The brief definitions below are designed to (hopefully) allow an investor, insurance purchaser, those needing estate planning, etc. to more easily comprehend some basic concepts used in the industry. The difference is that I have added some cautionary commentary that should help you further understand what they really mean and some of the "things" to look out for.
For more sophisticated and extended commentary, investors are referred to the major works on investments, estate planning, college funding, etc. For an excellent resource on investments, see Investments by Bodie, Kane and Marcus; for bonds, see Handbook of Fixed Income Investments, edited by Fabozzi. Be forewarned, these are master's level material- but they are very good.
Any opinions expressed herein are mine alone. (Though if I do happen to be wrong in an interpretation, I will try to blame it on others. See male ego.)
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1099 TAX FORM: Dividends and capital gains that are distributed
by a stock or mutual fund are taxable events (even in reinvested- called
constructive receipt) unless the accounts are in tax sheltered vehicles to
begin with. The amount of the distributions are identified on IRS form 1099
distributed to each taxpayer each year. These amounts increase tax basis
and reduce the amount of appreciation that is taxed when the assets are
subsequently sold.
12b-1 FEES: All mutual funds charge expense fees for running the fund. Others may also charge front end or back end loads. Several years ago, 12b-1 fees were also introduced. (12b-1 is the appropriate section of the Investment Company Act of 1940.) They add additional ongoing annual fees to the expense ratio to compensate the fund for promotion, sale and other activities connected with the distribution of the shares. Funds may charge up to a .25% fee and still call themselves no-load. 12b-1 fees are similar to loads overall since they continually eat into the funds return. Most commentary on 12b-1 fees is negative and most should avoid them like the plague. Better to pay a front end load and be done with it.
401(K) PLAN: This is a retirement plan offered by employers that allows an employee to put away a certain portion of their salary into various investments. Employers may offer contributory amounts. The selection of investments, per rule 404(C) must include at least three different risk types. Loans are available. Contributions are not currently taxed so it and the annual returns are fully tax sheltered. Monies always grow faster in a fully tax sheltered account than that in a partially taxable or fully taxable account, so even if your employer contributes nothing, investing just your own money is normally worthwhile. BUT NOT ALWAYS- check your present and subsequent tax brackets- as well as your estate- to be sure.
403(b) & 501(C)3 Plan: These are tax deferred plans offered to non profit organizations- schools, hospitals, charities, etc. A portion of one's salary- similar to the 401(K) plan- may be invested on a pre tax basis. Mostly marketed as conservative fixed rate investments, mutual funds have also gotten a foot hold. Special calculations are used to determine the amount that may be invested, including a catch up election.
404(C): This code section requires that employers give employees formal instruction on the risks and rewards of investing, primarily because many (most?) employee investors have negligible background in the risks of investing and have had a tendency of using the most conservative (and lowest returning) investments in the portfolio. Congress determined that professional and independent instruction was required to properly instruct employees about the investments available to them. If instruction is not provided in a proper manner, 404(C) indicates that employers may retain liability for inadequate employee retirement accounts. Most current information is sophomoric and does not address the real risks and rewards of investing. Look for litigation in the future once the market comes back to earth.
ACCIDENTAL DEATH AND DISMEMBERMENT: This is coverage built into a policy or, more often, purchased as a rider that pays additional amounts if the disability or death was due to an accident. Though the cost is usually not exorbitant, what is the true value? If somebody dies, the need for money for the survivors is the same be the death through accident or disease, etc. If you have a disability, it is more apt to be due to a back injury, not dismemberment. If you are going to spend the extra money anyway, it is probably preferable to simply buy more insurance up front.
ACCELERATED DEATH BENEFIT: If the policyholder should become terminally ill (normally), the benefit allows distribution of the insurance proceeds before death. Very restrictive, normally requiring physician's statement, etc. but can be a godsend if money is needed.
ACCRUED: Means added or owed to. For example, if interest is not paid on a liability, it is added to or accrued to the principal. If you do not pay your credit card in full, interest and finance charges will be added to or accrued to your bill. For bonds it means the interest that has accumulated since the last interest payment was made; the buyer of the bond pays the market price plus accrued interest.
ACCUMULATION PERIOD/STAGE. The time from when an annuity contract is issued until the start of income payments. Once payments begin, it's called the Annuitization Stage
ACCUMULATION UNIT. A term used in variable annuity products and represent the value of the investment you hold in such contract. Once you start a payout, they are converted to Annuity Units. To calculate the current value of the accumulation, multiply the number of units owned by the current value of one accumulation unit.
ACTIVITIES OF DAILY LIVING: (ADL) Used in long term care policies, they represent the "triggers" defined in the policy that are used justify the payments for home health and nursing home care. The major ADL's include, bathing, eating, mobility, transferring, toileting, continence as well as others. Some states require that only two ADL's be impacted before coverage will commence (California for example)- others allow three.
ACTUARY: A person trained to analyze the odds of insurance, mathematically and statistically, through mortality tables, law of averages and probabilities, etc. They calculate premiums, reserves and other values and are, most notably, used by insurance and annuity companies.
ADJUSTABLE RATE MORTGAGE. A mortgage whose interest rate may be adjusted due to the movement of a specified benchmark- 6-month or 1-year Treasury Bills, 11th District Average Costs of Funds, LIBOR, etc. Do your homework here since, depending on the projected movement of rates, you can find your own rates moving quickly or slowly.
ADJUSTED GROSS INCOME (AGI). Your income shown on your 1040 after allowing for certain "adjustments", but before subtracting Standard or Itemized Deductions and personal exemptions. There's also Modified Adjusted Gross Income that is used in other calculations such as the determinations of IRA's.
AD VALOREM TAX: The tax on the value of an asset. For general obligation municipal bonds, it is largely the tax on real estate that is used to pay interest due.
AGE WEIGHTED RETIREMENT PLAN: Allows a small business owner to make annual retirement contributions based on an employees' age as well as compensation. Older employees- and most probably the owner- are able to receive proportionately larger contributions than the younger employees. In other words, they can really be "top heavy" retirement plans for certain business owners.
AGGRESSIVE GROWTH FUNDS: Seek maximum capital gains and current income is not a significant factor. Many different concepts used- picking out of favor stocks, momentum investing, or possibly using option writing, hedging, futures. You need to carefully read a prospectus in order to determine the risk.
ALPHA: In combination with beta, it represents the ability of the fund manager in picking the best stocks available for the level of risk assumed. For example, if a fund's stocks had a beta of 1.0, you could assume that the fund would merely match the basic index- S&P 500 (beta 1.0). But if the manager statistically outproduced the given beta and index by, say 20%, the fund or manager therefore would have shown an ability to pick the best stocks from those available to get the higher return. He/she would have a positive alpha of , say, 2. Positive alphas are good; negative alphas reflect poor performance on the part of the fund manager.
Alphas should be drawn over a period of time to show consistent results- probably three years. Shorter periods of review- 1 month or even a year- do not necessarily have statistical usefulness. Even positive alphas over three years may have been due to luck and therefore cannot be solely relied upon for future results. Alphas may be determined by different formulas by different services and the figures from one service to another may vary. They mean the same thing but could be interpreted differently/incorrectly. Therefore compare alphas from one service to another carefully.
The formula for alpha is ( (Sum of Y) - ( (B) (Sum of X) ) / N
Where N = number of observations
B = Beta of fund
X = Rate of return for S&P 500
Y = Rate of Return for fund.
ALTERNATIVE MINIMUM TAX: Established by the 1986 tax act, it is an alternative way of figuring the tax owed by an individual- primarily a heavy hitter with extensive writeoffs- other than the regular 1040. It is also a major problem for some corporations. The AMT uses what is called preference items, too numerous and detailed for this glossary. An individual computes the taxes both ways and has to pay the higher of the two.
AMERICAN DEPOSITORY RECEIPT: (ADR) Buying a foreign security directly is fraught with risk- assuming you could do it directly anyway. An ADR is a U.S. security that is a repackaged foreign security. A U.S. bank creates an ADR based on ownership of the shares in the foreign security, while the underlying shares are held in a depositary in the issuing company's home country. The certificate, transfer, and settlement practices for ADRs are identical to those for U.S. securities.
Americanesia Expressaphobia, n 1. Financial affliction, first diagnosed in the late twentieth century, in which the sufferer forgets the amount charged on a credit card but is terribly afraid it's way too much. Closely related to Visago, n, in which a high level of debt prompts feeling of nausea and dizziness.
AMORTIZATION: The process of gradually reducing a debt through installment payments of principal and interest, instead of paying off the debt all at once. A mortgage for example where the principal and interest are amortized over a period of time.
ANNUAL REPORT: Mutual Funds must provide annual reports to all shareholders. You will find a complete listing of assets owned- but recognize that the allocation may have already changed by the time you receive the report. Nonetheless, it gives shareholders an opportunity to review the holdings at that time and determine if they fit the risk profile assumed. This is must reading for all shareholders.
Individual companies provide reports as well and show a very definitive position of its balance sheet, income statement, assets, liabilities, earnings profits, etc. and are known as 10K's. May be combined with other reports to offer a direction of management and competency, but may be difficult to interpret properly.
ANNUITANT: The person named in the policy on whose life the annuity will be based and is normally the person to receive such money.
ANNUITY: A tax sheltered retirement vehicle where investors put in money and the growth remains tax sheltered until pulled out at age 591/2 or later. Penalties apply for early withdrawal by most the annuity companies and decline over time. Rates of return vary tremendously from company to company, not only during the pay in period but also on the payout period. Some companies pay good returns for the, say, 15 years you put money into an annuity, but then pay dismal rates for the 20 to 25 years of retirement. You or you adviser may well need an HP 12C (described below) to figure out the rates of return. You need to absolutely consider inflation, how long you will live, what budget is expected during retirement, if assets are to go to beneficiaries and a host of other related issues. Not for the faint of heart though usually addressed as the most conservative of investments. These are long term contracts/investments, so analyze carefully before investing.
ANNUITY CERTAIN: An annuity payout for at least a minimum period of time and perhaps for life. For example, a 10 year certain period means that the annuitant will receive payments for life. But should he or she die before at least 10 years of payments, the survivor gets payments to equal 10 years' worth. For example, if the annuitant died after 7 years, the survivor would get payments for 3 more years and then they would cease.
There is confusion with a period certain. Under this scenario, the annuitant gets payments just for the time contracted for and nothing more. If he contracts for 15 years, then payments are made just for the 15 years and then they cease.
APPRECIATE: To grow or increase in value. Primary focus in equities and real estate- though bonds may do so as well in certain interest rate environments.
ARBITRAGE: There are times when there might be two different prices on a stock on two different exchanges. If you were "fast" enough, you could profit from this discrepancy by buying low on one and selling higher on the other. First, it is rare that the differences would be that significant. Secondly, you would need a lot of shares and money in order to make a reasonable profit. Third, it's all done by computers and institutions buying large amounts so the average investor will never be able to do this.
ARBITRATION: Many firms require that a new investor sign a form agreeing to arbitration for disputes rather than going to court. Unquestionably cheaper than court and, for the most part, far quicker as well. However the simplicity does not mean any better recognition of the problem by the arbitrators (most require two independent arbitrators and one from the industry). Nor does it mean a greater return to the investor either since most attorneys take from 25% to 33% of award. It is binding on both parties- meaning that you can't appeal, in most cases, to the court system. You can represent yourself- and may be forced to if claim is small since most attorneys will not accept a case less than $50,000. But hire someone at least as an adviser otherwise you'll get eaten by the system. Don't expect anyone to play fair. If the case is large enough, and the opportunity arises, you may wish to consider court. It may take longer and cost more, but, through my experience as an expert witness and arbitrator, I think the outcome could be better. That said, if you used the standard securities attorneys I have seen to date, it won't make any difference since they don't even understand diversification and their presentations end up not addressing the true violations that have occurred.
