1035 exchange: A transfer of money from one insurance policy (this includes annuities) to another. This type of exchange can be used when moving money out of high-fee insurance policies and into low-fee insurance policies. Educate yourself carefully regarding any possible surrender charges.
401(k): A defined contribution plan offered by a corporation to its employees to set aside tax-deferred income for retirement purposes. This is the place where you can grow your money tax-deferred (traditional version) or tax-free (Roth version).
403(b): A retirement plan offered by nonprofit organizations, such as universities and charitable organizations, rather than corporations. This is simply a company retirement plan that goes by a different name. Fees tend to be high compared to other defined contribution plans.
457(b): A retirement plan offered by some nonprofits, as well as state and local governments. This is another company retirement plan that goes by a different name. One big plus with this type of plan is the elimination of the 10% penalty for early withdrawal. This means you can take out money prior to age 59.5 without penalties.
529 Plan: An education savings plan designed to help parents save for their children’s college education. Go straight to the state and bypass the broker. Shop around. Some states have poor choices and others provide very good options that include index funds from Vanguard.
Active management: The attempt to uncover securities (stocks and bonds, for example) that the market has misidentified as being under or overvalued. This involves outsmarting and outmaneuvering the other smart people in the room. The past has shown us it doesn’t work with any degree of consistency (pure chance basically). Avoid the people who tell you they can provide it. They can’t.
Annuity: An investment that is a contract backed by an insurance company. Its main benefit is that it allows your money to compound and grow without taxation until withdrawal. The main drawbacks include high commissions, high fees, and difficulty in extracting your money. The financial industry loves annuities. That is a good reason to question the benefit of an annuity to you. Stay away, far away.
Asset allocation: The process of dividing up one’s securities among broad asset classes (stocks, bonds, and real estate, for example). This may include domestic and foreign stocks and bonds. The asset allocation should be identified only after the investor identifies their risk tolerance, time horizon, and specific goals that are unique to their particular situation.
Asset class: A group of assets with similar risk and expected return characteristics. Cash, debt instruments (think bonds), real estate (REITS or rental real estate), and equities (stocks) are a few examples. There are more specific classes that are broken down within an asset class, such as large and small company stocks and domestic and international stocks.
Benchmark: A standard against which mutual funds and other investment vehicles can be judged. Small-cap managers should be judged against a small-cap index such as the Russell 2000 Index. Large-cap growth funds should be judged against a large-cap growth index such as the S&P 500 Index. Comparing apples to apples is the point of using the proper benchmark.
Bond: A loan that investors make to a corporation or government. The investor provides the capital, and the other party promises a specified return. Bonds generally pay a set amount of interest on a regular basis. All bonds have a maturity date when the bond issuer must pay back the bond at full value to the bondholders (the lenders).
Broker: A person who acts as an intermediary for the purchase or sale of investments. Almost all brokers are paid on commission, which creates a conflict of interest with their clients (also known as victims). The more the broker sells the more money he makes. This is called churning, and it is illegal but difficult to prove in a court of law. Stay away from them.
Capital gain: The profit from selling your stock at a higher price than the price for which it was purchased. Example: You bought a mutual fund at $60 per share, and you sell it five years later for $90 per share. Your profit is $30 per share. If your investment is outside of a retirement account, you will pay a capital gains tax on that profit. This will not apply (in the year in which you sold the asset) to an investment that is in a retirement plan.
Cash-value life insurance: This is the type of life insurance that most life insurance agents recommend. In a cash-value policy, you buy life insurance coverage but also get a savings account to boot. The investment returns tend to be poor because of the high commissions and high fees that come out in the early years of the policy. Stay away.
Churning: When a broker has you buying and selling your investments often to feed HIS bank account. It is illegal, but practiced often as the broker rationalizes the extensive trading. A broker needs a lot of activity on your account otherwise the commissions will not be enough to feed his lifestyle. Avoid brokers, and you will avoid being churned. It doesn’t get any simpler than that.
