Investment terminology can be confusing. Here are some straightforward definitions of commonly used investment terms.
Short-term investments. These are investments that most investors hold to meet short-term needs, since they're usually safe but generally pay low rates of interest. Also known as "temporary investments" and "cash equivalent investments."
• Certificate of Deposit (CD). A debt security offered by banks or savings and loans associations. Generally, a CD is issued for a specific dollar amount, for a specific period of time at a preset, fixed interest rate. Government insured.
• Savings accounts. A deposit account at a bank or savings and loan which pays interest, and can generally be withdrawn at any time. Money market accounts are a variation of savings accounts that may have more stringent rules regarding withdrawals. Government insured.
• Money market funds. A type of mutual fund that invests in short-term (less than a year) debt securities of agencies of the U.S. Government, banks and corporations. Not government insured, but generally safe.
• U.S. Treasury bills. A debt obligation issued by the U.S. government, having a maturity of one year or less.
Bonds. Bonds are like IOUs. When you buy a bond, you are lending money to a government agency or a corporation in return for receiving interest along the way along with the return of your principal when the bond matures. Bonds are also known as "fixed-income investments" because the bond issuer pays interest at a fixed rate. For example, if you own a $10,000 bond that pays six percent interest, your annual interest income from that bond will be $600 ($10,000 multiplied by six percent) each year until the bond matures and you receive your principal back.
• U.S. Government bonds. Backed by the full faith and credit of the U.S. government, these offer total protection from bond default, although the value of government bonds will fluctuate with interest rates like all bonds and bond funds. There are a couple of types of U.S. government bonds. U.S. Treasury bonds (actually, most issues are called "notes" rather than bonds) are the best known. A second category of U.S. government bond involves mortgage-backed securities such as those issued by the Government National Mortgage Association (GNMA or, phonetically, "Ginnie Mae"). There are also agency bonds issued by various government agencies.
• Municipal bonds. The primary attraction of municipal bonds is that the interest they pay is generally not subject to federal income tax. Since municipal bond fund prices do not appear in the daily papers and are inconvenient for the individual investor to buy and manage, municipal bond mutual funds are a useful way to invest in municipal bonds while avoiding these problems. Interest earned from bonds issued in the investor's own state, including so-called "single state municipal bond funds" is generally free of both federal and state income taxes.
• Corporate bonds. As the name so amply suggests, these are bonds issued by corporations. Depending on the financial strength of the issuing corporation, there are two categories of corporate bonds, and mutual funds that invest in these bonds: Investment-grade corporate bonds, which are comprised of higher-quality corporate bonds and provide interest income with limited risk, and high-yield corporate bonds, which are issued by weaker companies. These bonds (called "junk bonds" in less polite company) pay higher interest, but the risk of default, in other words, possibly losing your original investment, is also higher.
Bonds come in different maturities.
Sorry to complicate matters a bit more, but this is one situation where complexity begets better investment opportunity. Bonds and bond mutual funds are not only categorized according to the type of bonds that the fund will invest in as discussed above - municipals, governments, and corporates, but they are also divided up according to the approximate length of maturity of the individual bonds or the bonds that the manager puts into the portfolio. There are three maturity levels:
1. Short-term bonds and bond funds (also called limited-term bonds and funds). These are bonds with an average maturity of between one and four years.
2. Intermediate-term bonds and bond funds. These bonds sport maturities of between four and ten years.
3. Long-term bonds and bond funds. If you understand short- and intermediate-bond maturities and are mathematically savvy, you have probably figured out that long-term bonds have a maturity of greater than ten years.
