7 Investing Terms You Should KnowStocks
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If you look up the word “jargon” on Google, you’ll find this definition: “special words or expressions that are used by a particular profession or group and are difficult for others to understand.” Unfortunately, investing is full of these special words and expressions, which can make it unnecessarily difficult for new investors to get a feel for the terminology.
Today, I’m hopefully going to clear up some jargon for you as it relates to investing. I’ve talked a little about investing in some of my recent videos and blog posts, and today I wanted to explain some of the terms that I’ve been using. There’s a lot of information to absorb, and I know that it can be really confusing when you’re new to investing and you’re hearing all these new words. So I think it will be really helpful to go over some of these basic concepts for new investors as well as those with more experience. So let’s get into seven investing terms absolutely every investor needs to know.
The first word I want to bring up is stock. You’re probably thinking that’s an easy thing to define, but I think there’s a lot of confusion about what stocks really are and what it means to buy and sell them.
On a basic level, when you have stock in a company, what you really have is a piece of ownership of that company. So let’s say you invest in Apple. Apple is a huge company, so if you buy one share you’re actually purchasing something like a one in seventeen billion stake in Apple.
Now a share that small isn’t necessarily going to give you any power over the direction of Apple. So it’s not like your investment means that you’re going to be calling the shots or anything like that, and hopefully you aren’t buying it in order to get involved in Apple boardroom meetings.
As an investor, you’re buying stock in Apple so that you can hopefully generate returns on that investment. And what that means is that if Apple stock grows by ten percent, your one in seventeen billion stake also grows by ten percent. So you’re going to be a richer man or woman with a higher net worth even though you didn’t do any actual work for Apple beyond buying the share.
Of course, there’s also a chance that your stock is going to lose value, there’s always a chance that Androids get more popular or something else happens that cuts into Apple’s value. When you invest in Apple, you’re ultimately betting on them to be successful and increase their value in the long run.
The point is that when you buy stock in a company, whether it’s Apple or anything else, you’re hoping that the company will become more valuable as a whole so that your little sliver of stock also becomes more valuable. And in a strict sense, you actually have control over that portion of the company. It’s going to be a tiny amount of control in this case, but if you’re an Apple shareholder then you’re technically entitled to vote on certain types of decisions, at the shareholders’ meeting for example. Unfortunately, you’re going to be drowned out by the major investors, so again the investment is more to earn money than it is to gain any kind of meaningful control.
We just got done talking about stocks in individual companies, but investing a lot of money in one or two companies isn’t necessarily the best strategy.
If you put your life savings in a single company, you might have the opportunity to generate incredible returns, maybe that company does really well and you gain fifty percent or something. But on the other hand, that company could also go out of business, and you could lose everything.
Instead of exposing yourself to that kind of risk, in most cases it makes sense to diversify. And diversifying means that you spread your money around in a lot of different companies and a lot of different fields. For example, you probably don’t want to only own stock in tech companies or in big pharma, because then you’re tying your money to those specific industries.
Now the idea of diversifying introduces a new problem, which is that you probably don’t know enough about that many companies or that many industries. So if you’re new to investing, and even if you’re not, it can be really hard to build a diverse portfolio just by looking at individual stocks.
This is where ETFs (exchange-traded funds) come in. An ETF is basically a fund that can be bought and sold like a stock, but it actually tracks the prices of hundreds or even thousands of different stocks. Instant diversification!
For example, one index fund that I invest in is VOO. This is a really common Vanguard ETF, and it tracks the S&P 500 Index, which is just weighted amounts of 500 large companies that are traded on U.S. stock exchanges. So you don’t have to buy shares in 500 different companies yourself, instead you can buy shares of the S&P 500. And from there, you’ll get the same returns you would have had with individual shares in those 500 different companies.
So that instant diversification is the main benefit of an ETF compared to an individual stock. If you’re looking for a way to invest, consider downloading the Webull app. You can get two free stocks if you deposit $100 or more, so click here to take advantage of that offer.
To be clear, an ETF doesn’t have to be limited to stocks. You can find ETFs that track the prices of certain bond indexes, real estate, or precious metals like gold or silver. Believe it or not, my portfolio is mostly ETFs. And I cover more details in my video on investing for beginners, so make sure to check that out if you want to learn more about ETFs.
As I mentioned earlier, the primary goal of investing in a stock is usually to have that stock increase in value. But in some cases, that isn’t the only way you can make money. Some companies actually pay their shareholders a portion of the company’s income on a periodic basis, generally quarterly.
McDonald’s is a really good example of a dividend stock. They paid a dividend of $1.25 per quarter for the first three quarters of 2020, and in December they’re going to pay $1.29 for the last quarter.