Data mining: Many “helpers” and organizations in the industry go back and retrieve data and then use it to convince the uninformed investor about the future based on that past data that was selected to make their argument. Be on guard for this and see through its lies. This deceitful approach leaves out a great deal of information they would prefer you not to know about.
Defined benefit plan: A pension that your employer promises you based on time with the company, your earnings, and usually your age. These are going away and being replaced with defined contribution plans. These types of plans are still widely available for state and federal employees. If you have one, count your blessings.
Defined contribution plan: A retirement plan funded primarily by the employee. It may come in the form of a traditional or a Roth version. Names of these types of plans are as follows: 401(k), 403(b), 457(b), and TSP (thrift savings plan). You must feed these accounts monthly and yearly if you want a comfortable retirement.
Diversification: Dividing investment funds among a variety of investments with different risk/return characteristics to minimize portfolio risk. A mutual fund that owns 3,000 companies is one example.
Dividend: The income paid to investors holding an investment. The dividend is a portion of a company’s profits paid to its shareholders. For assets held outside retirement accounts, dividends are taxable in most cases.
Dollar-cost averaging: A fixed amount of money is invested regularly and periodically. When the price of the asset is down, more shares are purchased. When the price of the asset is up, fewer shares are purchased. Simply put: investing the same amount every month into your portfolio i.e., on the 30th of every month investing x amount into your Vanguard portfolio.
Equity: Equity is a term often used to describe stocks. In real estate, it is used to describe the difference between how much your home is worth and how much you owe. Example: Your home is worth $200,000 and you owe $120,000. Your equity is $80,000.
Exchange traded funds (ETFs): Like mutual funds, they can be created to represent virtually any index or asset class. Like stocks (but unlike mutual funds), they trade on a stock exchange throughout the day. They work for long-term, lump-sum investing. They don’t work for investors who trade often and/or dollar-cost average money into their investments.
Expense ratio: The operating expenses of a mutual fund expressed as a percentage of total assets. They cover manager fees, administrative costs, and sometimes marketing costs.
Fee-based financial advisor/planner: This term is used to describe how a licensed salesperson earns his or her money. Fee-based usually means the salesperson works on commissions from the investments he or she sells and some other method such as a percentage of money under management or an hourly fee. Avoid fee-based salespeople.
Fee-only financial advisor/planner: This term describes how a professional earns his or her money. The drawback with this type of planner is they generally require a large amount of money under management before they work with you.
Fiduciary: The expert sitting across from you has an obligation to act in your best interest instead of his. When seeking financial advice, this is the kind of person you should seek. Sadly, they are hard to find.
Fixed annuity: An insurance contract in which fixed dollar payments are paid for the term of the contract. The insurance company guarantees both earnings and principal. A high initial teaser rate is generally offered to pull you in. High commissions, high fees, and high surrender costs make this a poor option.
Index mutual fund: A mutual fund designed to mimic the returns of a given market. Examples would include: S&P 500, Wilshire 5000, and the Russell 3000. These types of funds are ultra-cheap, and because of the cost difference, they have consistently beaten managed mutual funds over short and long periods of time. Never pay a load when selecting this option.
Individual retirement account (IRA): A retirement account that you open outside of your place of employment. There are many types: Roth (after tax) and traditional (before tax) are two. Which one you select will vary based on your current and projected tax situation. There are many rules as well as contribution limits to these accounts.
Institutional investors: Large investment organizations, including insurance companies, depositary institutions, pension funds, and philanthropies. Indirectly, your money is invested through them when you have a pension, give to a charity, etc.
International stock market mutual fund: Pooled stocks within a mutual fund that are invested in stock markets outside of the United States. This may include developed countries like Germany, Canada, France, and Japan or developing countries like Brazil, India, China, and Russia. The latter is identified as emerging markets.
Investment Management Company: A company whose main business is holding securities of other companies for purely investment purposes. The investment company invests money on behalf of its shareholders, who in turn share in the profits and losses.
Junk bond: A bond rated below investment grade. These types of bonds are also called high-yield bonds. Many people own junk bonds as they chase yield (interest on your investment). You do not need junk and that includes high-yield mutual funds.
