Glossary

Active investing

For mutual funds, active investing means the decision to purchase or exchange securities is made by a manager or team of managers attempting to achieve the best investment results possible within a given investment theme. Because of the need to compensate the manager and support the investment team, actively managed mutual funds tend to have higher management costs than passively invested mutual funds.

After-tax

An adjustment to the value of one’s income or investments, taking into account the effect of taxes. To overly simplify, a person earning $40,000 per year owing 10% in taxes could have a $36,000 after-tax income.

After-tax returns

The idea that we should reasonably compare investment results only after taking into consideration the amount of taxes that will need to be paid on that asset once it is sold, or the amount of taxes that will be charged on income from the asset.

Alt-A

An intermediate credit risk designation applied to mortgage borrowers who may be somewhere between subprime and prime, according to FICO scores and other risk factors. Alt-A may also indicate that the borrower has provided limited documentation of his or her income or wealth, resulting in higher interest rates to compensate the lender for the additional risk.

ARM (adjustable-rate mortgage)

A mortgage with a set interest rate for the first 2, 3, or 5 years, but which will readjust annually to a new, possibly higher, interest rate after the fixed period is over. This can be dangerous for borrowers for whom a higher interest rate will make monthly payments unaffordable.

Auto loan

Debt backed by an automobile as collateral. These can be obtained from an auto dealer or from a bank or credit union. Even if you eventually obtain a loan from an auto dealer, it’s a good idea to get preapproved for a loan from your bank or credit union before shopping for a car, in order to reduce the number of simultaneous negotiations involved in purchasing a car.

Automation

The absolute number one key to successful savings and investments. We need to “set it and forget it” when it comes to investing in order to overcome our natural human tendency to not save or invest when given a choice. The decision to automate removes the choice and leads to savings and investment success.

Beneficiary

The named recipient of a deceased person’s retirement account or life insurance contract.

Bonds

Also commonly known as fixed income. In simplest form, a bond is a loan to a company or government, for a known amount of time and at a contractually obligated interest rate. As an investor, returns come from the repayment of interest and principle over time. Bonds may also be made up of a combination of loans, such as mortgages, creating a bond securitization. If the bond is from a highly rated company or government, the investment is considered not risky.

Budget

Tracking income and expenses, ideally for at least a month at a time, to cover major expenses like housing, transportation costs, and credit card bills.

Capital gains tax

The tax owed by an investor who sells an asset that has appreciated in value since purchase. This applies to assets like stocks, but could also apply to a business or real estate. For example, at a 20% capital gains tax rate, an investor who bought a stock at $5,000 and sold it at $15,000 would owe 20% of the $10,000 gain in the year of the sale, or $2,000.

Car title loans

A typically high-interest loan collateralized by a car. Unlike prime auto loans, these loans are targeted at financially distressed or subprime borrowers and carry high rates of interest.

Cash back financing

A transaction from an auto dealer that allows the purchase to buy a car and also receive cash. This makes no sense financially, as it would only result in a larger loan.

Certificate of deposit (CD)

Typically purchased from a bank or credit union, CDs provide a fixed amount of interest for a set amount of time such as 1 month or 6 months or 2 years. These are a form of fixed income and are very low risk.

Claim

The monetary loss presented to an insurance company for payment in the case of the unexpected insurable event occurring.

Collateralized loan

A loan, such as a car loan or home mortgage or pawn-shop loan, in which the borrower pledges something valuable as a guarantee in case of nonpayment.

Compound interest

The idea that money grows over time and at an increasing pace, as “interest grows on interest.”

Consumer Reports

A service providing product comparisons based on cost, reliability, and performance on consumer goods including cars.

Coverage

The maximum payout available in case the unexpected insurable event occurs. The higher the coverage, the more expensive the premium. If you can self-insure through savings and investments, coverages can be kept to a minimum, thus lowering the cost of insurance.

