What’s the difference between a stock and a bond? What’s a capital gain? And what in the world is a short sale? Financial terms and acronyms are used by many people, from financial analysts who truly understand what these terms mean to pundits who may only think they know what they mean. But there’s a lot of admitted confusion among the public at large about key financial terms and their significance.
Everyday investors may not be entirely clear on the financial and investing terms regularly used by their advisors and in the media they consume, but they should be if they’re going to make informed decisions. Below, 15 Forbes Finance Council members define commonly misunderstood terms and concepts in the finance world and explain why they’re important.
1. Compound Interest
Many people know that when you invest, interest is added to your original investment amount (the “principal”). But what folks often don’t know is that interest is also added to the full balance of your account. Over time, this compound interest can lead to significant financial growth, demonstrating why investing early—regardless of how small the investment may be—can lead to a big payoff. – Anuj Nayar, Lending Club
2. The Difference Between A Financial Advisor And An Investment Advisor
Everyday investors need to understand the difference between a financial advisor and an investment advisor. Although both roles are regulated by the SEC, financial advisors are brokers who buy and sell securities for themselves or others. An investment advisor, on the other hand, provides advice, reports or analyses on investments. New investors in particular will benefit from knowing the difference. – Mara Garcia, Phonexa Holdings, LLC
3. Stocks And Bonds
A bond is a loan to a company and represents two contractual promises to the bondholder: the promise to be paid interest on a timely basis and the promise to be repaid when the loan matures. A stock represents an ownership interest in a company; there are no contractual promises to pay any of a company’s cash flows to a stockholder. For this reason, stocks are riskier than bonds. – Vincent Rossi, Intelligent Capitalworks
4. Risk-Adjusted Performance
The absolute most important concept every responsible investor has to understand is risk-adjusted performance. Risk is not a story; it’s not a relationship; it’s not a feeling. Risk is a number: it’s the probability of loss weighted by the potential degree of that loss. To meaningfully evaluate any investment, you have to measure its expected return and its risk—in other words, its risk-adjusted performance. – Benjamin D. Summers, Adagio Group
5. ESG Investing
Environmental, social and governance, or ESG, investing is a catch-all term for various investment approaches that incorporate ESG criteria—and it’s a term that is often misused. It’s not enough for institutions to claim an ESG investing approach; they must also evaluate the frameworks they’re using and how they’re living up to them. These investments should support people, not just profit. – Randell Leach, Beneficial State Bank
6. The Network Effect
The network effect is the idea that the more users a product has, the more value it creates; hence, the value of the product itself continues increasing organically. Companies such as Etsy, Ticketmaster and Instacart are examples of the network effect in practice. The more makers, ticket sellers and grocery deliverers, the more product that is available to the end consumer, who thus has a better experience. – Sean Cantwell, Volition Capital
7. Cash Flow
I often hear the term “cash flow” confused with “appreciation.” A retirement plan’s ability to deliver sustainable cash flow may be the driving factor that helps someone cover their income shortfall on a month-to-month basis. More often than not, I will hear someone tell me their portfolio grew by 6%, and they think that is their “cash flow.” Dividends and interest are simply a source of cash flow. – Keith Gebert, RightBridge Financial Group
8. Tax Planning
Tax planning is not standardized and custom-fitted for an accountant/attorney and their clientele. Do not just assume someone who is preparing taxes is a tax planner. You must also ask for more than just a tax projection (what you’ll owe)! Ask for savings strategies. – Jackie Meyer, Meyer Tax, The Concierge CPA Coach
9. Stock Split
A stock split doesn’t mean you’re going to instantly multiply your money. It’s simply a way for companies to make their shares cheaper and potentially easier to afford. As an investor, a stock split doesn’t affect the percentage of the company you own. You will own more shares at a lower price, and they will have the same dollar value as they did before the split. Don’t mistake this move for free money. – Bill Keen, Keen Wealth Advisors
10. Stock Price Versus Stock Valuation
Too often, people think that the price of a stock is what makes it expensive (or not). The price of XYZ stock may be $1,000, but that has nothing to do with its valuation. For instance, a stock split does not mean that a stock is suddenly a more affordable investment. I often see very smart people who are otherwise knowledgeable about finance sometimes mistaking price for valuation. – Sonya Thadhani Mughal, Bailard, Inc.
11. Equity, Convertible Debt And SAFE
Equity is ownership; convertible debt is debt with the option to convert it to equity down the road; and a simple agreement for future equity, or SAFE, is another form of future equity ownership. Make sure you have an accountant and lawyer explain potential tax and legal issues when investing in something, as nothing is truly “safe”—all investments carry risks! – JD Morris, SPE Funds Advisors LLC
12. Dark Pools
Dark pools are private exchanges that enable the trading of huge block orders of stock between institutional market participants at a fixed price. They do not publicly show the transaction prior to execution. This prevents a huge order from being misinterpreted by a trader who sees it without context. The trade is reported after the market closes, and there is no price advantage over a “lit” exchange. – Ryan Pannell, Kaiju Worldwide
13. Volatility Versus Market Risk
Many investors conflate volatility with market risk, but they are different. Volatility is the measure of a range of price movements of a stock from one point to another. Some stocks or markets are more volatile than others, but price fluctuations are normal. Market risk is the chance that a stock will lose value when the market declines. But unless you sell the stock, the loss is only on paper. – Jonathan Dash, Dash Investments
14. Phantom Stock
Phantom stock can be a brain teaser for sure. It’s an employee benefit designed for select employees that’s tied to performance metrics. The stock is hypothetical in nature and provides dividend payouts akin to owned shares/equity. Payouts are based upon earnings but are treated as ordinary income for the recipient. The upside for the issuer of phantom stock is protection against shareholder dilution. – Cynthia Hemingway, Fourlane, Inc.
15. Fully Diluted Shares
Fully diluted shares are the total common shares issued and the shares that will be outstanding after all sources of conversion—such as convertible securities, warrants and options—are exercised. It is important to understand that dilution isn’t necessarily a bad thing. Fully diluted shares increase the market cap, and even if the percentage of ownership goes down, improving the earnings per share, or EPS, can result in increased share value. – Peter Goldstein, Exchange Listing LLC