Understanding a few basic investment terms is a step forward on your journey toward financial security. Investing can be as complex or as simple as you want it to be. Thousands of people actually invest others’ money as a job…. but it’s also something literally anyone with money can participate in.
Start investing as soon as you can, especially in retirement accounts. Contributing early and regularly helps grow your wealth over time. When you receive unexpected money, and you have no debt, investing it (in retirement funds or an investment account) is smart.
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Basic Investment Terms
You don’t have to be a sophisticated, highly educated investor to contribute to a retirement account or buy stocks. There are super complex ways to manage your investments. There are also very simple ways to invest.
In Investing Terms 101, we’re focusing on the most simple of investing terms. This article will help you start investing or understand your existing investments, but you can quickly move beyond these terms with a little research.
Retirement Account Types
Retirement accounts are just a single group of investment accounts. You can invest money without saving for retirement or using a tax-advantaged retirement account. However, a special tax-advantaged account is your best option if your goal is to save for life after work.
You can read more about starting to save for retirement and the annual limits for each type of account in Financial Security Step 2b: Begin Saving for Retirement.
What is vesting?
Vesting is one of the most important basic investment terms for those contributing to employer-sponsored plans.
You become vested in your employer-sponsored retirement account when you have reached a predetermined length of employment and contribution to the plan. At that time, you have full access to all the funds in the account.
Basically, once you have worked and contributed to a retirement account for a specific length of time, you become vested. If you leave your job before you’re vested, you can only take the amount you contributed yourself. Leaving after vesting means that you can take both your contributions AND your employer’s contributions.
Employers offer 401(k) plans as a way for you to set aside money on your own and have it taken straight from your paycheck before taxes are deducted. Some employers match a portion of your contributions, which is basically free money for you.
Roth 401(k)s are just like regular 401(k) plans except that you pay taxes on the money before it goes into your account. This way, when you retire and start to withdraw funds from the account, that money will be tax-free.
An Individual Retirement Account (IRA) is a type of retirement account that you can set up on your own, without an employer. IRAs have similar advantages to 401(k)s, and they’re a great option if you don’t have access to an employer-sponsored plan. Contributions are not taxed, but the withdrawals in retirement are.
As you may have guessed, Roth IRAs are retirement accounts that are not sponsored by an employer and tax the contributions. The money withdrawn in retirement is then tax-free.
403(b)s are the 401(k) equivalent for public school and non-profit employees. There is also a Roth option, where the contributions are taxed initially.
A Savings Incentive Match Plan for Employees (SIMPLE) IRA can be offered by employers with fewer than 100 employees. They’re a way to offer retirement accounts without the employers’ hassle of a 401(k).
A Simplified Employee Pension (SEP) IRA is a retirement account for self-employed people and small business owners.
Types of Investments
Common stocks are shares of ownership in a company. Once you buy the stock, you own part of the business and get to benefit from any profits it earns – as the business issues financial statements showing profitability, the value of the stock should increase.
Stocks are issued by publicly traded corporations. Common stock allows the holder to vote on corporate matters, but that doesn’t mean much unless you own a huge percentage of the stock.
Preferred stocks are also shares of ownership, but they give you certain privileges. They don’t allow for voting, but they divest larger dividends that may be guaranteed. Dividends for common stockholders, on the other hand, are not guaranteed.
A dividend is a portion of a company’s profits, paid to shareholders as a benefit of investing in the company. The amount and frequency of payments are determined by the specific company.
Bonds are securities (a kind of investment) that represent loans to a company or government. You’ll get paid back the amount you originally invested plus an agreed-upon rate of interest.
The interest rates for bonds are usually pretty low because they’re a safer investment. Bonds issued by a government are almost always paid back. Less risk, less reward.
The basic idea behind investing in real estate is that you buy a property with the goal of selling it for more than what you paid. While you can include your home in your net worth calculations, it’s best to not view your place of residence as an investment.
Your home is where you live and you might not make money when you sell it… but you’ll have benefited from having a residence.
Real estate investments are properties that you purchase and then rent or lease out for money. Investing in real estate can be risky if the purchase is made with a mortgage. In that case, you have to ensure the rent charged is sufficient to cover the mortgage, taxes, insurance, and maintenance.
When real estate is purchased with cash, there is more room for error; the rent received doesn’t have to cover the mortgage each month.
Ways to Buy Investments
While you can buy individual stocks by yourself, there are many ways to buy spread the risk across a grouping of stocks.
Exchange-traded funds are baskets of stocks that trade like individual securities. Broadly speaking, ETFs offer exposure to a group or index of assets rather than just one company or sector.
Index funds are a type of mutual fund that aims to match the performance of an index, like the S&P 500. This means you’re investing in stocks like Exxon Mobile and Apple without having to pick them out yourself–you just invest your money with one company who’s doing all the work for you.
This spreads the risk out over many stocks but also dilutes potential rewards. Investing in an index fund means that you can own a teeny bit of many many different companies. When one company’s stock value increases, the index fund value will also increase, but by a smaller amount.
Likewise, when the value of an individual stock drops, the index fund value will decrease by a smaller amount. An index fund is a way to reduce the risk of market fluctuations, but it also reduces the payoff of crazy upswings.
If you want to invest money outside of a retirement account, an index fund is the way to go for a beginner.
Mutual funds are a type of investment that pools your money with many other people. The basic idea is that you invest in one fund and they buy stocks, bonds, or something else on your behalf–and because it’s pooled together, the more investors there are, the lower each investor has to pay in fees.
A mutual fund is managed actively by a professional, while an index fund is a passive reflection of the market. Involving a professional to manage the fund means that the administrative costs are often higher than other types of investments.
The trade-off is that you don’t have to research individual stocks or index funds yourself.
Trust funds are a legal entity that holds assets that will eventually be given to the beneficiary. They’re usually set up as a way to transfer wealth to the following generations (giving money to your children or grandchildren).
The structure of a trust fund can be customized to meet the needs of the grantor and beneficiaries. Trust assets can be invested in the stock market, or just held until they’re distributed to the beneficiaries.
Trust funds aren’t really something you can invest in, but they are a way to protect your assets and transfer them to others.
Hedge funds are a type of investment that can be risky and expensive, but they have the potential to earn higher returns. They’re often organized as a limited partnership (LP) or limited liability company (LLC). Hedge funds are managed by professionals who often charge huge fees.
As a beginner investor, don’t even worry about hedge funds. They’re for rich people with investing experience.
Real Estate Investment Trusts
Real estate investment trusts (REITs) are a type of security that’s similar to an ETF except you’re investing in properties instead of stocks.
They’re a way to invest in real estate without buying individual properties. Instead, you purchase a portion of many properties, with spreads out both the risks and rewards.
Even more basic investment terms…
There is so much more to learn about investing than what we’ve covered here, but this is a good starting place. When you’re just starting out, or don’t have a lot to invest, it’s ok to start small. Learn as you go and educate yourself about the areas you’re interested in, but don’t stress out now.
If you want to learn even more or look up a specific term not covered, J.P. Morgan has a huge list of terms and definitions.