Credit bureaus

Three companies—Equifax, Experian, and TransUnion—that continuously collect data from lenders on experiences with individual borrowers. Their reports are used by lenders for both marketing and risk management purposes. We can and should access our credit reports from these companies when seeking to borrow money, in order to see exactly what banks see when making lending decisions about us.

Credit card

A high-interest, short-term line of credit to which most adults have access. While many “teaser” rates begin at 0% or a low to moderate rate, most credit cards charge much higher rates over time through a combination of stated interest rate, fees, and penalties. In the United States, credit card companies may charge a maximum allowable rate of 29.99%.

Credit union

A business offering traditional banking services such as deposits and loans, but which operates for the benefit of members, rather than as a for-profit entity.

Death

My only 100% personal guarantee in this book!

Deductible

The amount of loss an insured person will endure before the insurance company becomes responsible to pay for the loss. With a $1,000 deductible on a $25,000 claim for homeowner’s insurance, for example, the company will pay out $24,000, leaving the first $1,000 loss to the homeowner. If given a choice of deductible, an insured person can choose a higher deductible in order to receive a lower cost of insurance. This can be a wise choice to save money, as long as the insured has resources to “self-insure,” at least to the amount of the deductible.

Discount rate

The mathematical number which, when applied to future amounts of money, translates those payments into an equivalent amount of present-day money. In mathematical terms of the compound interest formula and discounting cashflows formula, the discount rate serves the same function as yield.

Discounting cashflows

The mathematical technique that underpins banking and insurance, business investment decisions, and is the key tool of all fundamental stock and bond investing.

Diversification

The idea that investors should hold a variety of investments that have different characteristics. The key to having diversification improve your portfolio is that the investment results are not perfectly, or highly, correlated.

Dividends

A share of profits that may be distributed to owners of shares in a for-profit company. Under current income tax law in the United States, dividends are taxed at a lower rate than ordinary income.

Donor-advised fund (DAF)

A low-cost investment vehicle to achieve a tax advantage now for making future charitable gifts, while allowing for time to consider recipients. In addition, through the appointment of trustees such as one’s children, the DAF becomes a way to include others in a discussion of one’s philanthropic values.

Efficient markets hypothesis

The idea that asset prices adjust extremely quickly to reflect all known information about an investment’s prospects. The logical response to the efficient markets hypothesis is to develop deep skepticism about how much “edge” any individual person could have in selecting individual stocks (or other investment products) in attempting to “beat the market.” Even if you do not embrace a hardcore version of the efficient markets hypothesis, it is useful to assume it is true in most cases, until proven otherwise.

Emergency fund

The typical advice to new savers to build up a cash buffer for unexpected expenses. Not as useful, in my opinion, as an open line of unused credit, like an unused credit card.

Employer match

The only “free lunch” in the known universe, in which an employer adds money to an employee’s retirement account, such as a 401(k) or 403(b) plan.

Entrepreneur

A person who creates an organization that did not exist before to solve a problem.

Entrepreneurship

The act of creating a new line of business that did not exist before. Also, the key to building extraordinary wealth in one’s own lifetime.

Envelope trick

The technique for saving money and imposing discipline on spending through placing a fixed amount of cash in an envelope dedicated to specific spending categories like “eating out,” “transportation,” or “back-to-school clothes.”

Equities

The category of investments, like stocks, which represent ownership in for-profit companies, with rights to vote but more importantly, rights to share in future profits, if any. Traditionally the profits of companies are considered volatile and uncertain, so equities represent a high-risk, high-return way to invest.

Estate planning

Legal and tax planning, through documents and discussion, for disposal of your assets, especially after you die. Although taxes are typically a consideration, an even higher consideration should be pursuing an expression of your life’s values.

Estate tax

A tax on the value of cash and assets left by a deceased person.

Exchange-traded fund (ETF)

A basket of thematically related investments such as stocks or bonds that may be purchased or sold through a single transaction. Similar to a mutual fund, except that ETFs may be purchased at any time throughout the day at the then-prevailing price. ETFs are typically “passively invested” in the sense that the list of securities will be set ahead of time according to preset criteria, rather than made up according to manager discretion.

