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

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Continuing on in the 3 Investment Principles series (If you haven’t caught the first two here they are: Time Value of Money and Pay Yourself First) we come to the final principle: Dollar-Cost Averaging (DCA). The aim of DCA is to reduce the risk associated with a single, large investment by spreading out the investing (and risk) over time. Everyone has heard the token financial advice, “buy low, sell high.” Seems simple enough, but in reality no one can predict exactly when a stock will bottom out. By investing a fixed dollar amount at regular intervals (weekly, monthly, etc.) regardless of share price, you will end up buying more shares when the price is low and less when the price is high, thereby maximizing your total return.

An example of this from youngmoney.com:

“Dollar cost averaging works like this: systematic investments are made to an investment account. For this example we will say on a monthly basis. To keep things simple we will also say that the investment account is allocated 100% into one growth fund. We will use $100 as the monthly investment amount. Now, depending on how the market is doing that fund’s price is going to fluctuate from day to day. So let’s look at a six-month example in the table below.

In the example above, you have invested $600 and your account is now worth $791.73. Over the six-month period, you paid an average of $14.33 per share. If you would have taken all $600 and purchased the shares at the beginning of the six months, you would have purchased 30 shares and your account would now be worth only $750. For this example, using dollar cost averaging has increased your account by over 5%! Of course the above scenario is just one example of using dollar cost averaging. There are many.”

This isn’t to say that this method of investing doesn’t have its critics. DCA operates on two assumptions: 1) the investment (stock, mutual fund, etc.) follows an overall positive trend over the investment time frame, meaning, dollar-cost averaging isn’t going to help if the investment you’re putting money into ends up losing value in the long run. 2) If you happen to get extremely lucky and start investing at the bottom of a long-term price trend you would be better off buying a lump sum…good luck timing the market!! John Wagonner explains in USA Today, “Dollar-cost averaging typically does best when an investment goes sideways or down for years and then, at the end of the period, suddenly breaks to the upside.”

As is the case with nearly everything in finance, time frame matters. “Regardless of the amount of money that you have to invest, dollar-cost averaging is a long-term strategy,” explains Jim McWhinney for Investopedia.com, “While financial markets are in a constant state of flux, they tend to movie in the same general direction over fairly long periods of time. Bear markets and bull markets can last for months, if not year. Because of these trends, dollar-cost averaging is generally not a particularly valuable short-term strategy.”

In the end I like DCA for one simple reason, it builds a habit pattern of investing in season and out of season. Its very easy to form the wrong habits in an affluent culture like our own. It seems everyone, but you, always has the latest gadget, toy, car, etc. Spending, saving, investing are all habits. The purpose of this 3-part series on investment principles is to help make good habit patterns, ones that create wealth and enable you to live the High Life.

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If you want to create wealth you must either save more or spend less…that’s it. Why is it so hard then? Most people have the best intentions when it comes to doing these things, but at the end of the month, when the bills and statements arrive, the letdown begins. You realize that your money has yet again pulled a Houdini and is no where to be found…where did it go…you stand there puzzled, your empty Starbucks cups and Hollywood Video receipts mock your weakness. And so the cycle goes…unless you make a change. Thus, the second of the three investment principles every young person should know:

#2: Pay Yourself First

Most people pay everyone else before they pay themselves. They hope at the end of the month they will have some money left over to put towards savings or investments, but it rarely happens, its too easy to spend money. Paying yourself first means exactly that: when you get your paycheck, before you start paying bills, going grocery shopping, filling your gas tank, etc….take a percentage and put it in savings or investments. If you do this you will never go a month without saving money. At the end of the month you will still probably spend all your money…its what we are all great at, but the savings will already be in the bank, safe and sound.

The easiest way to pay yourself first is to set up automatic fund transfers on the days you receive your paychecks. This way you won’t even realize the money is gone, you’ll budget and spend according to the new amount. Spending is largely psychological, if you start out with a smaller amount your mind will tell you that you have to spend less, be more frugal.

Finally, an example of the power of paying yourself first from financial educator David Bach, author of “The Automatic Millionaire”:

“Let’s assume you make $50,000 a year. That’s about $2,000 every two weeks, which is how most people are paid. So to save 10 percent of your income, which is less than an hour a day of savings, you’d have to save $200 every two weeks — or $14 a day.

If you invested $200 every two weeks for 35 years in a retirement account that earned an annual return of 10 percent what would you have? Quite a pot of gold: $1,678,293.78.”

**Author’s Note: I actually pay myself second, I give the first 10% of my income to my local church, also known as tithing…but the principle remains the same.

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