INVESTING
GLOSSARY
bilateral agreement An agreement between two parties in which each has an obligation to the other.
capital Financial and tangible assets owned by an individual or organization, including money, securities, real estate, machinery, trademark and patents.
capital asset pricing model A formula that relates the expected return on a stock or other security to its systematic risk, i.e. the risk that cannot be diversified away. The CAPM and more advanced models help investors value assets and manage portfolios.
capital gains The profit made from the sale of an asset that has increased in value since it was purchased.
dividend Payment made by a company to its shareholders. Dividends are usually paid in cash, but sometimes are paid in additional shares.
equity The net worth of an individual or company, equal to their assets minus any debts. Also refers to owning stock in a company.
go long/go short A trader goes ‘long’ by buying an asset. The trader profits if the price of the asset rises, and loses if the price drops. A trader goes ‘short’ when they first sell an asset and then plan to buy it later. The short trader profits if the price declines and loses if it increases.
Great Depression A worldwide economic depression that began with the Wall Street stock market crash in October 1929 and lasted through the 1930s. It was the worst depression of the twentieth century and had a devastating effect on many countries.
interest rate On a loan, the interest rate is the cost of borrowing money, expressed as a percentage of the sum borrowed. For savings, the interest rate is the money earned from savings or bonds.
liquidation The process of closing down a business and selling its assets to pay its debts.
market index A way of tracking the performance of a group of stocks, providing investors with an overview of market trends. An index can track a particular sector or an entire market.
maturity The date for the final payment of a loan.
net asset value (NAV) The total value of a fund’s assets minus its liabilities. In open-ended mutual funds, investors buy and sell shares at NAV.
public company Ownership of a public company is distributed among shareholders and its shares are freely traded on a stock exchange. Shares are thus available to the general public, in contrast to a private company. The exact definition of a public company differs between countries.
secondary market Investors buy securities directly from companies on the primary market, they then trade them with other investors on the secondary market. Examples of secondary markets include the London Stock Exchange and Nasdaq.
STOCKS
the 30-second statement
Companies sell stock to raise capital. In return, investors buy stock to share in any growth in the company’s value and any profits distributed as dividends. Once a company goes public, investors can trade shares among themselves on secondary markets. These trades give investors flexibility, but don’t provide the company with new capital. People and institutions buy stocks because they expect a company’s value to grow, but there is no guarantee. If the company’s value declines, the value of your stock declines as well. If the company goes bankrupt, you could end up with nothing. But you won’t owe any money – your potential liability is limited to the amount you invested. Stocks thus have unlimited upside, but limited downside. Investors usually invest in common stocks, which provide a simple share in the ownership of a company. Companies sometimes issue preferred stock. Preferred stock provides a stake in a company’s equity, but also has special rights, such as higher dividends or priority in a liquidation. Most investors buy stock hoping it will rise in value but you can also bet against a company by ‘selling short’. To do so, you borrow someone else’s shares to sell and hope to profit later by buying them back at a lower price. Selling short can be profitable, but it is risky. You have limited upside but unlimited potential for loss.
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Stocks are a share of ownership in a company. When you buy stocks, or shares, you own a piece of the company and share in any growth, profits or loss.
3-MINUTE INVESTMENT
Stock prices fluctuate with company performance, economic shocks or political events. There’s longstanding debate about how well stock prices track a company’s real value. Some believe markets do a good job of assessing relevant information. Others worry markets are subject to fads, manias and panics. Others believe some of both. As Benjamin Graham, one of the most famous stock analysts, put it, ‘In the short run, the market is a voting machine, but in the long run it is a weighing machine.’
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MUTUAL FUNDS & EXCHANGE TRADED FUNDS
3-SECOND BIOGRAPHIES
JOHAN VAN OLDENBARNEVELT
1547–1619
Credited with founding the Dutch East India Company, which in 1602 became the first publicly traded company
EUGENE F. FAMA
1939–
Nobel Laureate in economics, known for the efficient markets hypothesis, which predicts that you can’t beat the overall market selectively picking stocks unless you get lucky or take on extra risk
30-SECOND TEXT
Jason J. Fichtner
Own a slice of a company and enjoy the fruits of its growth.
