Three Investment Terms You Should Know

April 22, 2015

Have you ever noticed how different words mean different things to different people? The other day I was talking with a helpline caller who was looking for a way to invest their retirement funds such that they couldn’t lose money and could draw an income from it in the future. When I mentioned the word “annuity,” they immediately had a negative reaction as they were lead to believe all annuities were bad, which seemed ironic considering that’s exactly what they just described they were looking for. When it comes to investment terminology, not understanding the meaning of a word can be a financial mistake. Here are three investment terms that are frequently used but often misunderstood:

  1. Annuity

Listen to Dave Ramsey or Suze Orman and you might think that an annuity was akin to financial suicide, but a better understanding of the term might have you think twice. According to Dictionary.com, an annuity is:

a specified income payable at stated intervals for a fixed or a contingent period, often for the recipient’s life, in consideration of a stipulated premium paid either in prior installment payments or in a single payment.

So what can be so bad about that? The problem may be when an investor treats an annuity like an investment rather than a product that offers guaranteed income for a specified period of time. Because deferred annuities have fees that are generally higher than other investment options, they may not be best for long-term accumulation, but for the investor that wants to convert a lump sum to a guaranteed lifetime income, income annuities may fit the bill.

  1. Diversification

If you’ve participated in any investment education courses then the concept of diversification has probably been drilled into your head, but what exactly does this mean? A basic diversified portfolio holds different asset classes like stocks, bonds, and cash, but diversification goes beyond this. A truly diversified portfolio should not only diversify across asset classes, but also within asset classes.

For example, a long-term investor should not only consider investing in stocks, but investing in stocks of different geography (domestic & international), market capitalization (large-cap & small-cap), and type (growth & value). You can achieve diversification using individual securities (I suggest at least 30 spanning multiple sectors), single asset-class mutual funds, or asset allocation funds (e.g., target-date funds). While it may not feel like it, putting your entire portfolio in one asset-allocation fund would constitute a diversified portfolio in many cases.

  1. Risk

Ask someone to define risk and you’ll probably get some different answers. Most often, people associate risk with losing money, and that would be classified as “market” or “investment” risk, but what about the risk of lower interest rates (i.e., interest-rate risk), a loss of purchasing power (i.e., inflation risk) or running out of money before you run out of time (i.e., longevity risk)? Risk is simply that which you do not know, and you can accept risk, avoid risk, or push the risk onto someone else.

For example, if you assume the investment risk, you accept market volatility for hopes of a return on investment. Obviously, if you are wrong the risk is that you may get back less than you expected in the future. You can avoid investment risk by not investing at all, but that just opens you up to other risks, such as not having enough money to retire.

We talked earlier about annuities, and that would be an example of transferring the risk to someone else, in that case the insurance company. Seldom will you find a truly “risk-free” investment, so understand that transferring or avoiding one type of risk may expose you to another. A financial professional can help you understand the various types of risk, and decide which ones to accept, avoid, and transfer to others.

Jim Rohn once said “Ignorance is not bliss. Ignorance is poverty.” When it comes to your money, don’t be ignorant. Brush up on your vernacular and you’ll be less likely to make an inappropriate financial decision.