Exclusions

The events not covered by insurance, such as suicides within a certain time frame after purchasing for life insurance, or claims for flood damage for most homeowner’s insurance.

FICO score

The single score produced by the Fair Isaac Corporation and available for purchase from three consumer credit bureaus that forms a key part of how lenders see borrowers. The score is determined by an algorithm that takes into account historical and current experience borrowing money. It does not take into account factors such as income, employment status, wealth, race, ethnicity, or geography. A 720 or higher score should qualify borrowers for a prime rate loan. Below a 660 FICO and borrowers may be offered a subprime loan. Between 660 and 720 is sometimes labeled Alt-A and may result in terms between subprime and prime. Borrowers should always know their FICO score before requesting credit.

Financial Infotainment Industrial Complex

The majority of financial media, including print, video, audio, and online. Although it pretends to inform, in aggregate it tends to confuse rather than illuminate. It is a mixture of sales, information, and entertainment and not typically a reliable source of financial guidance.

Fixed annuities

An insurance investment product that provides a fixed monthly or annual income stream, usually for the remaining life of the person, and often guaranteed for a limited amount of time, like 5 or 10 or 20 years. These are a form of fixed income, offer a very low return on investment, and are considered very low risk.

Fixed income

The category of investments, like bonds, annuities, and CDs, which offers a series of contractually obligated cashflows of a known amount for a set amount of time. In traditional form, fixed income is low risk and low return.

Flipping houses

A business activity commonly promoted by the Financial Infotainment Industrial Complex. Usually not a sustainable business idea through an entire economic cycle.

401(k) plan

A tax-advantaged, employer-sponsored retirement account, in which contributions are made directly from an employee’s paycheck into an investment account. Contributions may also be matched by employers, making these plans especially attractive. Contribution limits are higher than those of an IRA. The 401(k) plan offerings may be custom-designed to the specification of the for-profit employer’s wishes, and as such are relatively expensive to administer and more typically found at larger employers.

403(b) plan

A tax-advantaged, employer-sponsored retirement account available to nonprofit and government employees. Contributions are made directly from an employee’s paycheck into an investment account. Contributions may also be matched by employers, making these contributions especially attractive. Contribution limits are higher than those of an IRA.

457 plan

A retirement account available to highly compensated employees of nonprofit organizations. Employees may contribute to, or receive employer contributions to, both a 457 plan and a 403(b) plan simultaneously.

Future value

The monetary worth of money or an asset at some future point in time.

Gold

A shiny collectible metal with decorative value and limited industrial application that nevertheless gets sold by the Financial Infotainment Industrial Complex to the financially naïve as a safe place to protect your wealth. It has no legitimate place in an individual’s investment portfolio.

Hawthorne effect (aka observer effect)

The hypothesis that the act of observing a phenomenon will change the behavior of the thing observed. This is the real advantage of budgeting, in my opinion.

HELOC (home equity line of credit)

A revolving credit line, similar to a credit card, that may be drawn down, repaid, and then drawn upon again as needed. This type of line of credit typically is based on a second lien or mortgage upon a home. This can be a powerful advanced-level financial tool for a responsible borrower. Because it is a mortgage on a home, however, a HELOC can be a dangerous tool in the hands of someone who has a history of trouble with debt.

Homeowner’s insurance

Insurance commonly required by banks to insure against damage to the property, as well as personal property. Typically excludes protection against floods.

Income tax

The amount of federal, state, and local money owed per year as a result of annual earnings. Understanding the role of income taxes can help us think about the best and most efficient way to earn money.

Inflation

The economic term for the prices of goods and services going up over time. This may be in part because the value of the currency has decreased, or it may just reflect supply and demand of the thing for sale.

Inflation hedge

The idea that a home with a mortgage can act as partial protection in case of unexpectedly high inflation. In that circumstance, the nominal prices of the real estate will increase mostly in line with inflation elsewhere. The mortgage, however, will become worth relatively less, under conditions of high inflation.

