FINANCIAL LITERACY • READ TIME: 5 MIN
"People who work in specialized fields seem to have their own language.
Practitioners develop a shorthand to communicate among themselves. The jargon can almost sound like a foreign language."
Barry Ritholz
Breaking Through the Jargon Barrier
Like any other professional field, the financial industry has its own set of terms, jargon, and lingo that may, at times, seem intentionally opaque. Apart from providing sound financial advice related to investment strategies, wealth-building or wealth-generation, insurance products, or any number of other services, the RP Wealth Advisors team also strives to provide financial education to our clientele.
To this end, below are some common financial terms that you may recognize, but have trouble defining or understanding clearly. This list is by no means exhaustive, but may provide some new, additional information to help you build your financial vocabulary. And, for the die-hard students, Investopedia has an actual exhaustive (or, perhaps, exhausting…) list of 13,000 financial terms you may study by clicking here.
(1) Adjusted Gross Income (AGI)
Your AGI, adjusted gross income, helps determine your taxable income and eligibility for deductions or credits in a given tax year. To calculate your AGI, subtract IRS-specified deductions from your yearly gross income. AGI is most commonly calculated each tax year on your Form 1040.
For more tax-related information, publications, forms, and checklists, visit the RP Wealth Advisors “Tax Resource Center.”
(2) Capital Gains (or Losses)
Capital gains represent the difference between the current value of an asset and its original purchase price. Capital gains are taxed whether they are short-term (one year or less) or long-term (more than a year). However, long term capital gains are generally taxed at a lower rate than short-term capital gains. If an asset has declined in value since its initial purchase, you are not dealing with a gain, but a capital loss. Capital losses on one investment, though unpleasant, can be used to offset capital gains from other investments (to reduce your total tax bill in a given year). This strategy of "washing out" gains with losses is known as tax-loss harvesting.
Curious about calculating the capital gain on some of your investments? Learn about how much you owe in taxes (for estimation purposes only) using our “Capital Gain Tax Estimator” calculator.
(3) Compound Interest
According to Warren Buffett, “Time is your friend, impulse is your enemy. Take advantage of compound interest and don't be captivated by the siren song of the market.” Apart from the distinction being made between investing and trading by "The Oracle of Omaha," Buffett is emphasizing the financial power of compounding your investment dollars. Specifically in relation to savings or investing, compound interest is the interest earned on funds which have already accrued interest (interest on top of interest). What individuals should seek to avoid, then, is compounding interest on borrowed funds – loan interest compounding on itself to produce larger debts.
Play with the numbers and figures to see how compound interest works, and to learn why saving and investing now beats saving and investing later on - RP Wealth Advisors Compound Interest Calculator.
(4) Defined-Benefit & Defined-Contribution Plans
Defined-benefit retirement plans are those where an employer guarantees a specific retirement benefit depending on factors such as an employee’s (historical) earnings, age, and duration of employment. Depending on the plan, the employee may or may not be required to contribute their own funds to the plan.
Defined-contribution retirement plans are those which allow any employee to contribute some of their own money (typically via salary deferral) into an account earmarked for retirement. 401(k) and 403(b) plans are the most common, and employers often match (up to a certain percent) employee contributions. Like Traditional or Roth IRAs, 401(k) and 403(b) plans provide tax advantages so long as relevant criteria and rules are followed.
In the case of defined-benefit plans, the employer assumes much of the risk - they are, after all, "guaranteeing" a set amount for eligible employees at retirement. In defined-contribution plans, the employee bears the investment risk (and, generally, is also responsible for determining the allocation of funds into different financial products within the portfolio).
Curious about retirement accounts, retirement planning, and other related resources? Visit the "Retirement" section of our Resource Center to learn more.
(5) Drawdown
A portfolio or investment drawdown refers to the decline in value from a relative peak to a relative trough. A drawdown is calculated (as a percent) by identifying the relative peak less the relative trough and dividing this number by the peak value (i.e., it is a percent change calculation):
Max Drawdown (MDD) = (Peak Value – Trough Value) / Peak Value
Drawdown risk can be minimized by diversifying a portfolio. The “time-to-recover” measures the duration of the drawdown period and recovery – how long does it take to reach the previous peak? This metric is particularly significant when building or modifying portfolios as investors approach retirement.
(6) Liquidity
Financial liquidity refers to how quickly assets, investments, etc. can be “cashed out” and made available to the investor.
Checking and savings accounts, along with short-term CDs (certificates of deposit), are the most liquid assets available to investors (apart from a store of cash in your home…or buried in the backyard). Stocks (but not preferred or restricted shares) and bonds are also considered to be quite liquid, but are subject to different settlement periods after a sale before the funds are readily transferrable. Large assets such as property or equipment, private equity, and hedge fund investments are not as easy to convert to cash, so they are considered (to varying degrees) to be illiquid assets.
Liquidity is particularly relevant to savings and “emergency funds” – to learn more about calculating a suggested emergency fund balance, visit our article on “Your Emergency Fund: How Much Is Enough?”
(7) Mutual Fund
A mutual fund is a financial product comprised of “pooled” money from many different investors. Each share (or unit) of a mutual fund represents your proportional interest in the fund’s specific portfolio. As dictated by a mutual fund’s prospectus and/or charter, professional money managers use investors’ pooled funds to invest in securities such as stocks, bonds, money market instruments, derivatives, and other assets.
Ultimately, money managers seek to produce income or capital gains for investors in the fund. Each individual investor in a mutual fund participates proportionately in the gains or losses of the fund. Mutual funds, unlike ETFs, are not listed on stock exchanges and are priced at market close each day.
Although similar in some respects, mutual funds and exchange-traded funds have a number of noteworthy differences – to learn about these similarities and differences, check out “Mutual Funds vs. ETFs” in our Resources center.
(8) Net Asset Value (NAV)
Net asset value (NAV) is a term most commonly used in relation to exchange-traded funds (ETFs) and mutual funds. Net asset value represents the value of a given share of the fund’s assets at the end of the trading day (for mutual funds; ETFs have intraday pricing). Shares for a given fund may trade at, above, or below NAV.
NAV = (Assets - Liabilities) / Total number of outstanding shares
The net asset value of a share of a mutual fund or ETF is calculated by adding the value of all assets in the fund (stocks, bonds, derivatives, cash, etc.) less liabilities, and then dividing by the total number of outstanding shares. Using NAV calculations, it's possible to purchase a mutual fund or ETF that is trading "at a discount" - meaning, the share price does not accurately reflect the proportional value of the holdings within the portfolio (which, for ETFs, is often happens due to supply and demand).
Additional Resources & Information
For more information on any of the concepts defined here, visit the RP Wealth Advisors Resource Center. In addition to these terms and concepts, the Resource Center also has financial calculators, tax resources, and videos to help you develop your financial literacy.
Oh, and do not forget the quiz on the eight terms outlined above is next week – study up!
The content is developed from sources believed to be providing accurate information. All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy referenced here will be successful. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by RP Wealth Advisors to provide information on a topic that may be of interest. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.