8 Investment Terms You NEED to Know!

Hello and welcome to your first day at Dow Janes University. I’m Professor Britt Baker, and today, I’m teaching Investing 101. Pull out your pens and paper and get ready to take notes.

Ok, jokes aside – I know that it can seem like people in the investing world are speaking a different language…but it’s really not that hard to learn. All you need to know are a few key investment terms to unlock the world of the stock market.

8 Investment Terms You Need to Know

All right, let’s get into it! Here are eight investing terms you need to know.

I’m going to speak to each one of these terms and provide some examples so you really understand them and be on your way to being a confident investor!

1. Return

Your return is what you make (or lose) from your investment. Your return can be a positive or negative number as it refers to the gain or loss that happens after you invest, over a specific period of time.

For example, if you see an ETF that had historical returns of 5% over the past year, that means that if you had invested $100 at the start of the year, your investment would be worth $105 at the end of the year.

Your return is typically expressed as a percentage and it measures the profitability or performance of an investment over time.

Returns are essential in evaluating the performance of investments, comparing different investment options, and assessing the effectiveness of investment strategies.

They also provide insight into the profitability of an investment and help you gauge the risk and reward associated with a particular asset or portfolio. For example, stocks will tend to give you a higher return than bonds, while also carrying slightly more risk. More on that in a minute!

Keep in mind - historical returns are not indicative of future performance, so just because something had 30% returns last year, doesn’t mean it will have the same returns this year!

Now let’s talk about what you invest in to GET a return. That’s called an asset.

2. Asset

An asset refers to something of value that can be owned and has the potential to generate future economic benefits.

For example, if you owned a chicken that laid eggs that you could then sell - that would be an asset.

When it comes to traditional investing, there are lots of different types of assets, including, but not limited to: stocks, bonds, real estate, and commodities. Let’s talk about each one.

• Stocks: Stocks represent ownership shares in a public company. What does that mean? When you buy a stock, you buy a tiny piece of a big company. And then when the company does well, they either pay dividends to their stockholders and/or the value of your stock goes up.
• In general, stocks offer the highest potential returns (7-10% on average), but they also come with more risk than other asset classes. Speaking of which… let’s talk about bonds!
• Bonds: Bonds are IOUs from the government, municipalities, or corporations - it’s a way for them to borrow money (also known as raising capital) in exchange for paying interest.
• When you purchase a bond, you are essentially lending money to the issuer in exchange for regular interest payments - which become your return (remember from earlier?)
• Bonds - since they usually have a set interest rate - are generally considered less risky than stocks, but they also tend to have lower returns than stocks. Think 3-5% on average.
• Real Estate: Real estate refers to properties such as residential homes, commercial buildings, and land. Investing in real estate can provide potential income through rental payments and potential appreciation in property value over time.
• Real estate investments can range from direct property ownership to investing in real estate investment trusts (REITs) or real estate funds. Returns on real estate vary depending on the type of real estate investing you’re doing, but can range from 3-15%.
• Commodities: Commodities are physical goods or raw materials, such as gold, oil, natural gas, agricultural products, or metals.

So instead of investing in a business, or a property, you’re investing in a specific good - like corn. Some people like to invest in commodities because they either want to bet on something specific, or because commodities can add diversification to your portfolio and help hedge against inflation.

Now that you know about assets, let’s talk about how you decide what assets to invest in, which is called asset allocation.

3. Asset allocation

Asset allocation is the process of dividing an investment portfolio among different asset classes, such as stocks, bonds, and real estate, to achieve diversification and manage risk.

Asset allocation is based on the fact that different asset classes have varying levels of risk and return - remember when we talked about how stocks have a higher return and higher risk, while bonds have lower returns and lower risk?

The idea is that investing in the right mix of stocks and bonds, for instance, will help you achieve the right level of risk and reward based on your goals, time horizon and preferences.

For example, if you plan to leave your money invested for 30 or more years, you can tolerate more risk because you have lots of time to ride out the highs and lows of the changing market.

Given that, you may choose to invest more of your portfolio in stocks, which historically have higher potential for returns but also come with higher volatility and risk. In this case your asset allocation might be 95% stocks, 5% bonds.

If you only have 10 years to leave your money invested, say until retirement, you will likely want to add more bonds to your portfolio - which offer lower potential returns but more stability, since you have less time to ride out the ups and downs. In this case your asset allocation might be 70% stocks, 30% bonds.

Alright, now that you understand asset allocation, let’s get into the gold of investing: compound interest.

4. Compound interest

Compound interest is a magical concept that allows your money to start growing exponentially over time. We refer to compound interest as the avalanche of investing - once it starts, it accumulates more and more really fast!

Technically, compound interest is when you earn interest on your initial investment, which makes it grow, and then you keep earning interest on the new larger amount. You can think of it as “interest on interest.” It has a compounding effect where the interest you earn is added to your investment, and over time, it generates more interest.