Inheritance

Assets received from a deceased person.

Insurance

A financial product properly used to transfer unexpected and catastrophic risks from an individual or business to a company.

Interest rate

The additional money owed by a borrower to a lender, in return for the use of money for a set amount of time. Usually quoted as an annual rate.

Internal rate of return (IRR)

The growth of money in an investment over time. Usually quoted as an annual growth rate. In the mathematical formulas for compound interest and discounting cashflows, yield is an equivalent variable to internal rate of return (IRR), as well as discount rate.

Investment adviser

A professional who, ideally, helps an individual or family formulate a long-term investment plan, and then helps keep to that plan despite what happens in the market. Although frequently paid handsomely for this service, the fees are worth it if they help start an individual on a plan and then stick to that plan. At least 95% of people probably need an investment adviser.

Key man life

A type of life insurance purchased by businesses for important executives, to compensate the company against the risk of the executives’ death.

Latte effect

The term popularized by personal finance author David Bach for the idea that each of us spends small amounts of money on a daily or weekly basis on personal luxuries that go practically unnoticed by us. Bach’s insight is that these small “latte” purchases add up, in the long run, to huge amounts of forgone savings or investments.

Location, importance of

The number one determinant of price in real estate.

Long-term capital gains

Refers to the amount that would be subject to taxation if the asset were held for a year or more. Under current U.S. tax laws, long-term capital gains are taxed less than short-term capital gains, presumably to reward “investing” rather than “speculating.”

Lottery

Legalized gambling organized by the government as a tax on people who are bad at math.

Low-interest debt

Debt offered to prime borrowers, as well as debt lent with collateral, such as a car loan or home mortgage.

Marginal income tax rate

The highest income tax rate to which a person is subject. A person subject to a 30% income tax rate will pay that amount of tax on income earned above a tax bracket threshold. Income earned below the threshold will only be taxed at the lower rate. Because not all income is taxed at the highest rate, it is considered “marginal,” only applying to income above the threshold.

Mortgage

A loan specifically collateralized by real estate. For homes, the typical mortgage can be paid off in 30 years, or somewhat less commonly, 15 years. Mortgages with a schedule different from 15 or 30 years may have a worse interest rate, as the market for these is less common.

Mortgage-interest tax deduction

An income tax deduction, allowing most homeowners to receive a break on annual interest paid for a mortgage. A homeowner who paid $4,000 in mortgage interest over the course of a year and who pays a 25% marginal income tax rate could end up benefiting from this deduction up to 25% of the interest paid, or $1,000.

Mutual fund

A basket of thematically related investments such as stocks or bonds that may be purchased in a single transaction, according to the price of the basket at the end of a trading day. Investors receive over time the blended investment results of the underlying stocks or bonds and pay a management fee to the company that makes the investment selections. The investment theme varies greatly by mutual fund, placing mutual funds along any point on the risk spectrum.

Negative cashflow

In the real estate context, the idea that although it may be considered partially an investment, real estate typically costs money to own, unlike, say, a stock or a bond.

Net worth

A simple measurement of financial wealth, calculated as the sum of all financial and salable assets, minus all debts.

Not risky

Traditionally understood as describing assets that preserve their nominal value under a wide range of scenarios, as well as describing low volatility of results from an investment. Understanding the long-term prospects of a traditional basket of equities and fixed income, however, should help us reevaluate what not risky really means. Traditional “not risky” assets like fixed income typically offer close to zero real return after tax and inflation are taken into consideration.

Passive investing

For mutual funds, passive investing means that the fund will only own a predetermined list of securities according to a set of rules known ahead of time. No human manager intervenes to maximize the investment or try to “beat the market.” Because investing is done automatically based on those criteria, management costs of passively invested mutual funds tend to be very low.