So if you held McDonald’s stock all through the year, you would earn five dollars and four cents in dividend income. That will usually be deposited as cash into your brokerage account/ Now you can also tell your brokerage to reinvest your dividends automatically, but that’s a topic for a different day. Let’s say you owned ten shares of McDonald’s and you held them for the whole year, you would end up earning $50.40 in dividend income on top of any appreciation in the share price of McDonald’s stock.
Fortunately, dividends tend to be relatively predictable. McDonald’s, for example, has been periodically bumping their dividends over the past few years. So the quarterly payment went up from $0.94 to $1.01 in 2017, then to $1.16 in 2018, then to $1.25 in 2019, and finally to $1.29 for the last dividend payment of 2020.
With that being said, dividends are ultimately set by the board of directors. So other than the incentive to keep their shareholders interested, there’s nothing stopping them from pulling those dividends if the market is down.
On the other hand, the board can also increase the dividend on certain occasions. For example, Microsoft had some extra cash in the early 2000s, they wanted to give their investors more confidence, and they announced a one-time dividend of $3 per share in 2004. Again, the dividend is set by the board of directors, so there isn’t anyone forcing Microsoft to pay out their extra cash. But in most cases, companies try to consistently increase the dividend or at least avoid reducing it so that they don’t lose investors.
4. Capital Gains
If you follow the news at all, you probably have heard the term “capital gains,” specifically in the realm of taxation. But what are capital gains?
This may sound redundant, but capital gains are gains you’ve realized upon selling a capital asset. OK, your next question is probably “what’s a capital asset?”
Now, this isn’t a very technical definition, but a capital asset can be almost anything that you buy that increases in value. When that thing, let’s say your Apple stock, has increased in value, you can sell it for that increased value. So now you have a capital gain, and the gain is equal to the difference between the purchase price and the sale price. If you bought five shares for $500 and sold them for $600, then you gained $100. That $100 is your capital gain, and that is generally taxable.
The reason why people talk about capital gains so much is that you can usually get tax benefits by holding onto capital assets for more than one year. At that point, it will be classified as a long-term capital gain, which means that you will likely pay a lower tax rate than you would on other forms of income. In fact, at least at the federal level, you could pay no taxes on that capital gain at all if your income is low enough.
As we move closer to tax season, I’m going to be writing more articles on taxes, and I will write a specific article on capital gains to cover this topic in more detail. But for right now, that’s a basic working definition of capital gains.
5. Time Horizon
The first four points should give you a basic idea of how stocks and funds work, but they don’t necessarily help you pick particular stocks or funds. Of course you want to get dividends and capital gains and you want to maximize your earnings, but it isn’t always clear which assets are going to give you the best chance of achieving those goals.
The first thing you need to ask yourself when you’re coming up with an investment plan is how long you have to invest. That length of time is called your time horizon, and your investing strategy will be different for a time horizon of one year compared to a time horizon of ten or twenty years.
That might sound counterintuitive if you’re new to investing. You might think that the best investment for one year is also going to be good for two years, ten years, twenty years, or any length of time. In other words, if you expect one investment to grow consistently by ten percent per year and another option to grow by five percent, then obviously the ten percent one is going to be a better value. The problem with this line of thinking is that in general, assets with higher potential gains are also going to have higher levels of risk.
Take the S&P 500 for example. In 2008, the S&P 500 dropped almost 40 percent, and if you needed to pull out your money in 2009 then you were probably in trouble. But over the past 75 years or so, since World War II at least, the S&P 500 has consistently performed really well over pretty much any sufficiently long period of time, say twenty years or longer. There might be ten-year periods in there where it lost money, but you will be okay the vast majority of the time.
So even though you might have bad years, if you’re investing over a long time horizon, it usually makes sense to take on more risk in order to get better overall growth. On the other hand, if you’re investing on a shorter time horizon, you don’t want to put yourself in a position where your investment loses value right when you need it.
In that case, you might want to go with bonds, certificates of deposit, a high-yield savings account, or something else that isn’t going to expose you to a major loss in the short-term. But that is also going to put a cap on your potential growth. I don’t have time to get too deep into specific investing tactics here, but the basic point is that your strategy should depend on how long you’re planning to hold your investment before selling, and that period is called the time horizon.
Margin trading is more of an advanced strategy, but I still think it’s good to be aware of if you’re new to investing.
When you invest, you’re usually buying assets with your own money. Even though a broker might be facilitating the transaction, it’s still your money that’s being used to make that purchase.
Margin trading is a little different. You’re not actually using your own money in this case—instead, you’re borrowing money from the brokerage in order to buy more assets. In other words, the brokerage is giving you extra money so that you can buy more than you would be able to with your own cash.