Stocks. Stocks represent ownership in a corporation. If you own shares of stock, you own a portion of the company (probably a very small portion). Stocks are commonly classified according to the value of the stock, called its "capitalization." Capitalization is simply the number of shares issued by the corporation multiplied by the current market value of the stock. For example, a stock that has 100,000,000 shares outstanding and is currently trading at $50. per share would have a market capitalization or "cap" of $5 billion. The parameters as to whether a stock is classified as large, mid-sized, or small vary considerably, depending on who's doing the talking. But how the three categories of U.S. stocks are categorized is less important than what they can offer an investor who's interested in diversifying and making money. One such taxonomy is:
- Large-cap: Market capitalization over $10 billion
- Mid-cap: Market capitalization between $2 billion and $10 billion
- Small-cap: Market capitalization below $2 billion
• Large-cap. Stocks of the largest companies are classified as large-cap stocks. These are large, established companies that often keep large reserves of cash to take advantage of new business opportunities. Because of their large size, large-cap stocks are not expected to grow as rapidly as smaller companies. Successful mid-caps and small-caps tend to outperform them over time. Still, investors looking for dividends and preservation of capital with some growth potential choose large-caps. They pay relatively more in dividends than small- and mid-cap stocks. Finally, investors who want their money to remain relatively safe over the long term are often attracted to large-cap stocks.
• Mid-cap. Mid-cap stocks are typically stocks of medium-sized companies. Like small-cap stocks they offer growth potential, but they also offer some of the stability of a larger company. Stocks of many well-known companies that have been in business for decades are mid-cap stocks. Many mid-cap stocks have had steady growth and a good track record. They tend to grow well over the long term. Mid-cap stocks, like small-caps, emphasize growth rather than dividends.
• Small-cap. The stock of small companies that have the potential to grow rapidly is classified as small-cap stock. Many of these companies are relatively new. How they will do in the market is often difficult to predict. Because of their small size, growth spurts can affect their prices and earnings dramatically. On the other hand, they tend to be volatile and may decline dramatically. Because they look to grow rapidly, small-cap stocks are likely to forego paying dividends to investors so that profits can be reinvested for future growth of the company. Small-cap stocks are popular among investors who are looking for growth, who do not need current dividends, and who can tolerate price volatility. If successful, these investments can generate significant gains over time. Because small-cap stocks tend to be riskier than larger-company stocks, the most prudent way to invest in this important stock sector is through a diversified small-cap mutual fund whose manager has expertise in this specialized investment arena.
• International. International stocks are stocks of foreign companies. Some trade on U.S. stock exchanges as "American Depository Receipts" (ADRs), but the majority must be purchased on overseas stock exchanges. Adding international stocks to an investment portfolio enhances diversification since U.S. and international markets typically do not move in tandem. In addition, the higher expected growth rates of many emerging market economies (developing countries) offer the potential for higher relative returns with stocks issued by companies in emerging markets. Because of the difficulty of dealing with foreign stock exchanges and foreign currencies, the best way to invest in international stocks is through an international stock mutual fund. Most international funds invest throughout the world. Some invest only in one country or region. Global stock funds, however, invest in both international and U.S. securities.
Other investment terms. Here are some other investment terms that you may run across.
• High quality stocks. Also known as "blue chip stocks," these are stocks of large, nationally known companies that have a long history of profit growth and/or dividend payments. These companies are often leaders in their industry and have high quality products and services as well as generally excellent management. High quality stocks are the lowest-risk stock investments for investors who deign to invest in individual stocks or mutual funds.
• Speculative stocks. These stocks are subject to very wide price fluctuations and are typically associated with companies that are not well known, but that have products that are rumored to be on the verge of technological breakthroughs - typically these days in the areas of high technology, medicine, biotechnology, mining, and alternative energy. The operative word is "rumored," because these high fliers live or die by the rumors.
• Sector funds. Also called "specialized funds," these funds concentrate on a single industry like energy, precious metals, health care, banking, or biotechnology. Since they are not diversified across multiple industries like the typical mutual fund, sector funds are inherently riskier, yet there could be times when an investor wants to make a pure play on stocks in a single industry.
• Junk bond funds. These are also called "high yield bond funds" and represent mutual funds that hold either corporate or municipal bonds that are lower-rated by the rating agencies like Moody's. The attraction is that they pay higher interest. The drawback is that the risk of default, in other words, losing all or most of your investment, is higher than it is with higher-quality bonds. Corporate junk bonds are issued by corporations that lack long records of revenues and profits or are experiencing financial difficulties. The bonds of municipalities considered by the ratings agencies to lack a strong financial backing to assure the repayment of bond principal are also classified as junk bonds.