ARITHMETRIC MEAN: See Geometric Mean
ARTIFICIAL INTELLIGENCE: Almost all funds in existence are run by human managers- though literally all use computers to analyze their various investments. However a few funds have developed computer programs which do literally everything- analyzing, picking stocks, changing allocations etc. Recent statistics show they have done reasonably well, but the verdict is still out on future returns.
ASSET ALLOCATION: An attempt to design a portfolio of various investments that work well together through the use of, normally, random correlations to provide a mixture of risk and rewards consistent with an investors overall risk tolerance. Choices are among the broad asset classes of stocks, bonds and cash with other lesser categories of real estate, options, commodities, etc.
Aggressive portfolios tend to use more stocks and other investments with potential higher standard deviations. Low risk portfolios may focus more on bonds and lower risk investments.
The importance of using various investments to smooth out risk (standard deviation) while potentially keeping solid returns cannot be overstated. Recent studies have shown that a 93.6% of a portfolios return is due to the asset allocation of the portfolio. Only a small amount is due to either the individual stocks picked or to market timing.
ASSIGNMENT: A legal transfer of ones rights to another- such as assigning an insurance policy to another. You normally give up all rights under an assignment.
ATTENDING PHYSICIANS STATEMENT: This is a form completed by a prospective insured's physician(s) that outlines the current and past medical history of the applicant. It is used by the underwriters in evaluating the risks of approving an application. Some insurance companies do not required an APS, but it is the norm with all major policies including long term care.
AUDIT: An official examination of accounts of a corporation for the purposes of supplying accurate figures and adequate accounting controls. In a mutual fund, the annual report must be audited.
AUTOMATIC REINVESTMENT: An option available to shareholders to have either or both of the dividends and capital gains reinvested in the mutual fund. Investors must recognize that all such dividends and capital gains are normally taxable in the year of receipt unless the account is in a tax deferred or tax sheltered form.
AVERAGE RETURN: You need to know how well a fund has done over time. But the manner in which the returns are developed could lead to serious errors. Assume you started with $100
Year Return %
1 10
2 5
3 -10
4 15
5 0
Total 20 divided by 5 years = 4%.
But is that really how you did? Look at the real world numbers below. You started with $100 and went up and down as shown below. For the first year, a return of 10% (compounded annually for those who are already ahead of me) gives you $110.00 at year end. For the second year, you take what is in the kitty ($110) and multiply it by the return of the second year (5%) to get the value at the end of the second year of to get $110.00 + $5.50= $115.50). And so on till the amount at the end of year five is $119.43.
Year Return % $
1 10 $110
2 5 $115.50
3 -10 $103.95
4 15 $119.43
5 0 $119.43
If you had a financial calculator, the annual compounded rate of return is 3.63%- less than the simplistic method above. There are other ways of doing these numbers, but the point is this: you MUST be sure how a return is being quoted- other wise you can be misled/will not understand the difference in one fund's return versus another.
AVERAGE WEIGHTED MATURITY: Used primarily with bond funds, it gives a reasonable time frame for the average maturity dates of ALL the bonds held in the portfolio. Weighted means this. If you have only two bonds in a portfolio- the value of one is $999,999 with a maturity of 10 years and the other bond's value is $1 and matures in 5 years, the "average" maturity of the portfolio is 7.5 years (10 years plus 5 years divided by 2). However it should be clear that the larger valued bond of $999,999 means that the weighted maturity of the entire portfolio is essentially 9.999999 years. The $1 bond's impact is essentially negligible. Always be sure you ask for weighted average- or possibly duration, which is explained below.
BACK END LOAD: Loaded funds used to charge just front end loads- a percentage of the investment immediately deducted from the amount invested. Back end loads were introduced in the 80's that allowed all monies to go to work. Investors faced a charge only if they left the fund within a certain number of years. For example, a back end charge of 5% usually would cost 5% of the amount withdrawn the first year, dropping by 1% per year until five years had gone by. At such time the investor could withdraw all funds with no back end surrender charge. Commissions are paid to the brokers nonetheless through higher ongoing fees and expenses charged on an annual basis. Therefore back end charges tend to be combined with 12b-1 fees.
BALANCED FUND/INVESTMENTS: The use, primarily, of stocks, bonds and cash to balance the growth and risks of one investment versus another and per the perceived direction of the economy. Like asset allocation funds however, managers tend to have vastly different opinions regarding what percentages to take in the various assets and they therefore might not perform as anticipated.
BASIS: This relates to determining how much you actually made on an investment. To do so, you must determine what your actual cost/purchase price of the fund or investment was. For example, buying a fund for $5,000 means your original basis was $5,000. If it grew to $8,000 in five years, you would subtract your original basis of $5,000 (which was also your current basis) for a total taxable return of $3,000. That's fairly simple. But what if you had invested more money each year along with your original investment? Each one of those investments must be added to basis to determine a current basis that is then to determine how much you actually made. For example, if you also invested $250 each year, you would add another $1,250 (5 years x $250) to the original $5,000 for a total investment of $6,250 (called adjusted or current basis). Your appreciation is now smaller at $1,750. ($8,000- $6,250 = $1,750)
If your investment also paid dividends or capital gains which were REINVESTED, these are also added to basis. That is because you could have taken the money and spent it but decided to reinvest (called constructive receipt). Assuming the dividends were $150 per year and the capital gains were $50, the basis would now readjust to $7,250 (5 x $150= $750 plus 5 x $50= $250 and added to the $6,250 above). Now the return drops to just $750.00 ($8,000 - $7,250 = $750.00). The key point to also recognize is that you will be taxed on a much lesser gain. In the first case, the tax on $3,000 gain at 28% is $840. By keeping track of all the extra investment and the dividends and capital gains, the tax on $750 at 28% is just $210. The amount of dividends and capital gains for mutual funds are identified each year to investors via IRA form 1099.
See also step up in basis
BASIS POINTS: Most people are familiar with percent- 1% for example. A basis point is simply 1/100th of a percent. It is frequently used in many articles regarding interest rates, real estate, and other articles on the economy. The articles may say that interest rates increased 25 basis points. That means rates went up 1/4 of one percent. If a rate went from 10.05% to 10.72%, it went up 67 basis points.
BEAR MARKET: Different economists define what a bear market represents- a prolonged drop over 10% in the stock is probably an acceptable definition. In general terms, it represents a consensus by economists and market watchers that the stock market is suffering or will suffer a downtrend at least for the foreseeable future.
BENEFICIARY: An individual or organization who has any present or future interest in the assets of a trust, insurance policy, etc.
BENEFIT PERIOD: Normally associated with a disability policy, it is the time period, after the elimination period has passed, during which the disability income payments are made.
BETA: A mandatory understanding for risk. It is not prefect (most analysis of securities is an imperfect gauge for future performance since the statistics are all based on past performance) and should not be used as an absolute determination of future performance- but it's a great place to start. It relates to the return of an investment as compared to the S&P 500, in most cases. The S&P 500 moves with beta of 1.0. If you have a stock that has a beta of 1.0, it, statistically, should move exactly the same as the S&P 500. If the fund or stock has a beta of 1.2, it should move 20% more than the S&P 500. If the S&P market moved up 10% during a day, the fund should have moved 12%. By the same token, if the market moved down, the fund should have dropped 20% MORE. If a fund or stock has a beta less than 1.0, it is considered conservative; conversely if it is greater than 1.0, it is considered aggressive. Betas should be measured over two or three years. Beta's measured over short periods of time are statistically meaningless. Beta's over ten years may involve periods of time so economically different as to provide inappropriate conclusions.
Beta's of a fund should only be compared to the beta of an index if the fund's assets closely match the index's type of assets. For example, comparing a gold fund's beta to the index 500's beta has essentially no validity since they have literally no similarity. Same with high yield bonds, small cap stocks, etc. But there are other indexes that more closely resemble their own mix and that is what should be used.
The formula for beta
( (N) (Sum of XY) ) - ( (Sum of X) (Sum of Y) )
Where N = the number of observations
X= rate of return for the S&P 500 Index
Y = Rate of return for stock or fund.
Bid and Ask. Bid is the highest price
a potential investor is willing to pay
(e.g., for a stock); ask is the lowest price acceptable to a potential
seller. For more detailed info, click here
BLUE CHIP: Common stock of a highly recognized national company with a history of earnings growth and dividend growth. Does not guarantee certainty about future projections however- consider the volatility of IBM in recent years.
BOND: A certificate representing an agreement by a company, federal government or municipality to pay a certain amount per year to you (usually twice) for the "loan" you have given the entity. Further, at a certain period in time, the company, federal government or municipality agrees to return your principal- the maturity date. For example, if you bought a bond for $1,000 (defined as the "par value" for most bonds) with a coupon rate of 7%, the entity agrees to pay you $35 each six months ($70 per year). Further, if the bond had a maturity date of 05, it means that they will pay you back your $1,000 plus any accrued interest in 2005 (absent default or other problem). (A date of 97 means 1997, 15 means 2015.)
IMPORTANT NOTE: Most bonds have call dates- explained below- and many investors will have their principal paid back early under several conditions- most notably falling interest rates. If you buy individual bonds, ask about callability. If you buy bond funds, expect the many bonds to be called in the portfolio. This can cause significant adjustments to returns via risk of reinvestment- also described below.
BOND RATINGS: See text for chart. Basically, the higher the bond ratings, the less the risk of default on either the interest payments or the principal at maturity. Rating services include S&P, Moody, Fitch, Duffs and Phelps and many others. However, they tend to review different areas and may have different interpretations of this same company/municipality.
BOOK VALUE: The net value of a company less its liabilities as shown on its balance sheet. It will reflect amortization and depreciation, which are used for accounting purposes, and therefore may have little relationship to the company's net asset value if evaluated at market value.
BREAKPOINT SALE: Available in most loaded mutual funds, it allows a purchaser to get a reduced sales charge if he/she puts in enough money. For example, assume that any monies deposited between $0 and $9,999 will be charged a 6% front end load. From $10,000 to $24,999, it's 4%. If an investor therefore commits $15,000, they are not charged 6% on the first $9,999 and 4% thereafter. They are charged 4% overall- on the entire $15,000. The breakpoint for this fund (varies between funds) is the $10,000 level. Another breakpoint may exist at $25,000 and the sales charge might be 2.5%. If you therefore deposit $27,000, you'll be charged 2.5% on the ENTIRE $27,000.
BROKER: (Also called registered representatives, financial consultants, financial advisor, etc.) Each individual that can sell a product for a commission has passed one or more various licensing exams and becomes registered with the NASD. The series 7 license allows the sales of all products except commodities. The series 6 license allows the broker to sell just mutual funds. The unfortunate part of the licensing training is that the reps have never been taught anything of significance in terms of risk, reward, suitability or most other areas mandatory in analyzing an investment or determining proper investments for a client. Absolutely necessary that additional background through other degrees- business, economics- or designations- CFA, Certified Planner, ChFC- be utilized. Nothing wrong with paying a commission for valued service- but competency is NOT provided by any required training through SEC or NASD. Continuing education commenced in 1995. So far, I am not impressed.
BULL MARKET: The reverse of a bear market- where investors expect a prolonged up market.
