Financial Alphabet Soup

by Cameron Schaefer on July 24, 2008

Ever hear words like diversification and asset allocation dropped in conversations at the office or on CNBC and feel like you’re a stranger in a strange, strange land?  If so, I have news for you, you are not alone.  America is financially illiterate.

While the world of personal finance and investing can be quite intimidating, it’s not hard to learn a few of the basics AND in doing so, make better-informed financial decisions than the other 99% of the world.  Most of the terms used on Wall Street are fancy words for very simple concepts.

So, in an effort to make sure that readers of Schaefer’s Blog are well-equipped to “speak the language” of finance, I’ve surveyed a few of my friends and come up with the following terms and ideas that people should know.  This post will focus specifically on investing with an emphasis on the stock market.

The Basics

First things first.  When a company wants to raise money it basically has two options: sell stock or issue bonds.  By selling stock it’s essentially breaking up the company into a bunch of little chunks and selling them to investors.  By issuing bonds it is retaining ownership, but selling debt or, in other words, getting loans from investors.

Stock – Also known as “shares,” represents ownership in a company.  It usually entitles you to voting rights on company decisions and a claim on part of the companies earnings.

So when you hear someone say they bought 100 shares of Google, they are simply saying that they bought 100 units of ownership…they now own a fraction of the entire company.  How much ownership a share represents is dependent on how many shares of the company exist.  For example, Google currently has approx. 314 million total shares outstanding, so someone that bought 100 shares would only own .0000003% of the company.

Finally, when you’re looking in the newspaper in the finance section or you see a stock ticker online what you are seeing is the stock symbol (Google is GOOG, Coke is COKE), then the current price of one share of stock and how much it went up or down that day.  Looks something like this:  COKE   34.32   -0.56

Bond – an investment where the investor is purchasing a companies debt by loaning them money at a fixed interest rate for a defined period of time.  Different than stocks because instead of investors having to rely on company profits to make money, the company pays a fixed amount back to investors each year.

Another way of looking at it.  Just like you get a loan from the bank when you need to buy something, companies issue bonds to get lots of mini-loans from individual investors.  By buying a bond you are simply lending a company some money and trusting they will pay it back with interest.

Blue Chip – a stock of a well-respected company that is known to be consistent with paying dividends.  A blue chip is most likely a big company that you have heard of like Coke or Johnson&Johnson.

Mutual Fund – a pool of money managed by an investment company.  They all have different objectives, but the most common is a fund made up of many different stocks.  It is a great tool for the beginning investor because through buying one share of a mutual fund you are actually buying a fraction of several hundred or even thousands of different stocks.  Mutual funds are an easy way to diversify (to be discussed next) when you don’t have several thousand dollars to buy several different individual stocks.

A great explanation from Ramit Sethi, author of one of my favorite blogs, I Will Teach You to Be Rich:

Mutual funds work like this: You pick a fund you like (e.g., growth, value, technology, international…), buy shares of the fund, and let a money manager pick the stocks he thinks will yield the best return. In exchange for this diversification and his expertise, you pay an annual fee.

Diversification – This term is thrown around a lot and while it sounds complex it’s really just a fancy way of saying, “don’t put all your eggs in the same basket.”  If an investor puts all his money in American automotive stocks like GM, Chrysler and Ford he is NOT diversified and is at great risk if the auto industry or American economy in general hits a rough patch.  If, however, he buys GM, Nestle (Switzerland), Bank of America, Boeing and Petrobras (Brazil) he is much more diversified and as a result, taking on much less risk since it is less likely that all of these businesses and economies would hit a rough patch at the same time.

Asset Allocation – Instead of reinventing the wheel on this one I’ll defer to Ramit’s definition, “…asset allocation is a fancy way of describing where you put your money (e.g., 50% in stocks, 20% in index funds, etc). It’s like outlining a paper: You want to know where you’re going with your investments. Otherwise, you just get a hodgepodge of random investments with no central goal.”

A general rule is that when you are young most of your assets should be in stocks (less conservative, more potential for large growth) and as you get older you should transition more to bonds (more conservative).  The main reason is when you are young your investment horizon is much longer, you have several decades to let your investment grow so a few drops here and there won’t have a big impact in the end.

Bull/Bear Market – A prolonged period where the market is performing better than normal (Bull) or worse than normal (Bear).

Rally – when the majority of stocks in the market are going up for a given period of time, a sudden upturn.  Most investors love when the stock market rallies because prices are going up which means they are making a profit when they sell.

More to Come…

Obviously this is just the tip of the iceberg, but hopefully it has given you a few of the basics and shattered the idea that personal finance should be left to the “experts.”  I’m planning on continuing the Alphabet Soup series and including posts with emphasis on real estate, credit and banking.  So keep an eye out people!

***For a great resource in finding more definitions, check out Investopedia AND I Will Teach You to Be Rich AS WELL AS my other posts on Personal Finance

{ 7 comments… read them below or add one }

Akshay Kapur July 24, 2008 at 6:38 am

Cameron,

Thanks for running this series on finance made simple. This is great for beginners and reviewing fundamentals is always important even for veteran investors. I can’t wait for real estate!

Cameron Schaefer July 24, 2008 at 8:21 am

Akshay,

No problem, I think there are a lot of people out there that are interested, but too embarrassed to ask questions like what is a stock because they feel like they should know it by now.

What they don’t realize is that most people couldn’t answer that question! Sure, we know that people buy them and make money, but as to what a stock or bond actually is…I bet most Americans would be stumped.

Mike Bates July 24, 2008 at 12:52 pm

@ Cameron

I bet you’re right, particularly those Americans who weren’t lucky enough to grow up with parents who could explain it to them. When I was in college, my grandfather urged me to take an econ course, and I blew him off because I was a humanities type of guy. Now, I wish I had, I wouldn’t have had to go learn it on my own and would have been able to take control of my own finances (rather than letting them control me) a lot sooner. Why are grandparents so right, so often?

Marylou July 26, 2008 at 1:14 pm

Thank you for this insightful post…keep ‘em coming!
I found your blog by way of Glen Packiam’s blog. :-)

Cameron Schaefer July 26, 2008 at 7:22 pm

@ Mike,

You’re right, grandparents have an uncanny ability to hit the nail on the head when it comes to wise living. Taking control of your finances is so crucial, so much better than having to rely on others. Even though experts can help, the best person to make your financial decisions is you.

@ Marylou,

Welcome! So glad you made it to the party and especially via such a high-quality blog. :)

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