BONDS
the 30-second statement
When they need to borrow money, companies and governments often issue bonds rather then get bank loans. Investors who buy bonds act as lenders. Bonds generally pay interest or a ‘coupon’ regularly over time. For example, a bond might make quarterly payments over a ten-year life. When the bond ‘matures’, the company or government pays back the original loan amount or ‘principal’. Bonds are standardized so issuers can sell them to diverse types of investors – individuals, pension funds, banks – who can then buy and sell them in the future. Bond prices are inversely related to interest rates. A bond might pay 5 per cent interest. If market interest rates fall to 2 per cent, the price of the bond increases. Its 5 per cent coupon is more valuable in a 2 per cent interest rate environment. Conversely, if interest rates rise to 8 per cent, the value of a bond would fall. Investors would rather own a newly issued 8 per cent coupon bond. The exact change in price depends on the bond’s remaining maturity. If a bond matures soon, its price won’t change much. Investors will soon receive their principal back and will reinvest at the new interest rates. If the bond matures in 30 years, however, its price will move a great deal.
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Bonds are standardized loans between an issuer and investors that can be traded in financial markets. Bond prices fall when interest rates rise and vice versa.
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Bond issuers can vary in quality from AAA-rated governments, such as Germany, who are extremely likely to pay all of their coupon and principal payments, to a C-rated risky company, which is highly likely to default. As credit quality decreases, the interest rate on the bond increases. Investors need to be compensated for taking on the greater risk of not getting their money back.
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RISK, REWARD & THE KELLY CRITERION
COMPOUND INTEREST & PRESENT VALUES
3-SECOND BIOGRAPHIES
KING WILLIAM III OF ENGLAND
1650–1702
Initiated the first issuance of national government debt in 1694 to pay for England’s war against France
ALEXANDER HAMILTON
c. 1757–1804
As the first Treasury Secretary of the United States, he advocated to federalize state war debts and ensure payment in full
30-SECOND TEXT
Gerald D. Cohen
Bonds rated AAA are deemed safe and therefore pay lower interest rates than very risky C-rated ones.
FUTURES & FORWARDS
the 30-second statement
Traders face price swings when they trade on the spot market – the market for immediate delivery – or enter into long-term supply agreements based on spot prices. To avoid price surprises, coffee buyers and sellers, for example, can negotiate a forward contract, specifying the price and conditions for coffee delivery on a future date. The forward protects the buyer against price increases and the seller against price declines. Buyers and sellers can also use futures to hedge their price risk. Futures are standardized contracts traded on exchanges. A popular coffee future is for 10 tonnes of Robusta delivered in January. To lock in its January price, a coffee chain could go long (buy futures). Coffee farmers can do the same by going short (selling). These trades can be used for price protection, not just coffee delivery. If so, the chains and farmers will unwind their positions shortly before they come due. If Robusta prices track well with their specific coffee, the financial gains or losses on their futures should offset any unexpected losses or gains on their physical coffee. Speculators – traders who neither use nor produce coffee – can trade futures to bet on prices. Active futures markets exist for financial products and commodities including corn, wheat, soybeans, rice, oil, gold, copper, timber, interest rates, currencies and stock prices.
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Futures and forwards are contracts to buy or sell something at a specified price and date. Forwards are negotiated bilateral agreements, while futures are standardized for exchange trading.
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Forwards and futures limit some risks, but create others. Forward contracts involve counterparty risk. Will the buyer really purchase? Will the seller deliver? Parties carefully negotiate and monitor their deals to ensure partners come through. Futures trade on exchanges, eliminating most counterparty risk. However, they still have liquidity risk. Buyers and sellers must put up fresh capital – margin – if prices move against them, even if delivery is months or years away.