BUSINESS CYCLE: The fluctuation of business activity and the stages of recovery, prosperity, recession and depression. Also can be shown as the stages of initial growth, rapid expansion, maturity and stabilization or decline. It's really important to know where the economy is- or might be since there is sometimes a lot of second guessing- because different investments work better at different times. Admittedly you are not trying market timing (getting in at exact low as and out at exact highs) but, as stated elsewhere, basic rebalancing should take place once per year to reflect current or anticipated economic events and cycles. Some say that the continued expansion of the past 10 years means that business cycles are a thing of the past. Get real!
BUSINESS OVERHEAD INSURANCE: A policy which will insure the costs of operating a business- per the $ limits- when a business owner is disabled. Provides a short term relief for fixed operating expenses.
BUY/SELL AGREEMENT: A formal agreement between business partners outlining the terms and conditions of a potential sale to either party under certain circumstances.
CAFETERIA PLAN: An employee benefit plan offered under Internal Revenue code 125 where you are allowed so many dollars to distribute among various benefits on a pre tax basis.
CALLABLE BONDS: Very Important since it effects most bonds offered today whether purchased individually or in mutual funds. It allows an issuer to redeem a security prior to the stated maturity. Assume you bought a bond that pays 8%, maturing in 15 years. BUT it is callable by the institution after 5 years at their discretion. It means that they can pay you back all your money (perhaps with a small premium) before the normal maturity of the bond. Why would this happen? Undoubtedly because rates were dropping- say to 5% in year 6. By paying you off, they can then reissue new bonds costing them substantially less in interest payments. Unfortunately, you got back your money early and now have to find another investment paying a return as high as you just left. Good luck- or take on more risk. Brokers should tell you about the bond when purchased- it will be mentioned in mutual fund prospectus. Make sure you understand this issue since it makes planning with bonds difficult. You can never be sure what is going to happen and how long your income stream will last.
IMPORTANT: GNMA's, Freddie Mac and FNMA's have UNLIMITED call dates and these
can be very volatile investments. Do more homework before buying these and
see my other article herein.
CALL PROTECTION: Where the institution cannot call a bond for a certain period of time- say five years. As an investor, you are at least guaranteed to receive dividend payments for that period of time.
CALL OPTION- See OPTION
CAPITALIZATION: The sum of a company's long term debt, capital stock and surpluses. Most commonly referred to in mutual funds as the size of the companies in a fund. Large cap stock fund may refer to companies with over $1 billion. Small cap stock funds may have capitalization of $500 million or less. Mid cap stocks exist in between. However this definition is not consistent form fund to fund or text to text and one needs to read the prospectus to be sure what category the stocks really fit in.
CAPITALIZATION RATE: Used in real estate, it is the percentage computed by dividing the real or expected net operating income into the sales price/value of the property. For example, a $100,000 property with a net income of $10,000 would have a cap rate of 10. If the income was $20,000, the cap rate would be 5. As may be seen therefore, the higher the cap rate the greater the overall risk simply becuase the income is not as great.
CAPITAL EXPENDITURES: When a company invests in plant, equipment or property assets. May be seen by investors as a positive sign.
CAPTIAL ASSET PRICING MODEL (CAPM)
Equation in modern portfolio theory expressing the idea that securities in the market are priced so that their expected return will compensate investors for their expected risk. The equation is:
r = Rf + beta x ( Km - Rf )
where
r is the expected return rate on a security;
Rf is the rate of a "risk-free" investment, i.e. cash;
Km is the return rate of the appropriate asset class.
The risk factor beta is calculated in terms of the chosen asset class.
CAPM is used theoretically, to relate securities to the market as a whole, and practically, as the discount rate in discounted cash flow calculations to establish the fair value of an investment.
And from Bloomberg- An economic theory that describes the relationship between risk and expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification. The CAPM says that the expected return of a security or a portfolio is equal to the rate on a risk-free security plus a risk premium multiplied by the asset's systematic risk.
CAPITAL GAIN: Refer also to basis above. If you have an investment worth $55,000 and your original investment basis plus all added monies and reinvested dividends and capital gain distributions is $40,000 (current or existing basis), the gain for tax proposes $15,000. This may be taxed at the long term capital gain rate of 20% if held one year or more. If the asset has been held less than one year, the gain is taxed as short term rates which are the same as ordinary incomes tax rates. Not available for pension plans, 401(k)'s, IRA's and other qualified plan assets. See TAX section herein for more definitive explanation of the 1997 tax law.
CAPITAL GAINS DISTRIBUTION: Mutual fund mangers are normally required to distribute most gains from any sale of appreciated stocks in the portfolio (may be offset by losses). Capital gains are distributed once per year and are taxable to the investor unless the account is in a tax deferred or tax sheltered form. Losses in a fund may be carried over an offset in subsequent years.
CAPITAL LOSS: In this case, the value of the asset is less than the current basis. For example, if the basis is $40,000 but the asset is now worth only $25,000, there is a $15,000 capital loss. If the asset has been held over year or longer, it is a long term capital loss; less than one year, it's a short term capital loss. See capital netting below.
CAPITAL NETTING: Long term capital gains may be netted against capital losses each year. Short term gains may be netted against short term capital losses each year. If the long term and short term are different, one also and one a gain, they may be netted together. Whatever is larger is what it is. If a gain results, or both are gains, then tax as identified in capital gains above. If the netting results in a loss or both short term and long term losses result, then this special constraint exits. YOU CAN ONLY USE $3,000 OF A LOSS EACH YEAR. WHATEVER IS LEFT OVER IS CARRIED FORWARD TO THE NEXT YEAR AND THE NETTING STARTS ALL OVER AGAIN. YOU MUST UNDERSTAND THIS (OR AT LEAST YOUR ACCOUNTANT) BECAUSE IT MAKES A BIG DIFFERENCE IN SALES OF INVESTMENTS DURING THE YEAR AND THE ULTIMATE TAXES YOU WILL PAY.
Long Term Capital Gain.... LTC Loss...... Short Term Capital Gain..... STC Loss
$50,000 ............................$40,000 ........$30,000 ..............................$70,000
.......................Net........................................................... Net
...................$10,000 LTC Gain..................................... $40,000 STC Loss
....................................................NET
..................................................$30,000 STC Loss
But only $3,000 can be used this year. The rest ($27,000 of short term capital loss) is carried over to next year and the process is repeated all over again.
CASH DIVIDEND: Many stocks and almost all bonds pay cash dividends to investors, perhaps several times per year. They are based (bonds) on the yield indicated on the bonds purchased. Dividends (stocks) are based on profits generated by the company (most often) and whether the Board of Directors votes to have dividends paid to investors (not required). Dividends other than cash may also be paid to shareholders.
CASH SURRENDER VALUE: The amount of money PRE TAX that the policyholder will receive if he/she cancels the contract/coverage.
CASH WITHDRAWAL: A provision in an insurance or annuity contract that allows participants to withdraw some or all of an accumulation from the policy.
CAVEAT EMPTOR: Latin for "buyer beware". In colloquial terms it means "there's a good possibility you could get screwed".
CERTIFICATE OF DEPOSIT: (CD's) An obligation issued by a bank showing that a given amount of money has been deposited for a certain time and that it will earn (normally) a fixed rate of return. Normally guaranteed under FDIC to $100,000. Interest rate usually higher than those of treasury instruments but less than the return of corporate bonds. Returns are taxable unless the CD's are in IRA's or other tax deferred vehicles.
CERTIFIED FINANCIAL PLANNER: A good designation conferred by the National Endowment for Financial Education in Denver. Five mandatory courses. Weak on insurance. Should only be utilized in conjunction with corresponding additional degree- business, economics, etc. By itself, it may not be as encompassing as required for many planning situations. Definitely not as good as degree in financial planning. Continuing education required.
CHARITABLE GIFT ANNUITY: Your basic gift of an asset to a charity but retaining an income for life from the sale of the proceeds and subsequent investment by the charity. The income can cover one or two lives (or more if children are added) and are based on the actuarial lifetimes and the minimum payments established by law.
CHARITABLE LEAD TRUST: Essentially the reverse of the above where the charity receives the income for a period of time but the assets are subsequently paid to a noncharitable beneficiary(ies) (generally either the donor or his or her heirs)
CHARITABLE REMAINDER ANNUITY TRUST: the donor (or other beneficiary) receives an annuity based on a fixed amount of at least 5% but not more than 50% of the fair market value of property placed in the trust, for life or for a period of up to 20 years. One (or more) charities is the named recipient of the remainder interest upon the death of the donor (or other beneficiary). The value of the charitable remainder interest must be at least 10% of the net fair market value of all property transferred to the trust, as determined at the time of the transfer
CHARITABLE REMAINDER UNITRUST: the donor (or other beneficiary) receives an annuity based on a fixed amount of at lea st 5% but not more than 50% of the annually revalued trust assets, for life or for a period of up to 20 years. One (or more) charities is the named recipient of the remainder interest upon the death of the donor (or other beneficiary). The value of the charitable remainder interest must be at least 10% of the net fair market value of all property transferred to the trust, as determined at the time of the transfer
CHARTERED FINANCIAL ANALYST: (CFA) Excellent designation in security analysis- particularly as it relates to individual company review. Mostly used at institutional level though if you have LOTS of money and want to deal in individual stock issues, a CFA may wish to act as adviser. Continuing education required. Not versed in financial planning.
CHARTERED FINANCIAL CONSULTANT: (ChFC) A good designation conferred by the American College at Bryn Mawr, Penn. Twelve courses. Heavy emphasis on insurance. By itself, it may not be as encompassing as required for most planning situations. Should only be utilized with conjunction with corresponding additional degree- business, economics, etc. Definitely not as good as degree in financial planning. Continuing education required.
CHARTERED LIFE UNDERWRITER: (CLU) A designation offered through American College (see directly above) that focuses on the use of life insurance. Several steps up from just an insurance licensee but preferable to use the ChFC which encompasses even more competency. Better yet to use an MSFS (Master of Science in Financial Services) that are offered through the same College.
CHURNING: Where a broker is manipulating an account by masking innumerable trades primarily to generate a commission. Illegal, even if account may be making some money. Since trades are checked each day by a supervisor (or should be), it seems impossible that this trading wouldn't be noticed, but it still happens since there are no specifics ever taught in licensing training. Read your statements.
CIRCUIT BREAKER-- A procedure instituted in extreme volatility that temporarily halts trading on all U.S. stock markets for one hour when the Dow Jones Industrial Average falls 250 points or more within a trading day. The pause supposedly allows time for the markets to absorb the news that caused the decline. Further, should the average fall another 150 points within the same day, trading would again be halted, this time for two hours.
CLASS A, B, C, D MUTUAL FUND LOADS and EXPENSES: Both front and back end loads and 12b-1 fees are explained herein. In past years, loaded mutual the funds might have applied one fee or the other, but not all fees combined together. However, in an effort to increase commissions, loaded funds- particularly at the bigger wire houses, introduced various combinations of front end fees with or without a 12b-1 fee; back end loads with or without a 12b-1 fee, or with fees lasting only a period of time, etc,. etc. A selection may depend on how long one anticipated to hold a fund, whether rebalancing was indicated and a host of other implications. If you changed your mind from your initial position, you might experience higher fees overall than had you picked another type load. Frankly, very confusing. And many prospectuses had to spend more pages explaining how the fees worked than how the fund worked. Why bother. If you want sophistication in funds, this ain't it.