OK, you might be wondering why your brokerage would give you money like that. The answer is that they’re treating it as a loan rather than as an investment. And just like with any other loan, you’re going to have to pay interest on the money you borrow from the brokerage. That means that you’ll need to gain enough value to compensate for that interest just to break even.
On top of that, the brokerage is also going to take your existing assets as collateral, and you’ll need to have a specific margin account to get started. Let’s say you have $5,000 in a margin account, you borrow $1,000 to buy on the margin, and you eventually have to sell at $800. You took on the risk by buying on the margin, so you’re responsible for making up that $200 loss. And if you don’t have that money in cash, they’re going to take it in the form of the other assets that you have in your margin account, i.e. the ones that weren’t purchased on margin.
Furthermore, if your investment is doing really poorly and you get to the point where you’re overleveraged, the brokerage might issue what’s called a margin call. And a margin call tells you that you either need to cash out and sell your assets for a loss, or you need to deposit more cash so that you have enough collateral to hold your investment. So the more value you have to borrow against, the more the brokerage is going to let you borrow.
Now again, margin trading is a little more advanced, and it obviously involves more risk because you have to pay the brokerage back whether or not your investment succeeds. So you want to be really careful about margin trading, and you never want to borrow any money you can’t cover. But at the same time, if you can cover the risk, and if you think you can earn enough to make up the interest rate, then it isn’t necessarily a bad idea to borrow against your existing assets. With margin trading, you’ll have the opportunity to earn even more than you would have been able to with whatever cash you have on hand.
7. Short Selling
The last point I want to bring up is short selling, which is another term that you might have heard somewhere without really understanding what it means.
To be clear, the mechanics of short selling aren’t as straightforward as buying a stock and selling it later. But in basic terms, short selling means that you’re selling a stock now so you can buy it later. And in that sense, it’s basically the same as regular trading—you want to sell the asset for more than you paid for it. The difference is that in this case, the selling happens first and the buying comes at the end.
OK, in that sense it’s actually the opposite—you lose money if the asset gains value, and you make money if it loses value. And that can be a little confusing. It doesn’t really make sense that you could sell a stock without buying it, and it’s even less intuitive that you would be able to make money by selling something now and buying it again later on. So let me just quickly lay out what’s really going on when you short sell something.
First, you’re going to borrow the asset from a brokerage. You can do this with a lot of the big firms, so let’s say you borrow 100 shares of company A that you think is going to run into some problems. And just to keep things simple, let’s say each share costs $100. 100 times 100, that means you’re borrowing $10,000 in stock.
Now if that was the whole story, I would basically be describing regular margin trading. Up to this point, all you’ve done is borrow shares of company A from your brokerage. But from there, instead of holding that asset for future growth, you’re going to immediately sell it on the market for the same $10,000 that you borrowed. So you still owe the brokerage 100 shares in the company, and you’re going to have to give them back at some point, but for now you’ve cashed out for $10,000.
And OK, let’s imagine you were right. Company A starts trending down, and pretty soon the share price is down to $80 instead of $100. Remember, you still owe the brokerage a hundred shares, so you use the $10,000 that you earned from selling the borrowed shares earlier to buy 100 new shares back at their new market value of $80 each.
That works out to just $8,000, which means that you’ll be able to pocket the remaining $2,000 minus interest, commission, fees, taxes, and any other charges. So when you’re short selling, you want the stock to lose value because that’s also going to reduce the size of your debt. On the other hand, if the share price went up to $120 instead of going down to $80, then you’d be in a situation where you owe the brokerage $12,000 instead of the original $10,000.
This strategy is inherently risky, because it’s not like buying assets where you can only lose the amount you invested. If you short a stock and it goes up instead of down, there’s really no limit to how much money you can lose, and you can see this in the worst-case scenarios.
Let’s say you shorted Zoom at the beginning of the year. it was trading for around $75 in January, and now it’s over $400. So if you shorted 100 shares in January, you only would have borrowed about $7,500, but now you would owe your brokerage over $40,000.
Of course, it’s not going to be that bad in most cases, but you get the idea. There’s a level of risk involved with short selling that isn’t there with buying long, meaning just buying a stock as normal. There’s no upper limit to how much a stock can grow, so you could really lose your shirt if you don’t know what you’re doing when you sell a stock short.
On the other hand, when you buy a stock long with your own cash, the worst that could happen is that the stock goes to zero and you lose your initial investment. So again, shorting can be very effective, there are a lot of people who have done really well with it, but you definitely want to understand what you’re getting into before you start short selling.
Alright everyone, those are seven investing terms you should know. Are there any other investing words you’d like to learn more about? Let me know in the comments, and I will see you next time.
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Logan is a practicing CPA, Certified Student Loan Professional, and founder of Money Done Right, which he launched in 2017. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.