Appendix A: Key Investment Terms
Updated
by
Richard Phillips, EA, AIFA, CPC, CPFA, QPA, QKA
A conversational knowledge of key investment terms and philosophies is important for all investors. Wikipedia is an excellent source for a more detailed description.
Four Basic Types of Investments
TYPE | DEFINED | INVESTMENT CONSIDERATION |
Cash | The formal definition is money in the physical form of currency. | If invested, cash investments will typically pay interest, but the rate is usually less than inflation. |
Fixed Income | Lenders extend credit or loans in Fixed-Income investments with a pre-determined rate of interest. | Fixed-income investments may have an interest rate that matches inflation, but it won't stay that way. |
Stocks/Equities | In the stock market, the terms stock and equities are interchangeable; representing direct ownership in a company. | Stock values fluctuate and companies may not survive over the long-run. |
Alternatives | Alternative investments are investments that are not cash, fixed income or equities. | There are many considerations; proceed with caution. |
Investment Philosophies
When it comes to the stock market, there are two broad investment philosophies, Active, and Passive.
Active investing is premised on the belief that the art of investment selection, sector rotation or other strategies will result in higher investment performance over extended market cycles. In other words active money managers believe they can beat the market.
Active investment strategies have higher investment costs, creating a higher bar to achieve superior long-term performance.
There is no emperical evidence that active managers can beat the market over the long run.
Passive investing is premised on the belief that markets are efficient and all publicly available information is immediately reflected in the price of the security, and that money managers can't beat the market over the long run.
Common Asset Classes
Asset classes are a group of financial instruments that have similiar characteristics and similiar behavior in the marketplace. The financial instruments may also be grouped together into an asset class based on the laws and regulations they are subject to.
Marketable securities, as the name implies, is a tradable financial asset. However, marketable securities can be subdivided into liquid and illiquid securities. Liquid securites are typically those that are traded on public exchanges and converted to cash within a day. Illiquid securities on the other hand may not have a public market, or there is one trading may require an extended period of time to match up the buy and seller.
CASH & CASH EQUIVALENTS
Cash and cash equivalents are generally considered the safest of all investments. However, this can be a misguided assumption.
Insured Cash. Insured cash is cash deposits that are insured by the FDIC.
Uninsured Cash. Cash deposits that exceed the FDIC limit, or other cash deposits that are not subject to regulatory oversight.
Money Market Funds. A manufactured product consisting of short-term instruments intended to trade at $1 par.
Stable Value Funds. A manufactured product originally marketed by insurance companies. These investments are not as liquid as money market funds, therefore the expected yield is greater than other cash and cash equivalents. The underlying holdings consists of short-term instruments, a significant of which may not be liquid. Generally these are not $1 par funds.
BONDS & OTHER FIXED RATE INVESTMENTS
Commercial Paper. An unsecured promissory note with a maturity date of not more than 270 days. This is short-term instrument issued by large companies to cover short-term cash flow needs.
Fixed Rate Bonds. Debt obligations that may or may not be secured by assets of the issuing company. These bonds have a fixed interest rate (coupon) and a fixed maturity date. Par at issue is $1,000.
Zero Coupon Bonds. Debt obligations that may or may not be secured by assets of the issuing company. These bonds have a fixed interest rate, but unlike fixed rate bonds, do not pay interest periodically over the life of the bond. The interest is realized at maturity. The market value at time of issue is discounted from par (i.e. $1,000).
Mutual Funds. As stated in the fund’s prospectus, the investment objective is to invest in debt instruments. The investment objective may be further refined to specify certain grades of securities, maturities, etc. Mutual funds shares are priced to reflect the closing price of the underlying securities at the market close, therefore there is no fixed maturity date.
Exchange Traded Funds (ETF). Exchange Traded Funds are similar to mutual funds, but with a stark difference. ETFs trade intra-day instead of a market close settlement. Most are Act 40 Funds.
Collective Investment Trusts (CIT). CITs are a legal trust administered by a bank or trust company. They combine the assets of multiple investors who meet specific requirements set forth in the fund’s declaration of trust. They are not Act 40 Funds and therefore are not subject to the jurisdiction of the SEC. They are regulated by the OCC, a division of the U.S. Treasury.
STOCKS / EQUITIES
Common. Common stock is a form of equity ownership in a company. Shareholders may receive dividends but only after all preference obligations have been satisfied (bonds, preferred stock). With respect to claims on the issuing company, this is the lowest ranking security. In the event of bankruptcy and liquidation, common stockholders should expect to receive nothing.
Preferred. Preferred stock is a hybrid instrument, exhibiting some of the characteristics of debt and equity ownership. Preferred stock has a dividend rate that may be similar or greater than debt, but the dividend can be changed without violating debt covenants.
American Depository Receipts. ADRs are a type of depository receipt which are negotiable securities, representing foreign entities that are traded on US exchanges. This allows foreign entities to trade on US exchanges without going through the rigorous process of issuing securities in the US.
Mutual Funds. Mutual funds are a pool of marketable securities, rolled up into a securitized instrument. Each mutual fund share represents a beneficial interest in the underlying securities. In industry vernacular they are commonly referred to “Act 40 Funds”, referring to the Investment Company Act of 1940. There is a plethora of mutual fund types, with the most common being equity, fixed income and speciality.
Mutual funds shares are priced to reflect the closing price of the underlying securities at the market close. There is no intra-day trading.
Exchange Traded Funds (ETF). Exchange Traded Funds are similar to mutual funds, but with a stark difference. ETFs trade intra-day instead of a market close settlement. Most are Act 40 Funds.
Collective Investment Trusts (CIT). CITs are a legal trust administered by a bank or trust company. They combine the assets of multiple investors who meet specific requirements set forth in the fund’s declaration of trust. They are not Act 40 Funds and therefore are not subject to the jurisdiction of the SEC. They are regulated by the OCC, a division of the U.S. Treasury.
REAL ESTATE
Publicly Traded. Real estate may be "packaged" together and traded on the public exchanges as a mutual fund or exchange traded fund. This unique asset class has attributes of both fixed income and equities and is generally included in a portfolio to provide additional diversification.
Private Real Estate. This subcategory of real estate is not traded on the public exchanges and should not be considered a liquid investment. The other attributes of this subcategory are similar to those of publicly traded real estate.
ALTERNATIVES
An alternative investment is a loosely defined asset class that includes all investments except stocks, bonds and cash. Examples are commodities, private equity, private real estate, infrastructure, hedge funds, cryptocurrency, and collectables.
In the US, alternatives may include hedge funds, long-short funds, managed futures and a plethora of other investment strategies. Alternative investments may be publicly traded while others are private placement.