CLOSED END FUND: This is significantly different from an open end or mutual fund in that the purchase and sale of the fund occurs through brokers on an exchange, not directly from the fund. The managers invest in many stocks or bonds (normally) and manage similarly to a mutual fund. However, since they are not required to redeem shares from shareholders, they don't have to hold extra cash in case of a "run on the bank" and therefore may be more fully invested at any time. The fund's value is based on supply and demand, not necessarily on the net asset value of the underlying securities. Historically, shares tend to trade at a DISCOUNT to net asset value (don't ask why- they just do) and investors wishing to capitalize on the difference in value try to buy at the lower end of the discount range and then sell or profit as the discount narrows. For example, if the net asset value was $10.00 per share, the share price might actually be $8.00. If the normal trading range was $8.50 to $9.00, an investor would buy in the hopes that the discount would go back to "normal". Shares may also trade at a premium- but investors buying at that point can only hope that the price will go even higher (greater fool theory).
Investors can buy new offerings of closed end funds but it is NOT considered wise since the price must drop by the amount of commissions generated. Almost always wise to buy after initial public offering.
Historical returns have exceeded those of many mutual funds but the risks are higher. Better really do your homework. If you are looking at single country funds, check out Spider and WEBS first.
COGNITIVE DISSONANCE: The dynamics of overconfidence is clearly an important issue. It is logical to think that if we recall our successes and failures equally clearly, over time we should obtain an accurate view. Experience should make us wise. On the other hand, the prevalence and persistence of overconfidence suggest that forces able to eliminate it are weak. The reality is that we prefer to forget what did not go our way: this is called cognitive dissonance.
COINSURANCE. An insurance policy provision under which the insured and the insurer share losses a the deductible is met according to the contract ( 20% for the insured, 80% for the insurer). There usually is a specific dollar limit (say $1,00,000) after which the insured is no longer required to pay and the insurer bears all covered costs.
COLLATERALIZED MORTGAGE OBLIGATION: (CMO) Actually you really don't want to know since there are going to be few reasons why you would bother with these. However, many funds DO use them and that's the real importance. They are a derivative that start with mortgages. As stated elsewhere, an investor really doesn't know what monies they are going to get when since mortgages may be prepaid, some payments missed, etc, etc. A CMO merely takes mortgages and breaks them into tranches or slots of payments. The first tranche gets any monies paid to them first- the latter tranches get money only when everyone else is paid off. The first tranches have less risk- hence lower return. The latter tranches take far more risk and have a higher reward- whenever that may be. These tranches can be just a few to far beyond twenty. Requires a level of sophistication beyond most investors. See if they are used in the GNMA funds you are offered. If so, and the manager is correct, the return on a fund can go up. If they are wrong, the yields can suffer significantly. Caveat Emptor.
COMMISSION: A percent received by most brokers on the sale of a product. Since 1975, commissions are negotiable. Inherent conflict of interest since broker recommending a purchase may be dong so to increase his remuneration rather than providing the best product and price. Good advice is worth the fee. However, brokers have never been trained to know that much about risk and reward to begin with so paying for (probable) inadequate advice is not logical. Fees can range per year to about 3% of an account before the firm or any regulatory body may take notice that excessive commissions may be charged. This led to discount brokers which, supposedly, do not offer advice but simply execute the trade. However these lines are blurring with some discount firms now offering advice- even financial planning advice. But brokers, absent some formal additional training, are unable to spell financial planning, never mind do it. Before paying a fee or commission on anything, look to knowledge and competency of individual offering advice.
COMMODITY FUTURES. Contracts for future delivery of certain products like wheat, soybeans, pork bellies, metals, and financial instruments or indices of financial instruments. Commodity futures specify both prices and delivery dates and are traded on special exchanges, such as the Chicago Mercantile Exchange. These can be used to REDUCE risk if you are the farmer that produces the commodity and wish to hold onto a specific price. Many others use them for speculation. Most shouldn't. If you know what diversification is and what the Sharpe Ratio represents, you may have the capability to utilize. Otherwise you are WAY out of your league and probably a schmuck to boot.
COMMON STOCK: Also referred to as the equity of a company, an investor purchasing common stock owns a piece of the company and hopes that the management and fortune of the company increases. Shareholders have voting rights and may receive dividends. Bondholders and preferred stock holders have prior claims of all assets before common stockholders.
COMPOUND VERSUS SIMPLE INTEREST: Compounding a rate of return means that you multiply the rate of return by the amount of the initial principal plus (or minus) any accumulated interest or other gain. For simplicities sake, take a $100 savings account that earns 5%. At the end of one year, the value is $105. If I use compound interest, I multiply 5% return on the initial money ($100) PLUS any accumulated interest ($5.00). So, 05 x $105 = $5.25 which is added to the original amount of $105 at the end of the first year which totals $110.25 at the end of the second year. And so on. It's interest on top of interest.
Simple interest is the same $5 each year- there is no interest on accumulated interest. With simple interest, the first year's amount would be $105- the same as the above. But the total for the second year would simply be an additional $5 or $110. Third year = $115.00.
CONFIRMATION: A written statement by the brokerage firm confirming that a sale or purchase has occurred. It spells out price, amount, time and other terms. It may include commissions, but if you did a trade through NASD market makers, you'll only see net amounts on purchases and sales. You MUST review ALL confirmations of every transaction. Many of the mistakes seen in arbitration could have been avoided/limited if investors paid more attention to what was happening to their account. Being diligent stops a lot of problems.
CONSTRUCTIVE RECEIPT. If you could have gotten something- even though it was reinvested- the IRS will determine that it WAS received for tax purposes and apply tax. For example, if buy a mutual fund (non deferred account), you have the option of indicating whether or not you want dividends reinvested. Even if they are reinvested, since you had the option of getting them, they will be taxed to you. You will see that on your 1099 each year. Capital gain distributions is done the same way. Also an issue in tax deferred exchanges as well as other investment strategies. You'll see this often and is something you need to understand. Many investors don't. But then again, they are not real investors.
CONSUMER PRICE INDEX: A statistical measure of change in the price of goods and services calculated from one period to another of a basket of goods. Synonymous in many ways to a change in inflation.
CONTINGENT DEFERRED SALES CHARGE: A back end load that may be levied on a mutual fund or insurance contract if the investor/policyholder terminates/surrenders the contracts prior to the time frame set forth in the contract. Can vary considerably from company to company.
CONTINUING EDUCATION: Recently started by the National Association of Security Dealers in 1995. Since training of registered representatives does NOT include almost all basic info needed to address requirements to determine investors risk and suitability, the jury is still out as to whether the continuing education is any good either. Early reviews show training is pretty weak. Education also required for Certified Planners, ChFC and most real estate and insurance agents. (California instituted continuing education for insurance agents in 1991- many states already required.) Some of it is also terrible and sophomoric, but many courses are truly designed to advance knowledge and competency. The best "consumer protection" available since it weeds out many who are not really interested in pursuing a profession.
CONTRACTUAL PLAN: Instead of buying shares directly from a fund or through a broker charging the "normal" 4.5% to maximum 8.5% load, and having the option to buy or not buy at any time, the contractual plan is a formalized agreement wherein the purchaser agrees to contribute a (normally) small amount per month over an extended period of time. Unfortunately, purchasers usually pay up to a 50% front end load (not greater than 9% over the term of the plan). Used a lot for military personnel since contractual firms hire retired military and get them to sell new recruits. Also used for the unsophisticated. Some plans have done well since they know you are gong to be in the contract for a very long time and can invest more aggressively, but your flexibility is nil and your initial costs are exorbitant. Bottom line- higher fees and loss of control. Sucker bet. If you are offered one of these plans, be afraid, Be very, very afraid. Run away.
CONVERSION PRIVILEGE: Also called exchange privilege and allows an investor in a particular loaded fund family to sell shares in one fund and purchase another fund in that family without having to pay an additional sales charge (certain restrictions and funds may apply). Unless the account is tax sheltered or tax deferred, the sale is a taxable event and investor will be taxed on any gains (or use losses) accordingly.
CONVERTIBLE BOND: A bond with the option of the shareholder to convert into a prearranged number of common stock. The conversion ratio designates the number of shares. The yield on convertible bonds should normally be lower than other bonds due to conversion privilege, but risk adverse investors may like these since they at least get some return along with the option of converting to stock at their discretion to pick up (hopefully) the additional appreciation of the equity. There are both convertible bonds and convertible preferred stock.
CORPORATE BOND FUNDS: They purchase debt instruments of U.S. corporations as possibly some Treasury instruments and other fixed income securities.
CORPORATION: A form of a business organization in which the value of the company is divided into shares of stock each representing a unit of ownership. Each shareholder is liable only to the investment made- not to any additional exposure by the company's management.
CORRECTION: A difficult term to describe since it does not have a clear cut definition. In general terms it means that the market has dropped (or is expected to drop) for some reason that analysts may have difficulty explaining. They may say that the market has gone up so high that it must come down to correct for the fast upsurge. Others could say that the market was correcting for recent government or international news- i.e. the continued drop in the dollar, a spot of gravy on Greenspan's tie, literally anything they think they can justify. Most tend to state that as long as the market is not continuing to go down and down and down- the beginning of a bear market- it is just a correction. May say a correction can be up to 10% of the market value.
CORRELATION: A term used in asset allocation and portfolio construction in an attempt to find other securities or funds that do not move in necessarily the same manner at the same time for the same reasons or in the same amount. In building a portfolio, you are attempting to utilize different investments so that if one doesn't necessarily do well for whatever reason, the other one(s) might since they are not tied to the same underlying issues. For example, U.S. stocks might react unfavorably to U.S. changes in interest rates, but Korean stocks may not do anything at all in regards to that condition but move independently due to conditions in Southeastern Asia. Admittedly, with the world becoming "smaller" and with instant transmission of almost all data, many countries and investments may be impacted by another country' idiosyncrasies, politics, or economics and tend to do the same thing.
A correlation of +1 indicates perfect positive correlation- the investments move exactly in the same direction; a -1 indicates a perfect negative correlation- investments will move in a negative direction to each other. Most portfolios end up with random correlations with a positive correlation leaning.
COST OF LIVING RIDER: On a disability policy, it allows the policyholder the ability to increase the coverage on an annual basis by the cost of living index- normally established the government. The increase may be made by simple or compounded math (compounding is far more acceptable). There are two scenarios however- a cost of living rider to adjust the coverage obtainable PRIOR to disability and then another rider to adjust the disability payments AFTER disability.
A cost of living rider for a long term care policy is essentially the same though the riders are only for adjusting the coverage PRIOR to a entry into a nursing home.
COUPON RATE: The agreed on rate of yearly payment by the company, municipality or federal government. For example, if the coupon (or stated or nominal rate) is 8%, the institution will pay (absent default) $40 each six months or $80 for the year. It doesn't make any difference what you paid for the bond (because of changes in economic interest rates), you'll always get the $80.00 Also called nominal or stated rate.
COVARIANCE: A statistical measure of correlation of the fluctuations of two different quantities. In finance, covariance is applied to the annual rates of return of different investments, to measure the correlation of their year-to-year fluctuations in performance.
CREDIT LIFE INSURANCE: Term life insurance issued though a lender to insure for payment of a loan, installment purchase in case of death. Many times a rip off because it's so unbelievably expensive,
CREDIT RATING: Bonds are normally rated by several different firms as to the perceived ability to make scheduled interest and principal payments. The services include the more prominently known as Standard and Poor's and Moody's. Credit ratings are also attached to life insurance companies and include the services such as AM Best, Duffs and Phelps, Weiss, etc. The reviews are done periodically (and differently by the different firms) m and may change at any time. Changes in ratings are immediately felt in the marketplace by changes in stock or bond prices, interest rate requirements and so on.
CURRENCY RISK: See Foreign Exchange Rate Risk
CURRENT YIELD: This is different from coupon rate, but based on it nonetheless. Assume you bought a 8% coupon yielding bond in the secondary market and paid only $800 because interest rates in the economy had gone up. (New bonds were paying 10% so your bond was worth less since it only paid 8%). The current yield is $80 divided by the current price of $800 or 10%. If the bond had been purchased for $1,200 (probably due to the fact that economic interest rates had fallen and your bond was worth more), the current yield would have been $80 divided by $1,200 or just 6.67%.
