10 Investing Terms to Know Before You Set Up Your First Brokerage Account
If you’re like many Americans, the extent of your investing — if you invest at all — is probably limited to what you save in a retirement account. That’s because the idea of putting a lot of money into the markets can feel intimidating; in fact, 47% of respondents to the 2016 LearnVest/Barclaycard Financial Literacy Research survey said they felt they needed a lot or a great deal of guidance when it came to the topic of investing.
Unfortunately, this uncertainty could mean missing out on the potential to grow your money, particularly if you have a big-ticket goal that you could use a little help with — for instance, a down payment on that dream home you’re hoping to buy in the next five to 10 years. While it does come with its own risks, investing could help you reach that goal faster than, say, keeping that money parked in a low-interest savings account.
Not sure how to begin investing? First, you should consider opening a brokerage account — a type of financial account in which you deposit funds that can be used to buy or sell various types of investments. But even before you dip your toes in the investing pool, it’s important to get familiar with the financial jargon you may come across as you do your research. Here are some key terms to help you get started.
1. Discount vs. Full-Service Brokerage
There are two main types of brokerage accounts that can help you invest your money: discount brokerages and full-service brokerages. A full-service brokerage typically offers various financial services beyond just helping you create an investing portfolio, and if you open an account at a full-service brokerage, you’ll have face-to-face contact with a financial advisor or other reps who are there to provide investing advice.
By contrast, a discount brokerage is for the DIY investor who just wants a platform through which they can buy and sell investments. Most transactions are handled online, and while some discount brokerages will offer research and insights, you don’t have a dedicated advisor helping you. As such, fees for using a discount brokerage are typically much less than for a full-service brokerage.
2. Asset Allocation
This relates to your strategy for selecting the investments (or assets) that will make up your portfolio and how you might adjust the proportion of those assets over time. This strategy is dependent on your goals and the timeline by which you want to access your money. The idea is to balance both risk and reward.
Generally, the further away your investing goal is, the greater the percentage of your portfolio you may want to allocate to riskier investments. That’s because riskier investments carry the potential for greater returns but also greater losses. If you have a longer time horizon for your goal, then you have more time to recover from potential losses. As your goal gets closer, however, you may want to shift a larger portion of your allocation toward more conservative investments.
There are many different types of investments you can hold, but the three main asset classes include stocks, bonds and cash equivalents (more on those below).
Also known as equities. If you purchase stock in a company, it means you are buying shares of that company. Your share price will rise or fall depending on how the corporation fares financially and how Wall Street expects it to perform. Equity investments are typically considered riskier than bond or cash investments.
A bond is an investment in debt. When you buy a bond from a city, state or the federal government, you’re essentially lending the government money to help fund a public project, such as a new bridge. When you buy a corporate bond, you’re lending a company money to finance new projects, expansions or parts of its operations. In return for buying a bond, you typically receive set, periodic interest payments until the bond reaches its maturity date. These fixed payments are why bonds are also called fixed-income securities.
If you hold a bond until maturity, you’ll also receive the face value of the bond back; however, you could opt to sell a bond before then. The bond price at which you sell will depend on whatever interest rates are at the time; when interest rates go up, bond prices go down. And although bonds are generally considered less risky than stocks, there is always the risk that whoever issued the bonds could default.
5. Cash and Cash Equivalents
Of course, the cash you hold in a checking, savings or other type of deposit account is part of your assets. But when it comes to investing, you may also hear the term cash equivalents used. These are assets that are extremely liquid, meaning it’s easy to get your cash out of them. They can include money market funds, Treasury bills and other types of government bonds with maturity dates of three months or less. They are the least risky investments you can hold, but they offer very small returns.
6. Mutual Funds
Rather than pick and choose individual stock, bond and cash-equivalent holdings, many investors might prefer to invest in mutual funds. Mutual funds act like baskets that can hold different types of investments across asset classes, or they can hold investments that mirror a market index (like the S&P 500). When you invest in a mutual fund, you’re buying shares of the fund, not the individual investments the fund holds. A mutual fund is typically managed by professional fund managers, which means you’ll have to pay an annual fee for their services, also known as an expense ratio. Typically, the greater amount of active management a fund requires, the higher the expense ratio. The risk and return levels vary based on the type of assets that make up the fund.
Short for exchange-traded fund, ETFs are similar to mutual funds in that they can hold an array of investments and mirror a market index. One of the biggest differences between the two, however, is that you can buy and sell shares of ETFs throughout the trading day, as their share price fluctuates much like stock prices do. Meanwhile, a mutual fund’s share price is set at the end of the trading day, which means you can only buy or sell mutual fund shares once a day. ETFs also generally have lower expense ratios than mutual funds do because they tend to be passively managed (meaning fewer people and resources are required to manage them). Plus, they often don’t have the same minimum investment requirements as mutual funds. But, as with mutual funds, their risk and return levels vary based on the type of assets that make up the fund.
8. Capital Gain
Anytime you sell an investment for more than you bought it for, you’re realizing a capital gain. For example, if you bought a share of a company in 2004 for $50 and sold it for $125 in 2010, your capital gain would be $75. You have to pay taxes on capital gains, although how much you pay depends on your tax bracket and whether you realized long-term capital gains (meaning you held the investment for more than a year before selling it) or short term (you sold the investment in a year or less). Conversely, if you sell an investment for less than you bought it for, that’s considered a capital loss, and it could offset your tax burden. Because these can complicate your tax situation, you should consult with a certified tax advisor to understand how investment gains and losses could impact your taxes.
One way brokerages earn money is by charging a commission every time a customer executes a trade. These can be a percentage of the value of your trade or a flat fee per transaction (e.g., $10 per trade). Full-service brokerages typically charge much higher commissions than discount brokerages. It’s important to pay close attention to the commissions and fees you’re paying, since they can eat into your total returns.
10. Cash Account/Margin Account
These terms relate to how you pay for an asset you want to buy via your brokerage account. To keep it simple, you can employ a cash account, meaning you fund your purchases with money you transfer into your brokerage account.
A margin account, on the other hand, enables you to borrow money from your broker to purchase additional investments. The borrowed amount is called a margin loan, and the collateral for it is the value of the existing investments in your portfolio. However, margin accounts are much riskier than cash accounts because if the assets you borrowed against drop in value, you may end up owing the broker money to cover the cost of any purchases you made with the margin loan. This essentially means there’s the potential of losing more money in your account than you started with. As such, cash accounts are the simpler route to take for beginning investors.
No investment strategy can guarantee a profit or protect against loss. All investing carries some risk, including loss of principal invested.