Podcast: Play in new window | Download
5 Investing Terms You’re Probably Using Incorrectly
Like most professions, finance has a language of its own. If you’re not part of the club—and even when you are—it’s easy to get the lingo wrong, and that can lead to some very expensive mistakes.
To help you avoid that, I’ve compiled a list of some of the most frequently misused words in finance…and what they really mean.
A lot of people mistakenly think that volatility is the same as uncertainty and use the two words interchangeably. Volatility is also often framed as a bad thing, especially when people talk of “too much volatility” in the markets.
But volatility is just a way of measuring the change in the price of an investment over a particular period of time— whether stocks are going up or down, the amount they move either way, is the stock’s volatility.
Let’s say you have two companies, Company A and Company B, and both have an average share price of $30 over the past month. But if Company A had a bigger price swing than Company B, its stock is the more volatile of the two.
So when a stock has low volatility, it typically does not make extreme moves away from its average price. And when a stock has a lot of volatility, its price swings are bigger. But these movements are simply short term—and here’s the key: For assets held over a longer period of time, these day-to-day movements have little impact on performance.
One other note about volatility: A lot of people are afraid of it, but, if used wisely, volatility can be your friend. If you are buying, use downward volatility to buy; if you are selling, use it to sell. Be the master of volatility; don’t let it master you!
2. Cheap vs. Expensive Stock
I’m sure many of you have heard investors look at the price of a stock and make a declaration about whether it’s “cheap” or “expensive”. In this misused version of the term, shares of Apple are deemed “expensive” if they’re around US$110 per share. But shares of a healthcare company—we’ll use Affymetrix as an example—which trades around US$14 per share are deemed “cheap.”
But the price of a stock has nothing to do with whether it’s cheap or expensive. When financial professionals talk about cheap and expensive stocks, they are referring to what they see as a stock’s value relative to its long-term fundamentals and current earnings. So, for example, they may look at the price per share and compare it to the earnings per share and come up with a ratio called the price to earnings ratio or P/E.
In this case, Apple’s P/E is 12 and Affymetrix sports a P/E of 117. So Apple shares are cheap, and Affymetrix shares are nosebleed expensive, based on current earnings. So price and value are not necessarily related.
3 Median vs. Average (or mean)
This one takes me back to elementary school math, but there’s an important difference between median and average (often also called the “mean”). Both median and mean refer to a midpoint in a series of numbers, but the way they’re calculated is very different.
Let’s say there are 7 people in a classroom, 6 kids and one teacher. Here is a list of their ages: 5, 6, 6, 7, 7, 8 and 36
The average (or mean) age of everyone in the classroom is calculated by adding all the ages and dividing by the number of people. So the sum of the ages is 75 and dividing by 7 results in an average age of 10.7 years.
But we already know that, if all the kids are 5-6-7-8-years-old, an average age of 10.7 doesn’t really describe the scene because, of course, the teacher’s age skews the results. The mean isn’t representative of the age of everyone in the room since six of the seven people in the room are younger than the average age.
A more accurate indicator is the median age. The median is calculated by arranging the values from lowest to highest and picking the one in the middle – which works out to 7 years. So, the median age is 7.
Knowing the difference between the two helps you understand economic and other data. For example, in many countries, the average (mean) household income is a lot higher than the median because the average is skewed by the very wealthiest households. The median is much more representative because, when incomes are listed from lowest to highest, it’s the number in the middle.
4. Capital Protection
We all like to see our capital protected. Sometimes, financial products are advertised as offering “capital protection” which gives investors a false sense of security by implying that they are fully protected against losses. But that’s only part of the story.
The real story is that a product offering capital protection protects only the initial invested sum. So, if you deposit $50,000 and the investment grows to $75,000, only the original $50,000 is protected.
And this capital protection element kicks in if the investment falls below $50,000. If things go south, an investor could ask for the return of his original $50,000 (possibly minus fees). And while there’s no such thing as a risk-free investment, capital protection can limit your losses.
5. Nominal vs. Effective Interest Rates
Interest rates on loans are sometimes quoted as either nominal or effective, and there’s an important difference between the two terms.
Let’s say you have $10,000 to invest. Your bank offers you a product that offers a 4 percent nominal rate per year, with monthly compounding. How much money do you reckon you’ll have at the end of the year?
Four percent of $10,000 is $400, suggesting a final sum at the end of the year of $10,400—that’s based on the nominal, or stated, interest rate. But the product offered a 4 percent nominal rate… with monthly compounding… so the interest rate compounds monthly, which means that interest is paid every month, with the interest earned each month then earning interest, or compounding.
So any interest you’ve earned in a month will start earning interest, and the final interest rate, or the effective rate of interest you earn, will be slightly higher than the nominal rate. In this example, with monthly compounding, your $10,000 would be worth $10,407 after one year. That means the effective interest rate, or what you effectively earned, is 4.07 percent, or 0.07 percentage points more than the nominal rate.
That seemingly small difference can matter a lot over long periods of time, especially when interest rates are higher. For example, credit cards may charge a nominal rate that compounds monthly, and that could result in a far higher effective rate if you do not pay your bills on time.
Let’s say you’re paying 18% on your credit card, and you’re not paying back the principal, but leaving a balance every month. That balance is being charged interest which is then added on to the account upon which interest is being charged, therefore, making your effective rate much higher.
I hope that gives you a clearer understanding of a few key financial terms. But, more importantly, I hope I’ve taught you “how to fish,” so that the next time you come across some financial jargon, you’ll stop, look it up, and understand how it affects you and your finances so there are no nasty, expensive surprises.