If you own stock, the current yield is determined by analyzing the current payment and dividing by the current price of the stocks. For example, if a stock paid an annualized dividend of $6 and the current price is 77 ½, the current dividend is $6 divided by $77.50 = 7.74%.
CYCLICAL STOCKS: The movement of a company's stock is tied to the business cycle. When the economy is strong, certain businesses do well- steel, auto for example. When the economy declines, so supposedly should the stock values
DEATH BENEFIT. The amount payable to a beneficiary at a death. Also called the Survivor Benefit.
DECLINATION: The rejection by a life insurance company of a potential insured's life insurance application- normally for health reasons or occupation.
DEDUCTIBLE: The amount policyholders must pay out-of-pocket before the insurance company will reimburse them according to the contract ($500 for example)
DEFENSIVE STOCK: An investment in an industry that is unaffected by business cycles- such as the food industry and utilities. They supposedly provide stability in a down market.
DEFERRED ANNUITY: Money within an annuity that is not to be withdrawn until the future. See annuity
DEFINED BENEFIT PLAN: A traditional pension plan that provides employees a predetermined amount of retirement pension income and is based on income, years worked and age of retirement. Being replaced by defined contribution plans. Portions of payments are backed by the Pension Benefit Guarantee Corporation should the company default.
DEFINED CONTRIBUTION PLAN: Different from Defined Benefit above in that the value of the pension is not determined but simply the amount that is contributed annually. The ending benefit is determined by how well the assets are invested each year. Basic defined contribution plans are money purchase, 401(k), profit sharing and Simplified Employee Pension (SEP) Plans
DEMUTUALIZATION: A mutual insurer is owned by the policyholders. Mutual insurers typically provide returns by paying dividends to policyholders. These ownership rights may not be sold or transferred. In a full demutualization, company shares, or their equivalent in cash or benefits, are given to eligible policyholders. Those who receive shares become the owners and the stock of the company would trade on the open market.
DEPRECIATION: An allowance under tax law that provides for the "wasting away" of an asset. For example, real estate will finally require rebuilding sometime in the future. The IRS code allows the investors to write off the declining value of the property over a certain period of time depending on the type- commercial, multi family, etc. Depreciation also allowed on cars, furniture and other assets used for business or investment purposes. Schedules do not have to make sense; also change on whim of congress.
DERIVATIVES: A financial security where the value is dependent on the movement of a certain other conditions or thing. Options on stocks are dependent on the movement of that underlying equity. Options on the S&P 500 index are dependent on the movement of the index overall. They may be used to hedge risk, not to increase it. Other derivatives may be based on esoteric issues- the movement of interest rates in Korea solely between July and August- and the contracts may be very highly leveraged. If the guess is right, substantial profits. But if the guess is wrong- or very wrong- substantial losses may occur. Many money market funds in 1994 used derivatives to enhance yields. But when interest rates moved the wrong way, huge losses were reported. Investors need to check a fund to determine if, and most importantly, HOW derivatives are being used.
DIRECT PARTICIPATION PROGRAM: (DPP) An investment which allows a flow through of tax "benefits" to the participants. Otherwise known in the trade as limited partnerships. Limited offerings in the marketplace in the 90's due to the number of projects that tanked in the 80's as well as the major tax law change of 1986. If you still hold partnerships, check Moody's Directory for the companies that may list or buy the units. But be careful- the prices may bear no relationship to the actual value.
DISABILITY INSURANCE: A type of insurance that pays upon disability of a policyholder per the term of the contract. May cover for permanent or temporary disability and for full or partial depending on the terms of the contract. Due to the massive claims by professionals from about 1990, terms have become very restrictive, coverage limited and costs very expensive.
DISCOUNT: The difference between the maturity value or future worth of an asset as compared to its current value. May be due to liquidity factors or stated features on the instrument. For example, paying off a mortgage early may allow a discount from the full price. Having to sell a thinly traded security quickly may require the investor discount the price for a fast sale. A discount can also apply to a bond where economic interest rates have gone up. The older bond is discounted in value since it pays less. See par.
DISCOUNT BROKER: A firm charging less commission than the full service wire house firms. Usually they execute orders only- the investor does all of the analysis to determine what to buy and sell- but some are now offering advice as well.
DISCOUNT RATE: The rate charged by the Federal Reserve Bank of New York to other member banks who need short term loans to cover for a lack of reserves. Instrumental with the federal funds rates in determining where national rates will go. If the FED wants to increase rates (to slow inflation for example) it would adjust these rates upward. Synonymously, U.S. banks would follow with an upturn in their interest rates to almost all borrowers. Consider the reaction of the financial industry when the FED raised rates in 1994. Consider the numerous drops in 2001.
DISCRETIONARY INCOME: The amount your income available for "spending" after the essentials have been met. Mandatory to do a budget to properly determine. Mandatory for any type of financial or retirement planning.
DIVERSIFIED: Several meanings- many not well understood. Further, it is not clearly defined in a prospectus. By law, it actually means that at least 75% of the assets in a mutual fund must be invested so that not more than 5% of the assets may be invested in any one company nor own more than 10% of a company's outstanding stock. For most the rest of us, diversified should mean the definition directly below- having at least 10 to 15 stocks in a portfolio in order to insulate due to unsystematic risk (yes, you must read below. It's mandatory). And that assumes good correlation. Otherwise you might need as many as 30. Others also use diversified to mean not putting "all your eggs in one basket" but that is better defined by the term asset allocation explained above.
DIVERSIFIABLE RISK: Also referred to as unsystematic risk. The ability to reduce diversifiable or unsystematic risk by the addition of non or randomly correlated securities to the portfolio until the number tend to reach the level of systematic risk. Based on statistics, it means that the ownership of just one stock in a portfolio represents an extensive risk since if the company went bankrupt, you could lose everything. That risk, depending on several factors, may be as much as 70% greater than being in an S&P 500 index fund- the benchmark for most investors. As you add more securities, the corresponding risk drop so that by the time you have purchased 10 to 15 securities, you have managed to reduce the risk to the marketplace overall- but that assumes a random correlation. With fully correlated securities, you need even more securities. For example, with a correlation of 0.4, you'd need about 30 securities. Also if you purchased only auto or computer stocks, you have still NOT diversified into other areas/industries and your risk remains high and much greater than the diversified S&P 500. In general, the less the correlation among security returns, the greater the impact of diversification on reducing variability.
This is the reason why the purchase of an employers stock- where it represents a major portion of an employees pension plan- is so much of a risk. Also a reason why there is little sense in buying single issue securities. You'd need a whole mess of them before you were adequately diversified. Otherwise your risk is many times greater than that of the S&P 500.
If you don't understand diversification by the numbers, you have no business buying individual stocks. You have no idea what risks you are taking and that is stupid.
New for 2000- due to a higher correlation, you need from 40 to 50 stocks in order to be properly diversified. Maybe as many as 350 (University of Nevada)
DIVIDEND: A distribution of cash (normally) or stocks or other property distributed by a corporation per the voting by the Board of Directors. In insurance, it represents a return of part of the premium n participating insurance to reflect the differences between the premium charged and the combination of revised mortality, company expenses and the true investment experience. Premiums are initially calculated to provide some margin over the anticipated cost of insurance.
DIVIDEND ADDITION: An amount of paid up insurance purchased with a policy dividend and added to the face amount on the policy.
DIVIDEND REINVESTMENT PLAN: Automatic reinvestment of cash dividends by the shareholder or fund holder. Unless the investment is held in a tax sheltered plan, the dividends are a taxable event regardless (because you could have received the money- constructive receipt) and will be added to basis in subsequently determining taxable gain or loss on investments. Amount of dividends that an investor will be taxed upon is found on the 1099 tax form submitted at the end of each year by the company or fund.
DOLLAR COST AVERAGING: (DCA) The process of investing small amounts of money over a period of time instead of putting all the money to work at once. Statistically not valid since studies have shown that investing all the money at once has outproduced dollar cost averaging about two thirds of the time. . When you invest monthly amounts to 401(k), 403(b) plans, IRA's and the like, you are doing monthly investing. It looks the same as DCA and, everything else being equal, it coems very close. But you just didn't have a lumps sum to start with so the reference to DCA is wrong.
Even if DCA is utilized, there are several methods that have been shown to outproduce the simple "putting in $x per month" regardless of market volatility. Further, many investors using DCA do not review investments closely enough and are apt to lose more through a bad market.
DOW JONES INDUSTRIAL AVERAGE: The most well known average and followed by almost all financial services. However it reflect s the movement of just 30 large actively traded stocks- about 15% of the NYSE on a weighted basis. For example, IBM at 110 carries more than three times the weight of Woolworth at 35. Most analysts use the S&P 500 average or other indices that reflect a larger portion of the overall market.
DOW JONES TRANSPORTATION AVERAGE: This consists for the stocks of 20 major transportation companies
DOW JONES UTILITY AVERAGE: This consists of 15 major utilities that provide geographic representation.
DUE DILIGENCE: The review of a product, client, investing, insurance, etc., situation that should have been conducted to determine risk and suitability PRIOR to the investment or use. Must be made at least at the prudent man level. If conducted by those of advanced background or PERCEIVED capability (consider a broker with a title of Vice President), then higher standards should/will be applied.
DURABLE POWER OF ATTORNEY: A formal legal document giving the power to another person to act in your stead for certain acts as defined in the document. A plain power of attorney terminates upon disability. A durable power extends even when you are disabled- exactly when you need it the most. A general power gives most rights- a specific power more definitively details what powers are allowed. Difficulty in terminating since proper notification should be given to all parties. Also, many do not want to grant powers UNTIL disabled and that can be done through a SPRINGING Durable Power of Attorney.
DURATION: Represents the price volatility of a fixed income security- a bond for example. It is the weighted average term to maturity of the bond's cash flow. It is a better measure of a bond's sensitivity to interest rate changes than maturity because it takes into account the time value of cash flows generated over the (proposed) life of the bond. Say what? An example might help. Assume you owned bond A with 10 years to maturity and it paid 8%. You also owned bond B with a 8 year bond paying 8%. With which bond will you get back more money faster? B obviously since it will pay off the $1,000 par value sooner. How about Bond A with a 10 year maturity and a yield of 8% and bond B with 8 years to maturity paying 6%. Now which one is better? Now it's not so easy because in bond A you certainly get back a higher interest rate per year but the $1,000 is not due till 10 years. With bond B, you get less money per year but get the $1,000 two years earlier. There's a few formulas that can show you, but the overall issue is this. The shorter the duration on a bond or bond fund, everything else being equal (like ratings for example), the better. The higher the yield, the shorter the duration. The shorter the maturity date, the shorter the duration. More funds are providing this number to investors and even some of the basic financial magazine comment on it. So does the SEC. You need to be able to PV calculations with an HP12C if you want to do this yourself. Your adviser MUST have the capability of doing it. For more detailed info, click here.
EAFE: The European, Australian, Far East Index computed by Morgan Stanley and is a widely used index for non U.S. stocks.
EARNINGS: The net income for the company during the period of time selected- usually annually
EARNINGS PER SHARE: (EPS) Net income for the past 12 months divided by the number of common shares outstanding.
EE SAVINGS BONDS: Bonds offered by the U.S. government that are secure and possibly tax free if used for certain purposes by certain people. Limited yield that has changed several times during the last few years.