Pawn shop loans

A short-term 30-day or 90-day loan backed by the pledge of a valuable personal item. Annual interest rates can exceed 100%. Unlike most similar loans, however, pawn shop loans do not get reported to credit bureaus, as the pawn shop will simply keep the personal item in the event of default on the loan, instead of affecting personal credit of the borrower.

Pay-day loans

Short-term, high-interest loans, secured by a promise to repay when the borrower gets the next paycheck. All-in interest rates can exceed 100% annually.

Philanthropy

Charitable giving, ideally pursued in an undiversified way, and also pursued as an expression of your personal values.

Premium

The monthly or annual amounts paid to the insurance company. This is the cost of insurance.

Present value

The monetary worth of money or an asset in today’s terms.

Price per square foot

A common metric for comparing the relative expensiveness or affordability of real estate. It allows for a financial comparison between real estate of different sizes, locations, and styles. As a blunt tool, however, it does not tell us about important considerations such as aesthetics, quality of building, and livability.

Prime

Designation for highest quality lending terms, available typically to borrowers with a FICO score above 720, as well as income, wealth, and employment factors that justify the best terms. Prime loans for homes and automobiles will have relatively low rates of interest.

Real estate tax

A common way local governments raise funds. Varies greatly by state and somewhat by local government.

Real vs. nominal returns

The idea that while the numerical (nominal) price of an asset may be increased by some amount, we need to take into account the effect of inflation on the real return of the asset. For example, an asset that increased in value by a nominal 10% in a year will, in effect, have a negative real return if inflation runs at 11% that year.

Rent vs. buy

A common debate for people who have not owned their own home. My own test is whether you plan to own the house for 5 or more years. Less time than 5 years and the decision to own, from a financial perspective, becomes relatively more risky. More than 5 years and it will probably work out.

Required minimum distribution (RMD)

The amount that a retired person aged 70.5 or older must withdraw from retirement accounts per year, according to an IRS schedule. The point of the RMD is to make the income received from retirement accounts subject to income taxation in retirement. The RMD is set by determining the expected remaining life of the retiree, according to an actuarial table with the IRS, and dividing the account value by that expected remaining life.

Retirement

The act of leaving one’s work. Ideally one does not “live for retirement” but rather works at something from which full retirement isn’t even the goal. Because work can confer meaning and attachment to the world, retirement planning should include ways to remain engaged in meaningful work, even after deciding to forgo the need for full compensation for one’s work.

Retirement account

Investment accounts that typically offer tax advantages but cannot be withdrawn from (without penalty) until you reach retirement age. Because of the long-time horizon between investing and retiring, these should be concentrated with higher-risk, higher-reward assets to maximize the power of compound interest.

Risky

Traditionally understood as describing the possibility of loss in an investment, as well as the volatility of results from the investment. Understanding the long-term prospects of a traditional basket of equities, however, should help us reevaluate what risky really means. Traditional “risky” assets such as equities, held over the long term, offer such an overwhelming real return advantage over “not risky” assets such as fixed income that the real risk for young people and retirement savers is to not hold equities.

Roth IRA

An individual retirement arrangement available to any individual who earns income in a year. Unlike the traditional IRA, the Roth IRA does not provide income tax relief in the year of contribution. Rather, income withdrawn after retirement may be enjoyed tax free. Investments held inside a Roth IRA are also exempt from taxes such as on dividends and capital gains. Contribution limits on IRAs are relatively low, compared to contribution limits for an employer-sponsored plan such as a 401(k). Upper income earners may be ineligible to make Roth IRA contributions.

SEP-IRA

An employer-sponsored retirement account appropriate for small businesses. The contribution limit per year is relatively high.

Short-term capital gains

Refers to the amount that would be subject to taxation if the asset were held for less than a year. Under current U.S. tax laws, short-term capital gains are taxed at the same rate as ordinary income, which is typically higher than the tax rate on long-term capital gains.

Simple IRA

An employer-sponsored retirement account appropriate for small businesses. These are less flexible than 401(k) plans but are typically simpler and cheaper to administer. Contribution limits are also lower with a simple IRA than for a 401(k) plan.