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3-SECOND BIOGRAPHIES
HAMMURABI
c. 1810 BCE–c 1750 BCE
Babylonian king famous for the Code of Hammurabi, which included laws covering forward contracts
TOKUGAWA YOSHIMUNE
1684—1751
Shogun from 1716–45, he liberalized rice trading and encouraged the world’s first organized futures trading at the Dojima Rice Market
30-SECOND TEXT
Donald Marron
Futures help traders, such as coffee buyers and sellers, manage price risks.
OPTIONS
the 30-second statement
Options give you the right to buy or sell an asset at a set price in the future. Whether to do so is entirely your choice. With a call option, you get to choose whether to buy at a fixed exercise price. You might be able to exercise the option any time during a specified time period (an American option) or only at the end (a European option). With a put option, you get to choose whether to sell. Stock options are the most common example, but options also exist on bonds, interest rates, commodities, currencies and other assets. The value of an option depends on the current price of the underlying asset, the exercise price at which you can buy or sell it, interest rates, how long you can wait before deciding and how uncertain future asset prices are. Volatility – the potential for upward and downward price moves – makes options more valuable. So does more time to maturity. Options are an attractive tool for speculating on future price movements. They have limited downsides for buyers – the cost of the option – and potentially unlimited upsides. Options are also useful for hedging risks. A fund that owns many Japanese stocks, for example, might also own put options on the Japanese stock market to provide some protection against an unexpected, large price decline.
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Options are valuable because they let you wait before deciding whether to act – for example, in buying or selling an asset at a set price.
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Options appear in many areas beyond finance. Businesses can launch new products, enter new markets and invest in new equipment. These opportunities are effectively options. Businesses incur costs if they pursue these new ventures but they can wait for favourable conditions before doing so. In your personal life, keeping your options open is common advice. The future is not yet written. Choices that seem attractive today may be less so in the future, and vice versa. So there is benefit to waiting before making costly decisions.
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3-SECOND BIOGRAPHIES
THALES OF MILETUS
c. 624–c. 546
Greek philosopher who bought the first known option, securing the right to lease olive presses before what turned out to be a bountiful harvest
FISCHER BLACK, ROBERT C. MERTON & MYRON SCHOLES
1938–95, 1944–, 1941–
Financial economists who developed a famous method for valuing stock options, often known as the Black-Scholes-Merton formula
30-SECOND TEXT
Donald Marron
Options are valuable; keep them open as long as you can.
MUTUAL FUNDS & EXCHANGE TRADED FUNDS
the 30-second statement
Mutual funds pool your money together with many investors to invest in stocks, bonds, property and other assets to achieve a diversified portfolio that might be difficult to create on your own. Most mutual funds are operated by professional managers, who actively buy and sell investments hoping to maximize investment returns. An increasing share of assets, however, are invested in funds that take a passive approach and allocate investments to match a broader market index. There are thousands of mutual funds from which to choose to align with your own personal investment strategy. Mutual funds allow you to buy or sell fund shares once a day at the close of the market based on the net asset value (NAV) of the fund. An exchange-traded fund, or ETF, is similar to a mutual fund, since it also invests in a portfolio of stocks, bonds, property and other assets, but unlike mutual funds, ETFs trade like stocks and are bought and sold on the secondary market and experience price changes throughout the day. Because ETFs trade like stocks, they are more liquid and typically have lower fees than mutual funds, making them an attractive alternative for long- and short-term investors. Most ETFs are passively managed to track a market index, but some are actively managed.
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Mutual funds and ETFs allow you to purchase a diversified portfolio of assets at a lower cost than you can do on your own.
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Mutual funds and ETFs offer average investors an easy way to invest in broad portfolios of stocks, bonds and other assets. Portfolio returns are a bigger driver of investor returns but not the only one. Investors should also keep an eye on expenses and taxes. Expenses can vary greatly among funds – and so can taxes. For example, mutual funds can generate unexpected tax liabilities from capital gains even if investors don’t take out any money. Many ETFs avoid that problem.