ECONOMIC RISK: The risk related to international developments and domestic events. For example, the changes in the money supply or interest rates by the FED are an economic risk. Also a devaluation of a country's currency.
EDUCATION IRA. An education savings plan that allows a person to put aside funds each year for the college expenses of a specific beneficiary. Contributions are not tax-deductible, but any earnings are tax free.
EFFICIENT FRONTIER: An investment where you are able to get the highest return for the risk taken. But even if you did get it right initially with your investment, the frontier has already changed. The theory is valid: the moving target makes it almost impossible to know if you did it right.
ELIMINATION PERIOD: For insurance policies, it is the time frame in which the insured elects to self insure until the disability or long term care policy starts to pay. The longer the time of self insurance/elimination period, the lower the cost of the policy premium.
ENDORSEMENT: An added document- not a part of the original contract- that becomes a part of such contract when attached thereto and cites certain added/revised terms and conditions. Riders to life insurance contracts are similar to endorsements.
ENDOWMENT: In life insurance, it is the life insurance payable to the policyholder, if living, on the maturity stated on the contract- or to the beneficiary if the insured dies prior to that date.
ERISA: Employee Retirement Income Security Act established in 1974 governs the operation of most private pension and benefit plans. Will guarantee certain monies on defined benefit plans if the corporation falls into bankruptcy.
ESTATE: The asset owned by an individual at death. For tax purposes, it is usually the net estate after expenses, mortgages, etc. have been deducted. Each citizen has the right to exclude $675,000 from taxes in 2001 going up to full exclusion by 2010.
ESTOPPEL: A legal term with "real life" implications. It refers to a pattern of history that allows other to rely upon even if documentation might indicate otherwise. For example, assume you had to make payments on a car by the 30th of each month. However, the lender always accepted payments made five days later. Then, out of the blue one day, they took your car because the payments weren't made according to the written agreement. The essentially are ESTOPPED from doing so since they have allowed such practice to continue. They would have to renotify you of their intent to change the terms to correspond to the stipulated agreement. The court would hold that their pattern of activity was one you could have relied upon.
EXCLUSIONS: The circumstances delineated for which the policy will not pay.
EX DIVIDEND DATE: In regards to stock, it represents the date where, as an owner of the stock, you are entitled to the dividend or it remains with the seller. Theoretically, the stock will drop exactly by the amount of the dividend paid so no "harm" to either party. However, if a purchaser buys a stock close to the ex dividend date, he/she will get the dividend paid back out of recently contributed monies AND THE DIVIDEND IS TAXABLE. The same result happens with mutual funds and therefore all investors need to know when the ex dividend date is to they can avoid the excessive taxation. Read the prospectus or call your broker or fund. Reading is better.
EXCHANGE: A national or regional auction market where stocks, bonds, options and futures commodities and indices are traded. Some exchanges include the New York Stock Exchange, American Stock Exchange, Pacific Stock Exchange, etc.
EXCLUSIONS: In life insurance, it defines the circumstances under which benefits will not be paid.
EXPENSE RATIO: This is the cost to run a mutual fund and includes almost all charges paid by the fund on an ongoing basis. (It does not include front and back end loads). The fees include costs for the manager, postage, rent, 12b-1 charges, etc. The ratios vary tremendously between funds and fund families but are normally less for bond funds than U.S. stock funds . International funds costing the most due to more extensive and costly analysis and travel expenses. Ratios also tend to be higher overall for load versus no load funds. Everything else being equal, the lower the fees the better.
EXPERIENCE: Used by many in the investment business to justify capability and knowledge. They are NOT one and the same. A twit with 20 years experience may have simply repeated one years worth of mistakes 20 times. You still have a twit that can screw things up. If you think that is too caustic and cynical, consider the huge debacle in Orange County. Merrill Lynch has been around a long time- lots of experience. So had the Orange county treasurer- lots of experience. But between the years and years of experience, they screwed up the entire bond market in California and the people in Orange County will be paying back the losses for a long time. Prudential had lots of experience. Between the debacle in limited partnerships and insurance and about $2 billion in fines, they are lucky they are still in business. Experience is great when coupled with a good background /degrees/designations and current knowledge. Otherwise, CAVEAT EMPTOR if you are using this as your sole justification for using someone.
FACE AMOUNT: The amount stated on the face of a policy that indicates how much will be paid in case of death, disability, at the maturity of the policy, etc. It does not include the additional amounts available under included riders (accidental death) or indicate the amount of the offset that may be due to loans.
FACE VALUE: Also referred to par value of a bond or note when issued. On bonds, it's normally $1,000; Municipal- $5,000. Remember, this is not necessarily the amount that you will purchase the security for in the secondary market. Many factors- most notably a change in ratings or economic interest rates- will alter the market value of the security at the time of purchase. The face value is usually what you expect to receive at maturity.
FAMILY LIMITED PARTNERSHIP: A legal ownership of a business (normally) wherein the general partners are the parents and the limited partners are the children (though obviously there are numerous variations). The idea is for the parents to retain control of the business as they get older but have the ability to gift part of the business to the children at discount. The discounts are attributable to a minority ownership and the lack of liquidity. Such discounts are as high as 40% and effectively allow up to $16,667 of real assets to be passed and still fall within the $10,000 annual gift limitations. These are highly touted, but recognize a major flaw that has not really been addressed. Parents ARE giving away a part of their business/assets and the assets become the sole ownership of the child. Bankruptcy, divorce, rivalry, estrangement, etc. can all cause major subsequent problems and are not the panacea many planners make them to be. You should consider post nuptial agreements, formal valuations, etc. Caution advised. Also be careful of state laws and IRS audits if you push your luck.
FANNIE MAE: One of several types of mortgages that are purchased by the Federal National Mortgage Association (FNMA) may be placed in a pool and purchased by investors separately or through mutual funds. These issues are not fully backed by the Federal Government regarding default. The market value will fluctuate according to the interest rate environment. See also GNMA's.
FDIC: Federal Deposit Guarantee Corporation responsible for guaranteeing certain deposits of banks up to $100,000.
FEDERAL FUNDS RATE: One of several interest rates directly impacted and effected by the Federal Reserve Board. It represent the rate charged by one institution lending federal funds to another for temporary reserve shortages.
FEDERAL RESERVE BOARD: A seven member group appointed by the president (approved by Congress) to oversee the operations of the Federal Reserve System. Last two directors have been Volcker and Greenspan . The FSB is responsible for money direction in the United States.
FEDERAL RESERVE SYSTEM: The central bank system of the U.S. Responsible for controlling the flow and amount of money and the interest rates.
FEE ONLY FINANCIAL PLANNER: These planners charge only a fee- no commissions- so that the conflict of interest is apparently negated. Not so- they are still selling advice so a conflict always exists. Most importantly, it still says nothing about capability and competency. A twit charging a commission is a twit. If they revert to simply charging a fee, they're still twits. Fee only planners must be registered with both the SEC and most states as registered investment advisers and in some states for insurance licensing.
Also note that fee-only is the definition only for the planner. If you are charged a fee for insurance advice, for example, and end up paying a commission through someone else, true fee only planning for the client has not been accomplished.
FINANCIAL CALCULATOR: These "special" calculators can do the present and future value of money. It is absolutely mandatory that your adviser-whether in investments, insurance, financial planning, estate planning, etc. know how to use one. Read again- it is MANDATORY. If you adviser doesn't have one of these, be afraid. Be very afraid. Run away.
FINANCIAL PLANNER: Individual who professes an ability to analyze and interpret a client's financial situation and risk profile (though other areas may be involved) and then determine a plan that effectively incorporates all aspects of the client's needs. Most planners focus on investments, but the review should/may incorporate issues of insurance, estate planning, retirement, college funding and a host of other areas since they are all interrelated. Most planners must be registered at the government level through the SEC as registered investment adviser if they charge a fee for advice. In the alternative, they must be registered representatives with the SEC and licensed to sell product. Individuals may also be required to be licensed by the State department of Insurance as well if they provide any info on insurance (usually required in any planning).
Regardless, neither the registration or licenses represents any specific capability. Caution is advised when using any planner. Certain designations indicate an effort by the individual to enhance knowledge, but background may still be- and in many cases is- inadequate to address most concerns.
Clients should demand a complete background history of planner and refer to local and national governmental agencies to check out record. Most planners still work on commissions so there is an inherent conflict of interest in the selection of any product to buy. See material herein- Who Can You Trust- for more complete definitions and clarification.
FLEXIBLE PREMIUM POLICIES: A life insurance or annuity policy where the policyholder has the option of varying the amounts or timing of premium payments. In life insurance, they are also known as universal policies.
FOREIGN EXCHANGE RATE: The market relationship between the currencies of two countries. May fluctuate widely depending on economics of both countries and may subject an investor in either country to severe swings in value. For example, if an investment is made in a foreign country in their currency, and if the dollar declines in value compared to this country (it has been declining for years compared to many other foreign countries) or the value of the foreign fund APPRECIATES in value to the dollar , then the investor has made money even though the actual investment may have gone nowhere. By the same token, if the dollar appreciates- or in the same vein, the foreign currency depreciates in value to the dollar, then the investment has lost money, everything else being equal. A major risk factor with international stock and bond funds.
FORWARD PRICING: In regards to mutual funds, the value of the portfolio may not be priced till the end of the day (must be done at least once per day, normally after the close of the market). Therefore, investors selling during the day will have no idea of the actual price till the next time the portfolio is priced. Implications are obvious when one thinks of 1987. Those selling at 10 a.m. did not get that price- but the much lower price at the close of the market. When you buy, it's the same thing. You buy at the day's closing price. Some funds price hourly but whatever it is, it is indicated in the prospectus.
FRONT END LOAD: A fee charged by loaded funds to compensate a broker (normally) for selling the fund to investors. The charge can be as high as 8.5% (standard mutual fund- can be higher in certain instances) but most funds have lowered fees to around 4.5% to 5.5% average. Some funds charge loads but simply keep the money for themselves. The majority of funds sold are loaded funds but the percentage has continually dropped over the last number of years. Most commentary on loads is whether the broker provided valued service.
FUND FAMILY: The entity that sells and repurchases the shares of any number of funds. The larger fund families are Vanguard, Fidelity, Putnam, etc.
FUND MANAGER: The individual (normally) or committee that oversee the selection of the investments in the fund. The greatest amount of the expense ratio payment for the fund is for the manager. Investors need to look at past performance of fund manager- and how long they have been doing it for the fund in question and experience overall. Clearly one of the most critical items in review of any fund.
FUNDAMENTAL ANALYSIS: In the review of the potential growth of a company and the market overall, one can use charts and graphs (technical analysis) or study the economics, industry conditions and forecasts, market share, financial statements, management quality and capabilities, competition, P/E ratios, etc. The latter represents the fundamentals on which the company or the economy is projected to respond. The vast majority of analysis used by investors and advisers is fundamental. It doesn't mean that the interpretation is the same, just that they usually start with the same focus.
FUND SWITCHING: Only a item with loaded funds. It represents the ability to move from one fund in a fund family to another in that group and not have to pay another load. For example, assume you bought the "Great Appreciation" loaded fund for $10,000 and paid a 5% front end charge. Now you decide to sell "Great Appreciation" and move into "Great Value" in the same fund family. Most fund's allow you to simply move your money without incurring another load. The prospectus will tell you if this is available.
If the fund is back end loaded, the time you have accumulated in the first fund is normally "tacked on" to the second fund and no back end charge is imposed. For example, if the back end load for "Great Appreciation" covered five years (dropping 1% per year) and you had been in it for two years and you took all your money and left the family, "Great Appreciation" would levy a 3% load for totally removing your money. However, by going into "Great Value", there is no back end charge and the fund would "say" that you had been in Great Value for two years already. Variations now occur with the innumerable combinations of front, back end loads and the 12b-1 fees. You need to read the prospectus.