Stocks

Also commonly known as equities. A stock represents a fractional ownership in a for-profit company, and typically confers rights to vote and share in future profits, if any, in proportion to total ownership in the company. Because the profit of any individual company is uncertain, the investment results of any single stock can be volatile. As an investment, individual stocks are rightly considered risky.

Subprime

Designation for lending terms that may include high interest rates, penalties, and fees. Borrowers with no credit history, limited credit history, or a checkered credit history will tend to only qualify for subprime loans. FICO scores of around 660 or below may result in subprime lending terms.

Subprime car loan

A car loan for borrowers with less than prime credit, usually a FICO score lower than 720. Interest rates may be between 5% or 10% higher, or more, than they are for a prime borrower.

Subprime home loan

A home loan for a borrower with less than prime credit, usually a FICO score lower than 720. Interest rates on subprime home loans could be 5% or more higher than for prime loans.

Tax advance loans

Short-term loans meant to bridge the time between filing taxes for which a refund is due, and the actual receipt of the tax refund. These loans tend to have very high rates of interest.

Taxes

Funds owed to federal, state, and local government. While important, they should never be the primary reason for making a financial decision. Do not let the tail wag the dog.

Taxes, preparing for filing

My rule: Don’t do your own taxes if you are no longer a student. You will save money in the long run, and will avoid running afoul of the IRS.

Term life insurance

Insurance purchased to protect against the risk of death for a set amount of time, such as 5, 10 or 20 years, that pays out upon the death of the insured person. Term life insurance isolates the “risk transfer” aspect of life insurance better than whole life, and therefore is typically a better choice.

Time value of money (TVM)

The idea that money in hand today is inherently more valuable than that same amount of money will be in the future. This is partly due to the fact that the future is risky, partly due to the usefulness of money today that can be spent on things today, and partly due to phenomena like inflation, which lessens the value of currency over time.

Traditional IRA

An individual retirement arrangement available to any individual who earns income in a year. The traditional IRA provides a deduction on income tax for qualifying contributors. Investments inside an IRA are also exempt from taxes such as on dividends and capital gains. IRA investors will eventually pay ordinary income taxes on funds withdrawn after retirement. Contribution limits on IRAs are relatively low compared to contribution limits for an employer-sponsored plan such as a 401(k). Income tax deductibility on contributions may phase out for upper income earners.

Transaction costs

The price of buying or selling an investment. Real estate has some of the highest transaction costs of any investment.

Variable annuities

An investment product offered by insurance companies that purports to offer safety through a guaranteed minimum return, but also some high yield if the stock market performs well. Because of the high fees, high commissions for salespeople, and illiquidity of the product, I consider these a garbage product that will mostly enrich the insurance company and their salespeople at your expense.

Warranty

A type of insurance for services or consumer goods to financially compensate the purchaser for losses due to faulty work or damage.

Wealthy

Being wealthy consists of having sufficient assets or cashflow to cover your lifestyle costs on a monthly basis, for the rest of your life, such that you can work at whatever lights you up personally without regard to the level of compensation for that work.

Whole life insurance

Insurance intended to be maintained for life, and to pay out upon the death of the insured, whenever that eventually may occur. Often combined with savings, lending, and investing concepts such as “accumulated value” and loans to pay premiums, whole life insurance usually violates the pure concept of insurance as a risk transfer. For that reason I prefer term life insurance.

Yield

The investment term that describes the rate of growth of money over time, typically for a specific investment. Usually quoted as an annual growth rate, making it comparable to an interest rate. In mathematical terms, yield is equivalent to internal rate of return (IRR), as well as discount rate.

Zero percent financing

A transaction that allows borrowers to pay no interest on the loan for a period of time. Understanding the time value of money theory, however, we can understand that the only way a zero percent financing transaction makes sense for the seller is if they sell the product at a substantially higher price than they would be willing to sell the product for cash. Commonly offered with large consumer transactions such as furniture and cars.