For example, say you have an initial principal of $1,000 and an annual interest rate of 5% compounded annually. At the end of the first year, you would earn $50 in interest, bringing the total to $1,050. In the second year, you would earn 5% on the new total of $1,050, resulting in $52.50 in interest. That additional $2.50 is from the compounding effect - and this number gets bigger and bigger over time. Assuming the same rate of return, after 10 years your initial $10,000 investment would grow to over $16,000 because of compound interest.

Compound interest is a key factor in long-term wealth accumulation and can significantly amplify investment returns.

5. Diversification

Diversification in investing refers to the strategy of spreading your investments across different assets or asset classes to lower your risk.

It’s the same idea as the adage, “don’t keep all your eggs in one basket”. If you drop the basket, you lose all your eggs. We don’t want that to happen with your investments, so you want to have multiple baskets carrying your eggs, or multiple types of assets that you’re invested in.

One easy way to diversify is to invest in funds instead of individual investments. Funds allow you to bundle stocks or bonds and invest in many of them at once, which automatically increases your diversification. Three types of funds are mutual funds, ETFs, and Index Funds.

A mutual fund is a fund that pools money from multiple investors to invest in a diversified portfolio of stocks, bonds, or a combination of both. It is professionally managed by a fund manager or a team of managers who make investment decisions on behalf of the fund's shareholders, which usually means there are higher fees involved in investing in a mutual fund.

An Exchange-Traded Fund (or ETF) is an investment vehicle that combines the features of a mutual fund and a stock. It is designed to track the performance of a specific index, sector, commodity, or asset class.

ETFs are traded on stock exchanges, allowing investors to buy or sell shares throughout the trading day at market prices - this makes them not only really easy to invest in, but they also have really low fees.

I love investing in ETFs and have designed my entire portfolio using ETFs.

Finally, an index fund can be a mutual fund or exchange-traded fund that is designed to replicate the performance of a specific market index, such as the S&P 500, Dow Jones Industrial Average, or a bond index. It’s another easy way to add instant diversification to your portfolio.

Now that I’ve mentioned portfolio a few times, let’s talk about what an investment portfolio really is.

6. Investment portfolio

Your investment portfolio refers to your collection of financial assets, such as stocks, bonds, mutual funds, ETFs (exchange-traded funds), real estate, and other investments.

Building a proper investment portfolio involves selecting a mix of different asset classes and individual investments that align with your goals, risk tolerance, and time horizon (which I’ll explain in a moment).

A well-diversified portfolio typically includes a range of investments across various sectors, regions, and asset types, as we just discussed.

Now let’s talk about risk tolerance and time horizon, two things I’ve mentioned a few times in this article.

7. Risk tolerance

Risk tolerance in investing refers to your ability to handle or accept uncertainty and potential losses associated with investment decisions. It is an important factor to consider when creating an investment portfolio and choosing what to invest in.

Every investor has a different risk tolerance based on their personal circumstances, financial goals, investment knowledge, and emotional capacity to withstand fluctuations in the value of their investments. Some investors are more willing to take on higher levels of risk in pursuit of potentially higher returns, while others prioritize the preservation of capital and seek lower-risk investments.

Usually you have a sense of whether you’re more risk averse or more risk tolerant, and you can use this self-awareness as you build your portfolio. For instance, if you’re more risk tolerant you might choose riskier assets to invest in - like more stocks in your asset allocation, and maybe cryptocurrency. If you’re more risk averse, you might choose to increase the bond percentage in your portfolio or only invest in things you understand really well.

Finally, there’s your time horizon.

8. Time horizon

In investing, your time horizon refers to the length of time you expect to hold an investment before needing to access the funds. The time horizon can vary greatly from one investor to another and depends on individual circumstances and goals.

For example, if you’re 60 and investing for retirement, your time horizon will be shorter than if you were 30.

If you’re investing the money you’ve saved for your kid’s college fund, then you have the number of years until they go to college.

Your time horizon is a critical factor to keep in mind when making investment decisions - as we discussed during the asset allocation section. Why does this matter?

Because the longer you have before you need to take the money out, the more you can tolerate ups and downs, knowing you’ll be invested for a longer time - this usually means you might be willing to take on more risk. Alternatively, if you need the money on a shorter time horizon, you likely don’t want to risk the value changing dramatically so you’ll likely take less risk with your investments.

Knowing your time horizon, combined with your personal level of risk tolerance can help you determine an appropriate investment strategy.

Want to Become a Confident Investor?

Great job! You have aced Investing Lingo 101! Give yourself a huge round of applause - you’ve mastered investment terminology and you’re on your way to being a confident investor. I’m excited for you!

If you’re ready to put it into action right away, join our free masterclass where we share some of the secrets of being a successful investor.