SPECIAL NOTE: Even though you move to another fund in the same fund family, this is a sale of one asset and the purchase of another. Any gain on the first sale is TAXABLE (or a loss may be deductible). So check your tax position for the year before making any switches.
FUTURE VALUE: How much a sum of money today will be worth in the future based on the number of years, compounding, interest rate(s) assumed t heat a future date. Requires use of a financial calculator such as the HP12C.
GAAP: Generally Accepted Accounting Principles which public companies are to confrom to.
GENERAL OBLIGATION BOND: When purchasing a municipal bond, you need to address how the municipality is going to pay the annual interest payments. A general obligation bond means that the bond is backed by the full taxing power of the municipality. It essentially means that the governmental entity can "simply" increase taxes to make sure the bond payments are kept current. The greatest amount of tax received by a municipality is generally through real estate (ad valorem).
GENERAL PARTNER: Whereas limited partners are effectively limited in liability to their contributions, a general partner has unlimited liability and is responsible for the day to day management.
GENERATION SKIPPING TAX: A tax assessed on amounts greater than $1,000,000 that pass to anyone at least two generations below the donor. Assets are still taxed at the regular estate level and this is an additional tax if beyond $1,000,000. generation-skipping transfer tax. Three types of generation-skipping transfers will trigger this tax: taxable terminations, taxable distributions, and direct skips.
GEOMETRIC MEAN: The geometric mean answers the question, "if all the quantities had the same value, what would that value have to be in order to achieve the same product?"
For example, suppose you have an investment which earns 10% the first year, 50% the second year, and 30% the third year. What is its average rate of return? It is not the arithmetic mean, because what these numbers mean is that on the first year your investment was multiplied (not added to) by 1.10, on the second year it was multiplied by 1.60, and the third year it was multiplied by 1.20. The relevant quantity is the geometric mean of these three numbers.
The question about finding the average rate of return can be rephrased as: "by what constant factor would your investment need to be multiplied by each year in order to achieve the same effect as multiplying by 1.10 one year, 1.60 the next, and 1.20 the third?" The answer is the geometric mean . If you calculate this geometric mean you get approximately 1.283, so the average rate of return is about 28% (not 30% which is what the arithmetic mean of 10%, 60%, and 20% would give you).
GIFTS: An individual is able to gift up to $11,000 of a present interest to anyone per year without incurring a gift tax. A present interest does not include life insurance save for special circumstances involving minors and Crummey powers. An individual may also use any or all of their lifetime exclusion of $1,000,000 at any time during life without incurring a gift tax. Maximum one time gift, therefore, to any one individual with no recognition of gift tax could be $1,0110,000 and going up. Recognition of all prior gifts are analyzed on the estate tax return. The $11,000 gift can be relatively straight forward but one would still need to document basis for subsequent sales (except for cash) by the beneficiary. I'd suggest that you contact an advisor before giving away any assets.
GLOBAL INVESTING: A specific foreign fund may invest in just one country. International funds may just invest in non U.S. stocks/bonds. But a global equity fund may invest in both foreign and U.S. stocks. It may therefore be difficult to use this fund in asset allocation since you are not really sure just where the investments are being made and what the impact of correlation might be on the entire portfolio. A global bond fund may use bonds of other countries which, in many cases, pay higher returns than the U.S. However, there is considerable risk with either foreign equity or bonds due to currency exchange rates. Reversals can wipe out any returns made in the country and create higher risks. Since returns on bonds are limited, I tend to forgo global or foreign bonds and just use equities where the higher potential return can offset any currency differences.
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION: (GNMA) Similar to FNMA explained previously, GNMA's buy groups of mortgages where the borrowers had to comply with stringent lending requirements. GNMA then pools some together that pay the same rate of interest and sells them directly to individual investors in $25,000 blocks. Investors can also buy them on the secondary market or through mutual funds that own millions of dollars in different groups of (normally) 30 year mortgages. However, GNMA's are paid off well before 30 years due to refinancing and the fact that, on average, about 16.5% to 20% of Americans move each year. GNMA principal is backed directly by the U.S. government in case of default. The payments are NOT guaranteed. Irrespective of the guarantee, prices of GNMA's are all over the board since value changes due to fluctuation in economic interest rates. In fact, this volatility and a uniqueness in valuation can make them MORE risky than regular bonds in a highly charged interest rate environment. First see Bond Valuation in text. You'll note that a bond's value drops as interest rates rise and vice versa. One would therefore tend to expect GNMA's to rise in value as interest rates drop. Almost absolutely not. That's because as interest rates decline, mortgage holders want to refinance. Investors therefore get back money as rates drop. So the value of GNMA's may therefore drop as interest rates decline- the opposite of "regular" bonds. Additionally, as rates rise, mortgage holders hold onto their mortgage longer and it tends to make GNMA's end up as longer term, lower return investments. They are good if rates are fairly stable. Otherwise, you must understand the risk.
GRACE PERIOD: A period of usually 30 days after a premium due date where you could still make payments and be covered without penalty and without additional evidence of insurability.
GRANTOR: The person who establishes a trust.
GROSS DOMESTIC PRODUCT: Real Gross Domestic Product (GDP) is the output of goods and services produced by labor and property located in the United States.
GROUP INSURANCE: A policy covering an company's employees and sometimes their dependents. The risks are distributed over a large number of people and therefore group life and health plans may offer broader coverage at lower costs than individual policies. BUT NOT ALWAYS. This is a perception that requires further research before one blindly opts for group coverage.
GROWTH STOCK/FUND: Capital appreciation is the primary goal, not dividend payments. Most earnings are plowed back into the company for expansion, research or other development. Small capitalization funds and stocks may immediately come to mind since they are know for their almost sole effort to grow. Dividend payments are usually nil.
GUARANTEED: The word guarantee may be used for Treasury instruments directly backed by the U.S. government, GNMA's principal that is guaranteed against default and for many bank accounts under FDIC protection up to $100,000. Outside of these minimal presentations, the word guaranteed cannot be used in the securities business since none of the other investments are "absolutely" guaranteed against a loss. Even buying insurance on a bond is not an absolute guarantee since the insurance company could go bust. And certainly guarantee may not be used to assure growth, payment of dividends or anything of the like. If you are presented a "guaranteed investment" that is not defined above, run away. Or be prepared to get screwed.
GUARANTEED INSURABILITY: Notable on life policies, it is a contractual requirement that the policy will always cover an individual in subsequent years as long as the rest of the terms are complied with- premium payments for example. However, the term does NOT guarantee that the premiums will not increase. For example a 10 year level term policy will, in most cases, guarantee insurability after the ten year period, but if you happen to be ill at that time, the premium increases may cause you to die. That's the main reason why term policies that are NEEDED (versus wanted) can cost so much as to be prohibitive. As regards LTC policies, see guaranteed renewable below.
GUARANTEED INVESTMENT CONTRACTS: A fixed income investment backed by an insurance company. Rates may change every six months or year or so depending on the contract. The return may be closely comparable to bonds but without the interest rate risk fluctuation. However, returns still are limited as compared to stocks. Also recognize that as interest rates decline or stay low overall, reinvestment by the insurance company in new bonds will be at lower interest rates and projected future return must be reduced. Guarantee is only as good as rating of insurance company- and even good rated companies have had problems in the last few years.
GUARANTEED RENEWABLE: Similar to guaranteed insurability, it means that the company will continue to the policy at the end of the current period of coverage, BUT THAT IT CAN INCREASE THE PREMIUMS AT THAT TIME. The disability or LTC company may change rates for an entire group within the state. Some have by as much as 600% and many elderly simply dropped the far too expensive policy when they needed it most. A noncancellable policy is one that does not increase in price. It is therefore the reason that if you need long term coverage to consider one that cannot increase. Not possible with most companies but there are some that have payments over 10 years and then cease. No subsequent increase.
HEALTH MAINTENANCE ORGANIZATIONS (HMO): Health plans that contract with medical groups to provide a full range of health services for their enrollees for a fixed pre-paid, per-member fee (called capitation). There are three different kind of HMOs: Group, Staff and IPA Model HMO's.
Group Model HMOs contract with independent groups of physicians that provide coordinated care for large numbers of HMO patients for a fixed, per-member fee. These groups will often care for the members of several HMOs.
Staff Model HMOS employ salaried physicians and other health professionals who provide care solely for members of one HMO.
Independent Practice Associations (IPA) contract with groups of independent physicians who work in their own offices. These independent practitioners receive a per-member payment or capitation from the HMO to provide a full range of health services for HMO members. These providers often care for members of many HMOs.
Point of Service (POS): More HMOs now offer a Point of Service (POS) option. These dual plans allow HMO members to seek care from non-HMO physicians but charge extra for the right. And normally, there are deductibles as well.
HEDGING: Through the use of certain types of derivatives, firms, mutual funds managers and the like try to reduce the volatility of a portfolio by reducing the potential for loss. For example, buying a put option (the value of which goes up as the underlying securities value goes down) can help a manager who wishes to hold a particular security but is uncertain about current economic events that might drop the price. Other hedging vehicles include selling call options, futures investing, short selling, etc. Considered to be good conservative strategy by many. Recognize, however, that it costs the funds to implement these strategies and therefore the ultimate return to investors would be lower.
HEWLETT PACKARD 12C CALCULATOR: (or similar) The standard financial calculator in the industry is the HP 12C (though not the fastest nor the best). It does present and future value, can determine interest rates, IRR, etc. If you use a broker or financial adviser that does not have and cannot use one of these, you are committing economic suicide since the adviser simply does not have the essential competency to do basic numbers. Run away.
HIGH YIELD BOND FUNDS: Such funds use bonds that are less that "Investment Grade" which are rated by S&P as BBB. Anything below BBB is euphemistically called a junk bond and is a higher risk- with a commensurate higher yield. But within a fund, you can have average weightings of BB which is pretty good and the risk is somewhat limited. On the other hand, you can take far more risk and use a fund that has an average weighting of C. Of course if the economy/ business is good, a C rated company might have its rating revised to a B. In such cases the bond value will escalate nicely and the returns for such funds are much higher than those funds than using higher ratings to begin with This is more similar to a small cap equity fund and they should be identified as such in your asset allocation as such. Just remember that when you sue lower rated bonds and the economy is poor, you can lose money all the faster. AS I have always stated, a review of current economics is mandatory.
HYPOTHECATION: The term represents the pledging or loaning of securities in your brokerage account as collateral to secure a loan and is required for a margin account.
IMMEDIATE ANNUITY: Upon giving money to an annuity (insurance company) payments immediately commence. However, while you get money, without an HP12C, you will not know of the yield provided. Payments may cover for life, but at a 2%, 3% or 4% return (some will be negative) that 's not good retirement planning unless you live a VERY long time. See also deferred annuity
INCOME PORTFOLIO/STOCKS: Stocks most notable for paying high dividends- such as utilities. They tend to be favored by the more conservative investors seeking high current income, but their value is still subject to fluctuations due to interest rate movements. That is the reason one considers asset allocation.
INCOME REPLACEMENT RATIO: The percentage of income that an individual needs to maintain the same standard of living during each year of retirement. Many magazines and consulting services say that that is anywhere from to 60% to 90% of a current budget. Garbage. Do a full budget since that is the only way to determine what you are actually spending and what might be anticipated during retirement. Rules of thumbs are useless when you find out at age 72 that you will run out of money at age 76. Too late to do anything then Do your research early to avoid these mistakes.