Keogh plan: A tax-deductible retirement plan that is available to self-employed individuals. They are relatively easy to set up at your favorite investment management company, such as Vanguard.
Large-cap: Large-cap stocks are those companies considered big relative to other companies, as measured by their market capitalization. Large can be subjective.
Load mutual fund: A mutual fund sold with a sales charge and paid to the salesperson that initiates the action between the investor and the investment company. A load and a commission are one in the same.
Mutual fund: A portfolio of stocks, bonds, or other assets managed by an investment company. They provide wide diversification that is necessary and prudent for the average investor.
No-load mutual fund: A mutual fund sold without a sales or distribution fee. There is no commission attached to your investment.
Nominal return: Returns that have not been adjusted for inflation. These are the types of returns you will almost always see when reading a newspaper, a magazine, or listening to a presentation on investing.
Passive management: A buy-and-hold investment strategy. The passive management approach includes lower portfolio turnover, lower operating expenses and transactions costs, greater tax efficiency, consistent exposure to risk factors over time, and a long-term perspective.
Real estate investment trust (REIT): A mutual fund that owns stock in shopping centers, apartment buildings, and other commercial real estate. Focus on owning publicly traded REITs while staying away from Private REITs pushed hard by commission-hungry brokers.
Real return: The nominal return minus the inflation rate. Example: You earn 5 percent on an investment and the inflation rate is running at 3.2 percent. Your real return would be 1.8 percent.
Rebalancing: The process of buying and selling portfolio components so as to maintain a target asset allocation.
Recency bias: An investor is overly influenced by recent events when selecting a particular asset.
Roth: A retirement plan that places your money into your selected investment accounts after the money has been taxed.
Russell 1000 index: This index is intended to track 1,000 of the largest publicly traded companies in America. It is used as a benchmark for large-capitalization stocks.
Russell 2000 index: This index is intended to track 2,000 of the smallest publicly traded companies in America. This index is used as a benchmark of small-capitalization stocks.
Russell 3000 index: This index tracks the Russell 1000 and 2000 index of companies. It is used to replicate the entire market of large and small companies.
Simplified employee pension individual retirement account (SEP-IRA): A retirement plan for self-employed people.
Standard & Poor’s 500 Index: An index that measures the performance of 500 large-company US stocks.
Stock: Shares of ownership in a publicly held company. You can invest in stock by purchasing individual shares or by owning a stock mutual fund.
Survivorship bias: Mutual funds that die don’t count against the overall return as if they never existed. Managed mutual fund historical returns would look much worse if all of the headstones were counted.
Target date retirement fund: This type of fund allocates your investments within the fund based on the date you select. A 2050 fund will be more aggressive (more stocks) than a 2030 fund (more bonds and cash).
Term life insurance: Inexpensive life insurance that has no cash value. It should be purchased when someone relies on your income to live.
Thrift Savings Plan (TSP): A defined contribution plan offered by the federal government to its employees (military and civilian).
Timeshare: You are renting a really nice place for a week or so during the year. They call it buying. Avoid them and the salespeople who push them. They are expensive to maintain and difficult to sell. Don’t fall for the pitch.
Turnover: The portion of a portfolio that is traded in a given period of time. For example, a portfolio with an annual turnover of 300 percent will increase the costs by approximately 3 percent per year.
Universal life insurance: Cash-value life insurance that grew out of whole life insurance. Part investment and part insurance is the idea. Stay away.
Variable annuity: A life insurance contract providing future payments to the holder. The size of the future payments will depend on the performance of the portfolio’s securities, as well as the investor’s age at the time of annuitization and prevailing interest rates. Stay away.
Variable life insurance: A cash-value policy that has part of the account invested in investments like stocks and bonds that will fluctuate over time. Stay away. The costs are high and the returns are low.
Whole life insurance: Cash-value life insurance that provides level premiums over time. High commissions and high fees make this a bad deal.
Wilshire 5000 total market index: This index mimics the entire US stock market, which includes small, mid, and large capitalization companies. Use this index when identifying a total stock market fund to invest in.