Investing terms and questions explained
Below you’ll find a guide to some commonly asked investing questions and terms.
U.S. Treasury securities
U.S. Treasury securities, like bills or bonds, are issued by the U.S. government. When you buy a U.S. Treasury security, you are lending money to the federal government for a specified period of time in return for the future guarantee of more money. Securities from the U.S. Treasury are backed by the government, and are considered one of the safest things you can invest in with your money. But with lower risk comes lower potential reward.
Money Market Accounts
MMA's are savings accounts that tend to have competitive interest rates in exchange for higher deposit requirements. Many money market accounts also place restrictions on the amount of transactions you can make in a month, so it's not ideal as an investment or savings vehicle if you'll be withdrawing money often.
Mutual funds are an investment vehicle that include some combination of securities like bonds, stocks, or commodities. Mutual funds are managed by professional money managers, who actively manage the holdings of the fund depending on their strategy. Mutual funds can provide a way for individuals to diversify their portfolio, but remember to keep an eye on fees, which add up over time.
Hedge funds are similar to mutual funds, they also are professionally managed investment vehicles, but there are a few key differences. Hedge funds can be very aggressive, so risk is an issue. Unlike mutual funds, there is less government oversight, which allows for flexibility, but more risk. Hedge funds also tend to have very high investment requirements, are limited to selected individuals and investments in hedge funds are usually locked-in for at least one year.
Municipal, or muni, bonds are similar to U.S treasury bonds, but are issued by local governments, like states, counties, cities or school districts instead. Governments and government agencies can use bonds to raise money for their own projects, like new highways or bridges. Many muni bonds are also tax-exempt, which make them popular for investors in higher tax brackets.
Stocks are a type of investment security that a corporation issues to the public. Essentially, when you buy a share of a company's stock, you own part of that company. Stocks are the backbone to most investments, as the stock market outperforms other investments over the long-run historically.
Unlike stocks where you own shares of a company, bonds are more like loans. An investor basically loans money to a company or government agency that promises to pay back the money with interest, depending on how risky it is and how long they'll borrow the money for. Bonds are ranked by their level of risk, from AAA to D. Bonds ranked AAA have a very low expectation of default, but offer much smaller returns. Bonds can range anywhere from 90 days to 30 years.
Junk bonds are basically very high-risk, but high-reward, bonds from companies or government agencies that have a high risk of defaulting on their loan to investors. Junk bonds are rated BB or lower.
401k and 403b plans are retirement accounts offered by companies to their employees. Contributions to these retirement accounts are tax-advantaged, which means contributions to these accounts are not subject to income taxes until being withdrawn. This can be helpful in retirement if you expect to be in a lower tax bracket in the future than you are today. Also, many companies offer some sort of "401k match" to any contributions an employee makes, which is basically free money.
529 and Coverdell Education Savings Accounts
Coverdell accounts and 529 plans are the primary ways to save for your child's education, and are kind of like retirement plans but for education instead. In both plans, earnings on investments are tax-deferred and can be withdrawn free of federal income tax if used for education. 529 savings plans are issued by individual states, where as Coverdell accounts are issued by companies like Scottrade. There are a couple of key differences between the two plans, The Motley Fool has a good guide on deciding between a 529 or Coverdell ESA.
Economics editor Chris Farrell also answered some questions:
What’s the difference between investment and savings?
Savings is your income minus your consumption. In other words, you have money coming into your household and you spend money on food, clothing, shelter, smart phone data plans and so on. What’s left over is savings. (It isn’t easy to set aside money, is it?)
Investment is the term for capturing how you allocate the money you’ve managed to save. For example, you might “invest” all or some of your savings into a savings account, stocks, bonds, certificates of deposit, and U.S. Treasury bills. These options—from an FDIC savings account to high-flying high-tech company--are investments.
What does it mean to own a bond or a bond fund?
Let’s use an example. Let’s say you buy a bond for $1,000, such as a 10-year U.S. Treasury note. You own the bond. You have lent the U.S. government $1,000. The government sends you an interest payment semi-annually. At the end of 10 years, the so-called maturity date, you get your money back ($1,000). Of course, you could sell your bond to someone else before the 10 years is up, but it’s your choice. The basics of bond ownership are fairly similar whether you buy a bond sold by the U.S. government, a corporation, a state or local government.
A major attraction of owning a bond is its certainty. You know how much you’ll get if you own it until maturity.
Bond mutual funds take small bits of money from thousands of individuals, pool that money, and invest it in bonds. There is no set maturity date for a bond mutual fund, although most bond funds slice themselves into short-term funds (5 year fixed income securities and less), medium term funds (5 to 10 years) and long-term funds (10 years and more). The mutual fund is always buying and selling fixed income securities within its target range.
A major benefit of bond funds is the ease of reinvesting money into the fund. All you do is check a box telling the fund manager to put your interest payments back into the fund.
What’s a REIT?
REIT stands for real estate investment trust. With a REIT you can own commercial real estate just like wealthy investors.
By their charter, REITs must invest their money into real estate. Like a mutual fund, REITs take money from many investors. There are two major categories of REITs. A kind of REIT owns direct stakes in properties, such as hotels, hospitals, office buildings and storage units. The other kind of REIT invests in mortgages.
The big attraction of REITs to individual investors is they pay a high dividend. (A dividend is paid to the owners of a company out of profits, usually every three months.) The reason for the higher than normal dividend is if a REIT pays at least 90 percent of its earnings in dividends to its investors the REIT doesn’t pay income taxes.
What’s a preferred stock?
Preferred stock is what Wall Street calls a hybrid security. It has characteristics of both equity (or stock) and debt (or bond). Companies sell preferred stock to raise money. It’s called a preferred stock because the company must pay dividends to its “preferred stockholders” before it pays dividends to its regular stockholders, better known as common stock. (Yes, one simple definition leads to multiple definitions on Wall Street.) Unlike a company’s common stock, preferred stock doesn’t come with any voting rights. That means if a company gets a takeover offer the preferred stock owners don’t get to vote on the merger. The common stocks owners do get to vote thumbs up or thumbs down. Investors like preferred stock because the dividend is higher than the dividend on common stocks. It’s also a stable dividend. Individual investors tend to own common stock. Preferred stock is more of niche dominated by institutional investors, such as large pension funds and insurance companies.
How should portfolios change as you age? And does concern about the bond market change this calculation?
There is no simple answer to this question. The rule of thumb is that the fixed income portion of a retirement portfolio should equal your age. So, if you are 30 years old, fixed income securities comprise 30 percent of your portfolio; 55 years old, the fixed income portion is 55 percent, and so on.
A believer in the calculation is octogenarian Jack Bogle, founder of the mutual fund behemoth Vanguard. When I interviewed him during the 2008-09 bear market he told me that in his 80s he had so much of his portfolio in fixed income securities that the plunge in stock market values didn’t affect him financially.
Thing is, like all rules of thumb using your age as a guidepost is only a starting point. There are many questions to ask. And the answers may push you into a more conservative or a more aggressive approach. Among the issues are how well off are you when retirement looms, whether you plan on having some money go to grandchildren, and if you’re able to work well into the traditional retirement years.
Does the current concern about the bond market affect this calculation? Good question. Bond yields are likely to head higher and bond prices lower if the economic recovery gathers momentum. When interest rates go up bond prices go down, and vice versa. It’s in the nature of the financial instrument. For the average and median worker with a 401(k) and IRA the big effect will be to encourage them to put money into shorter-term fixed income securities, such short-term bond funds.