NEW YORK (MainStreet) — Wading through the catchy phrases and arcane vernacular used by financial advisors and Wall Street can be vexing.
Learning even a soupçon of the lexicon means you can decipher the terminology better and learn how it relates to building up the funds in your retirement portfolios. Reading your quarterly statements from your 401(k) plan sponsor or IRA can now be less maddening.
Here are ten popular terms that we demystify.
Stock market indexes - S&P 500, Nasdaq, Dow Jones
Industry insiders are always commenting about the S&P 500, Nasdaq and Dow and how they performed that day in the stock market. These three indexes are one way to track the thousands of publicly traded companies. The S&P 500 tracks the 500 largest companies by market capitalization while the Nasdaq tracks mostly tech and biotech stocks. The Dow tracks the 30 most influential companies, said Koosh Saxena, co-founder of TipdOff, a Mountain View, Calif.-based investing social network platform.
“This helps investors understand the overall movement and direction of markets with easy glances,” he said.
Deciding on your asset allocation in your retirement portfolio is not an exact science. Simply put, this refers to an investment strategy aimed at managing risk in the proportion of funds an individuals holds in equities, fixed-income and cash. Stocks are perceived to be riskier investments while bonds are deemed to be safer ones. Many financial advisors recommend that you own more stocks when you are younger and increase the amount of bonds as you get closer to retiring.
“The main issue to consider when choosing your asset allocation is your tolerance for risk,” said Thomas Walsh, an investment analyst at Palisades Hudson Financial Group in Atlanta. “Once an initial asset allocation strategy is determined, the two vital elements which round out your plan are diversification and consistency. Many academic studies have concluded that asset allocation is the most important determinant of a portfolio’s performance, even above the securities you choose or investment expenses.”
One of the most critical components of investing is rebalancing your portfolio. If you are a Millennial and have a greater tolerance for risk, your portfolio might consist of 80% of stocks while only 20% entails bonds. If the market is having a stellar year, your stock allocation might increase to 85%. If you want to remain true to your strategy, experts recommend that you sell some stocks so you are not too concentrated in them and should purchase additional bonds or another security.
“Conversely, falling markets may leave an area under-represented, signaling the need to add funds to bring the asset class back up to target,” Walsh said. “This process is called rebalancing your portfolio and forces you to sell high and buy low. Rebalancing can be done at set intervals or when an asset class deviates outside of a specific predetermined range.”
Index funds remain one of the most popular assets that investors purchase for their 401(k) or IRA, because they are buying a basket of stocks since it attempts to replicate the elements of a market index. If you purchase shares of a S&P 500 index fund, you will own a portion of the 500 largest companies found in the U.S.
“Index funds are great tools for novice and experienced investors alike, since they tend to be cheap and offer broad diversification all in one investment,” said Walsh.
When investors try to “time” the market, many invariably get it wrong, much like the experts. Some investors wind up selling their stocks or mutual funds at the wrong time and do not follow the adage of “buy low and sell high.” Financial experts recommend that investors avoid this sentiment at all costs, because choosing the winners over the losers is a short-sighted goal.
“The onslaught of advice regarding the next big investment or which stocks to avoid can be overwhelming to a new investor navigating their way through the investment world,” Walsch said. “If you have a long-term investment strategy and determined an asset allocation, ignore all the noise trying to disrupt you from reaching your financial goals.”
When you are researching the return of a stock, mutual fund or ETF, examining only the price at which you bought the security and comparing it with the current market value is a misnomer. This excludes the value of the dividends, said Don Shelly, a finance professor at Southern Methodist University’s Cox School of Business in Dallas.
If you look at the S&P 500 index from 2005 to 2014, the value of the benchmark index rose at a compounded annualized rate of 5.1%. Most of the companies in the index paid dividends to investors.
“Assuming the dividends received were reinvested in the index, the actual compounded annual return over the period would have been 7.3%,” he said.
Average Annual Performance or Return
The industry standard for mutual funds or ETFs is to report Average Annual Performance (or Return) over one-, five- and ten-year periods. These figures include reinvested dividends or the total return, Shelly said.
Bid/AskThe best way to understand the bid/ask for a stock or an ETF is similar to purchasing an item through an online auction. If you wanted to sell a guitar, you might start the price and "ask" $100 for it, said Saxena. The highest someone might want to "bid" or pay for it is $80. In this instance, the bid is $100, and the ask is $80. If you both agree on $90, then the guitar will be sold. The current stock price becomes the last traded value of the stock or in this case a guitar, he said.
This is the most fundamental ratio to evaluate a stock or company, said Saxena. It is calculating the price of a share divided by the earnings per share it creates. The average PE ratio for companies in the S&P 500 is roughly 15. A stock trading at $15 per share with "15 PE" makes $1 per share, he said.
This is an approach that combines actively managed funds and passive index-like strategies to construct efficient portfolios, said Kalen Holliday, a spokesperson for Covestor, the online investing marketplace based in Boston and London.
In the "core" portion of the portfolio, investors aim to match the return of the market with an index such as the S&P 500. In the "satellite" portion, investors try to outperform the index, often with actively managed investment products.
“Active management is an investing approach based on the theory that the greatest returns can be generated by moving in and out of stocks at the appropriate time,” she said. “For some investors, the appropriate time can be when a stock reaches a specific price while others believe it is triggered by 'buy' or ‘sell’ levels based on the overall market.”
--Written by Ellen Chang for MainStreet