INDEX: A statistical benchmark that measures the stock or bond market or a part of it and represents the common, systematic or market risk of investing. The most notable is the S&P 500 index- explained more fully herein- though there are many others.
INFLATION: The result of supply and demand of various goods in the economy usually reflecting a rise in prices of products and services now and in the future. Has varied tremendously over the last 25 years- much lower and with less volatility in the past 10. Statistical evidence clearly shows that low inflation produces stronger growth nationally and internationally.
INFORMATION: Kirschenheiter (2002) proposes the following distinction between hard and soft information: “Hard information (…) is when everyone agrees on its meaning. (…) Honest disagreements arise when two people perfectly observe information yet interpret this information differently (i.e. soft information)”.:
INITIAL PUBLIC OFFERING: (IPO) This is the first offering of a stock to investors. Many are small companies where there is high risk coupled with considerable volatility, at least in the first year or two. Substantial profits may be made, but good IPO's are essentially presold to institutional investors and the odds of small investors buying them may be nil. Statistically, for the average consumer, it's a crap shoot with most of the crap burying the little guy.
INSIDE INFORMATION: Directors, officers, attorneys, accountants, brokers, investors, etc. are not allowed to divulge information that has not yet been relayed to the general public and on which someone would have an advantage in trading. If they use such information to their advantage, they and the recipients of such knowledge are subject to fines and jail time.
INSURABILITY: Acceptance of an applicant by an insurance company.
INSURED: The person named on the policy as the person covered by the policy. Do not confuse with owner since the do NOT have to be the same.
INTEREST RATE RISK: Described more fully in the text, the impact is most noticeable on bonds. As an example, if you own a bond that pays 7%, you get $70 per year regardless of what happens to economic interest rates. But if economic rates actually went up, new bonds may have to pay 9%. If an investor could get $90 a year buying a $1,000 bond, it stands to reason he/she would pay less for your bond paying only 7%. Hence the older bond is discounted down in price, perhaps $800. In the reverse, if interest rates went down to, say 5%, and new bonds paid $50 per year, an investor would pay more for your bond earning 7%- everything else being equal. You must understand this risk scenario before buying bonds.
Does not necessarily happen with GNMA's and the like. See other commentary herein.
INTERNAL RATE OF RETURN: A somewhat sophisticated method of determining the return on an investment. It is the rate of discount at which the present value of the future cash flows equals the initial investment. May not be necessary for mutual fund analysis but very useful with real estate, partnerships and similar investments. You or your adviser must have use of a financial calculator.
INTERNATIONAL FUNDS: Unlike global funds, international invest solely in foreign stocks/bonds. Still subject to currency risk and that makes bonds funds all the more risky since their upside is essentially limited to yield. See also Global.
INTERNET: You undoubtedly know about the super information highway but the point here is to indicate that there are many services on the Internet that provide info on investing, investing and most everything else. Admittedly some are blatant product endorsements, but check around and you'll find come valuable commentary. Watch the chat lines, though. You never know if the person you're "speaking to" knows what they are talking about. And everyone is now an investment expert simply because their stock or fund has gone up.
INTESTATE: The legal term for dying without a will. One of the dumbest things you could possibly do. At least do a will.
INVESTMENT ADVISER: An individual or organization that advises or manages assets- most normally associated with securities. Must either be registered with the SEC or the particular state. And for heaven's sake, get the info and read it before you invest.
INVESTMENT GRADE SECURITY: Standard and Poors rate securities relative to their perceived risk. Securities rated BBB and above are investment grade. Those below BBB are called less than investment grade quality- but more euphemistically called "junk" bonds. That's not really fair since BB rated bonds are not in imminent difficulty or subject to default- they just are not as credit worthy.
IRREVOCABLE BENEFICIARY: A beneficiary designation that cannot be changed without the beneficiary's consent.
IRREVOCABLE TRUST: Normally associated with life insurance and estate planning, it reflects putting an asset into a trust where the grantor loses all control. Therefore it need not be subsequently included in the taxable estate upon death. See other section on Estate Planning.
JENSEN'S MEASURE: See alpha
JOINT LIFE ANNUITY: Income paid as long as either of two individuals is alive. However, the percentages do not have to be the same. For example, when an annuitant dies, the survivor could get the same payments or 75%, 66%, 50%, etc.
JOINT TENANCY WITH RIGHT OF SURVIVORSHIP: A undivided interest of ownership of a property by two or more people in which the survivor(s) automatically assume ownership of a decedent's interest.
JUNK BONDS: A bond that has a rating of BBB and above (Standard and Poors) is called Investment Grade. Bonds rate under BBB are euphemistically called junk bonds. Bonds rated B and BB might still be considered reasonably decent companies in terms of risk since any exposure to default should be a ways off. Bonds rated in the C category have a greater concern to default on payments. In good economic climates lower rated securities may provide the highest return since, if the company's capabilities and financial prospects are enhanced, the ratings and value of the bonds will increase accordingly- more so than more highly rated bonds. Some analysts say that using lower rated bonds is more akin to investing in small cap stock since the risk and returns are similar. That's why in a strong market, some lower quality bonds do very well. The company rating might go up. Additionally, interest rates might be stable or dropping. Just remember, the opposite can happen
They have had some real problems during the past 10 years with the likes of Boesky, Milken and new laws requiring banks to divest themselves of lower rated bonds. The thinly traded market, in particular, hurts marketability if the bonds need to be liquidated in a short period of time. Interestingly though, defaults are not that extensive. Yields are higher than more conservatively rated bonds (normal) and are valid for many investors. Investors buying individual junk bonds should be fairly sophisticated. Most investors would prefer using the expertise of a mutual fund and its professional manager. But, as described in asset allocation, you should not put all your money in just this one area and must diversify the portfolio to limit risk exposure..
KEOGH PLAN: A retirement plan for the self-employed. Keogh plans allow tax-deductible contributions Rather complicated- many businesses may opt for simpler plans- SEP's for example. Do your homework well before using these or any other plans.
(See tax section for updated numbers)
KEY PERSON INSURANCE: Used in a business to cover the loss of business income in case a key person were to die. Also to cover costs or retraining a new person to take over position.
KURTOSIS: a measure of whether the data are peaked or flat relative to a normal distribution. That is, data sets with high kurtosis tend to have a distinct peak near the mean, decline rather rapidly, and have heavy tails. Data sets with low kurtosis tend to have a flat top near the mean rather than a sharp peak. A uniform distribution would be the extreme case.
LADDERED PORTFOLIO: Normally associated with bonds and Treasury instruments, it means the selection of different maturities of interest bearing securities for a portfolio and simply replacing as they mature. For example, $100,000 portfolio may consist of $20,000 in one year maturity bonds, $20,000 in five year, $20,000 in seven year, $20,000 in 10 year and $20,000 in 15 year maturities. Any type of laddering may be utilized depending on the needs, time horizons and risks of the investor.
LAPSED POLICY: Where a policy has been terminated for nonpayment of premiums. Remember the tax implications- previous loans may become taxable.
LEADING ECONOMIC INDICATORS: The Index of Economic Leading Indicators consists of 11 equally weighted indicators:
Average Workweek/Manufacturing: the number of hours manufacturing employees are working
Unemployment Claims: a rise could mean an increase in unemployment
New Consumer Goods Orders: gives an indication of the future pace of consumer spending
Vendor Performance: slow deliveries can indicate an inability to keep up with increasing orders in a strong economy
Plant and Equipment Orders: new orders reflect current business spending on capital equipment
Changes in Unfilled Orders for Durables: an increase can reflect a strong economy
Building Permits: suggests future housing activities
Interest Rate Spread: the 10-year Treasury yield minus the federal funds rate. The smaller the spread, the more restrictive the economic policy
S&P 500: changes reflect investors' perceptions of earnings and profitability for large corporations
Real M2 (broad money adjusted for inflation): indicates liquidity, where higher liquidity relates to increased economic activity
Consumer Expectations: reflects consumer sentiment about the economy
LEGISLATIVE RISK: The risk that local or national government will change certain laws- tax law for example- and effect the value of an investment. For example, the tax law changes of 1986 decimated real estate.
LETTER OF INTENT: Used in conjunction with a breakpoint sale. Assume that the sales charge charges are 7% up to $9,999 and 5% starting at the $10,000 breakpoint. However, you only have enough money to put in $7,000. Also assume that, perhaps in the next 13 months you might have enough money to put in another $3,000. If you sign a letter of intent at the time of the initial sale or at least within 90 days thereafter, the fund will charge the smaller commission on the $7,000 NOW and the $3,000 later. If you don't put in the extra money by the 13th month, the commission simply reverts to the higher percentage on the $7,000. This is truly a free lunch- no strings, no gimmicks. You have nothing to lose by signing it so if you have any idea of putting more money in the near future, go ahead and sign.
LEVEL PREMIUM LIFE INSURANCE: There are two types for review. A level term policy- say 15 years- costs the same amount each year. At the end of the term the policy terminates, though, with most, you may be able to continue the policy but at different (normally higher) rates
With a level term whole life policy, you pay level premiums for the entire term. Premiums made in the early years are in excess of the amount needed for coverage. The "excess" goes into a reserve that grows. As the cost of insurance increases in later years, the reserves, along with continued payments, help meet the higher cost of insurance. Most policies "suggest" much greater premiums than necessary to meet this cost in an attempt to build up a retirement kitty. I'd "suggest" a lot of review before doing so.
LEVERAGE: The amount of borrowing or debt a company, individual, government, etc. may have taken on as compared to the total equity. Different ratios cover different industries but high leverage may indicate problems. Some statistics show a high ratio as 3:1 or greater; moderate at 0.5:1 to 3:1; low leverage of 0.10:1 to 0.5:1; all cash at 0:1 to 0.10:1. Rate of return on investment should exceed cost of borrowing.
LIABILITY: A debt owed by one party to another. In the investment business, the best evidence is a bond. It is a liability by the corporation to pay an investors $x plus interest at a maturity date as specified in the liability contract.
LIBOR: London Interbank Offering Rate is an international interest rate on which other rates- even U.S. rates- may be pegged. It has even been used in past years for U.S. real estate mortgages.
LIFE EXPECTANCY: The average number of years of life that a group of "average" people might expect to live upon reaching that age. Life expectancy- for most countries has been increasing. For that reason, you need to be sure you are looking at the most recent mortality tables.
LIMITED PARTNERSHIP: A form of ownership of an asset where limited partners, liable primarily only to their investment should something go wrong, invested most of the monies for purchase of an asset and a separate general partner managed the investment(s). Used extensively in the mid 80's as a vehicle to shelter taxes since there was a passthrough of partnership losses to individual investors. The 1986 tax act changed many features and, due to the overbuilding of real estate, many partnerships were no longer financially viable. Many were sold with bad management, poor financial outlook, because of the large commissions generated to brokers- maybe all the above. Major problem both then and now is the illiquidity of the partnership interests. If you can sell, large discounts may apply. For all the reasons, thousand of investors lost millions and millions. Current partnerships are based on financial fundamentals and may be viable, but the illiquidity is still an item of contention.
You do NOT buy partnerships before you have purchased more conservative investments. Further, they should not encompass more than 10% to 15% of an entire portfolio and then in two or more different type partnerships.
LIMIT ORDER: An order to buy or sell a security at a certain price. For example, assume you wanted to buy IBM at 100 and it was currently at 102. The order is placed and should it drop to 100, you MIGHT get your purchase. The reason you might not be successful is if there were other order in front of you and the market changed before your order was completed.
LIQUIDITY: The ability to cash in the investment quickly with the ability to trade quickly at prices that reflect current market demand and supply conditions. Real estate is an illiquid asset while stocks and mut