investors by investing in assets from specific regions, in certain industries, or maintaining a desired split between stocks and bonds. The benefits of instant diversification come with management fees, which is why it is important to review the fund’s prospectus to understand the fee structure and underlying assets before committing your money.
Exchange Traded Fund (ETF)
ETFs are very similar to mutual funds in the sense that both fund types offer quick diversification across asset classes. ETFs usually track an index. The primary difference is that mutual funds are priced once at the end of the trading day, whereas ETFs can be traded throughout the day much like stocks.
Why is this important? Imagine you held a fund which was rapidly losing value during the day. If that fund was a mutual fund, you would have to wait until the end of the day for your sale order to be put through at which point you may have lost even more money. If it was an ETF, you could place you sell order instantaneously at a more palatable price.
An index is a tool that is used to measure the movement of a specific sector of the marke. An index fund is an ETF or mutual fund that actually holds the assets contained in the index or similar statistical representation of the index. Many new investors are advised to put their money in index funds, specifically ones that track the S&P 500 or DJIA, because of their low fees and predictable returns. Fees are able to stay low because the funds are passively managed—they track exactly what is happening in the market and adjust accordingly. It’s worth noting that the time lag in adjusting can cause differing returns. Though, generally speaking, returns are “predictable” because you can look at index to get a strong sense of how your fund is performing instead of having to look at your actual fund.
Much has been said about the derivative market, the mechanics of its operations, as well as its contribution to our financial woes. Tabling that, let’s just focus on its core premise: a derivative is a contract between two parties whose value is derived (get it?) from the value of the underlying asset—commonly securities, commodities, interest rates, currencies, and indices.
The main types of derivative contracts are:
- Forwards: A contract between two parties in which one party agrees to purchase the underlying asset at a predetermined price on or before a set date.
- Futures: Operate much like like forward contracts, with the exception being that the contract is handled by a clearing house which acts as an intermediary between the two parties.
- Options: A contract which gives the owner of the underlying asset the right, but not the obligation, to buy or sell the underlying asset at a set price on or before a set date.
- Swaps: A contract in which parties agree to exchange the cash flows of one underlying asset for the cash flows of another. This can be beneficial when parties are concerned about fluctuations of interest rates.
There is no denying that the derivative market is confusing and jargon laden. For a basic understanding of the market, realize that the aforementioned contracts could be beneficial when parties hope to lock in prices for assets whose values are prone to wild fluctuation. To put it in perspective, most intro to finance books will give the example of farmers hoping to set their prices going into the harvest season rather than once their goods are available for sale.
You’ve been armed with enough info to keep up and contribute when the conversation shifts to finance, but do you find yourself wanting to know more? I’ll introduce other common finance terms in a upcoming pieces, but in the meantime, check out sites like Investopedia, Investor’s Business Daily, and E*Trade to decipher other tricky terms.
Do you have more questions about financial terms? Ask Carleton in the comments below!
If you’re interested in a career in finance, ask Levo Mentor Warren Buffett, Chairman and Chief Executive Officer at Berkshire Hathaway Inc., a question on his profile.