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3-SECOND BIOGRAPHIES
SIR JOHN MARKS TEMPLETON
1912–2008
American-born British investor and creator of the modern mutual fund. In 1939, he bought 100 shares of every company trading on the New York Stock Exchange below $1 – a $10,400 total investment he sold later for $40,000
NATHAN MOST
1914–2004
Created the first ETF, the Standard & Poor’s Depository Receipt based on the American S&P 500 index
30-SECOND TEXT
Jason J. Fichtner
Pool your investments to diversify your risk.
ACTIVE VS. PASSIVE MANAGEMENT
the 30-second statement
Active investing involves selectively buying and selling individual stocks, bonds or other assets in hopes of earning good returns. Active investment attempts to beat broader market returns through a hands-on approach to picking assets. Passive investment involves purchasing mutual funds or exchange-traded funds (ETFs), in which assets are invested in a diversified portfolio to match the return of a broader market index. Passive investing takes a hands-off approach, while active investing requires market timing or knowledge about individual stocks or bonds. Even if you’re not market savvy or have no understanding of the stock market, you can follow an active investment strategy by hiring a stockbroker or money manager to invest for you or by investing in mutual funds whose managers take an active approach to investing. However, active investment usually results in higher costs from trading fees and commissions. These costs reduce your returns, making low-cost passive investment appealing to many. As a result, investors have shifted an increasing share of their assets from active to passive management. There is ongoing debate about how far that shift can go. Passive investing reduces costs but some degree of active investing is necessary to link stock and bond prices to underlying fundamentals.
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Investors as a group cannot outperform the market. Active investors hope for better returns through skill and insight; passive investors aim for market returns at minimal cost.
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Many people think a professional money manager should be able to outperform an index fund. But they don’t. Study after study shows disappointing results for active investing. Any edge the professionals have in choosing individual stocks and bonds is more than offset, on average, by the extra costs they incur in doing so. As a result, only a small percentage of actively managed funds do better than passive index funds.
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BENJAMIN GRAHAM
1894–1976
British-born American investor known as the ‘father of value investing’ who advocated for actively identifying and buying undervalued stocks
BURTON MALKIEL
1932–
Princeton University professor who famously claimed ‘a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts’
30-SECOND TEXT
Jason J. Fichtner
Roll the dice or follow the broader market?
ALPHA & BETA
the 30-second statement
Which had the better year: a stock fund up 20 per cent or a bond fund up 10 per cent? In absolute terms, there’s no contest. The stock fund trounced the bond fund. But that does not mean the stock fund was better managed. If the stock market gained 25 per cent, the stock fund underperformed. If bonds returned 7 per cent, the bond fund outperformed. The bond manager is a star (or lucky) and the stock manager a laggard, even though the stock fund gained twice as much. In investor lingo, the bond fund delivered alpha, a return 3 percentage points more than its benchmark. The stock fund’s alpha was dreadful: negative 5 percentage points. Another Greek letter, beta, is used to measure how closely fund returns track their benchmarks. A fund that tends to go up and down to the same extent as its benchmark has a beta of one. Beta is bigger than one if the fund swings more wildly and less if less wildly. A stock fund might lag a rising market because of poor investments (negative alpha) or tempered swings (low beta). A bond fund might outperform a rising market because of good investments (positive alpha) or wild swings (high beta). Knowing which helps investors judge fund performance.
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When evaluating investment returns, consider relative performance not just absolute. Reward managers for alpha, not beta.
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Alpha and beta are terms from regression analysis, a statistical technique for analysing how things are related. Regressions allow investment analysts to measure how fund performance depends on market returns and economic conditions. Betas measure the sensitivity to each factor. Alpha measures the fund return that remains once you control for all the other factors. The terms first gained prominence when Jack Treynor, William Sharpe and others developed the capital asset pricing model.
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MUTUAL FUNDS & EXCHANGE TRADED FUNDS
3-SECOND BIOGRAPHIES
JACK L. TREYNOR
1930–2016
American economist who pioneered the measurement of investment manager performance
WILLIAM F. SHARPE
1934–
American economist and Nobel Laureate who analysed investment risk, return and relative performance
30-SECOND TEXT
Donald Marron
Investors use alpha and beta to understand swings in asset prices.
