This article was adapted from Rebecca Reisner’s “10 Investing Terms to Know Before You Set Up Your First Brokerage Account” that appeared on the Northwestern Mutual website on March 06, 2017.
Many Americans overlook the opportunity to invest more money than they already do for their retirement. That is, if they invest any money at all. This is usually due to feelings of intimidation towards putting a lot of hard-earned money into the markets.
Sadly, this means missing out on all the possibilities towards building wealth and growing your money. This is a waste of potentially earning more money to funnel into your dreams –a big house, nice getaways, or even early retirement in the next five to 10 years. Investing, while certainly posing some risks, can help you reach your goals faster than if your money were sitting in a low-interest savings account, gathering dust.
If you aren’t certain about how to begin investing, it would be wise to consider opening a brokerage account. A brokerage account is a financial account in which you can deposit funds that will be used to buy or sell different types of investments. Before doing this, however, you should take the first steps to learn about it by learning the jargon of the financial world to better understand what you’re getting yourself into. Here are the top ten key terms for beginners:
Full-service Brokerage vs. Discount Brokerage
To get you started, it would help for you to understand the two main types of brokerage accounts: discount brokerages and full-service brokerages. You can guess by the term “full service” that a full-service brokerage offers several different services beyond creating an investment portfolio. Opening a full-service brokerage account usually happens with the help of a financial advisor or other representatives to help equip you with their investing advice.
On the other hand, if you’d like to roll up your sleeves and DIY your investments, you can avail of a discount brokerage. Discount brokerage provides you with a platform through which you could buy and sell investments. In this case, most transactions are handled online. Many discount brokerages will offer insights and some research, but not a financial advisor.
From understanding the difference between these two types of brokerages, you can gauge which one is likely to cost more. Having a financial adviser is great, but it costs a little more than if you did your investments yourself.
Asset Allocation
Asset allocation relies on your strategic selection of assets (or simply, your investments) that will constitute your portfolio. Over time you will either want or need to adjust these proportions based on your needs and what you think is best for your goals and how soon you want to access your money. Asset allocation is the act of balancing the risks that come with investment vs the reward.
For example, a person whose investing goal is further away can opt to allocate a greater percentage of their portfolio into riskier investments because of the potential that these riskier investments carry. However, it is important to know that riskier investments also pose greater losses. Having a longer timeline for their goal, this person has more time to recover from the potential losses identified. As the goal gets closer, however, it is ideal to shift a larger portion from allocation towards more conservative low-risk investments.
The three main asset classes include stocks, bonds, and cash equivalents. All of which you can invest in. It is important to first learn and understand what these investments are and how they fit with your goals.
Stocks (or Equities)
Owning and purchasing stocks of a certain company means you own or have purchased shares of this company. This gives you a small percentage of ownership wherein your share price can increase or decrease depending on the financial performance of this corporation. Equities are usually seen as riskier than cash and bond investments.
Bonds (also Fixed-Income Securities)
Investing in bonds is investing in debt. When you buy bonds from the city, state, or federal government, you are essentially lending your money to the government for it to fund a public project. On the corporate end of things, it would be the same, except that you will be financing these companies’ expansion projects, new deals, and so on. With bond investments, you receive your returns in the form of fixed periodic interest payments until the bond reaches its maturity date, plus the face value that you invested into the bond.
It is possible to sell your bond prior to it reaching maturity. You can expect to sell your bonds for a price that depends on the interest rates at the time that you are selling. Higher interest rates mean that bond prices go down, and while bonds are generally less risky than stocks, there is the risk that whoever issued this bond could default on their loan.
Cash Equivalents vs. Cash
Cash Equivalents usually pertains to extremely liquid assets that are easy to get cash out of. Cash equivalents can include money market funds or government bonds that have short-term maturity dates (three months or even less). These are the least risky investments for you to hold, but they also yield the lowest returns.
Mutual Funds
Mutual funds are a favorite for many investors. Mutual funds provide investors the opportunity to channel their money into different “baskets” that can hold the various types of investments in various asset classes. Instead of choosing an individual stock, for example, the investor could hold investments that mirror a market index.
Investing in a mutual fund means buying shares of the fund itself. Professional fund managers then take all the shares from different investors to invest in the individual investments held by the fund. These professional investment managers charge a fee (usually annual) called the expense ratio. If the fund requires active management, the expense ratio is typically higher. Share prices for mutual funds are usually posted at the end of the trading day. You can only buy shares once a day.
Mutual funds pose risks and returns based on what assets constitute the fund. If the fund is invested on a high-risk stock investment, it is likely the reward (and risk) is greater. In general, risk and reward are two sides to a coin, and it would be wise to keep this in mind when investing in any asset class.
Exchange-Traded Funds (ETFs)
These are similar to mutual funds in a way. They can hold a number of investments and mirror a market index. However, unlike mutual funds, ETF shares can be bought throughout the day. ETFs usually have a lower expense ratio compared to mutual funds due to the fact that they require less resources and people to manage them. ETFs commonly have lower minimum investment requirements compared to mutual funds.
Similar to mutual funds, the risk and return are reliant on the type of assets that make up the fund.
Capital Gain
Capital gain is the product of selling your investments for more than you bought them for. Simply put, it is the what you gain from selling more than the capital that you invested. On the other side of this is a capital loss. This happens when you sell your investment for less than the capital that you invested.
Because you are taxed for your capital gains, it would be wise to approach a professional tax advisor who is certified to assist you in this regard. This will truly help you clear your understanding of how these capital gains and capital losses can affect you and your taxes.
Commission
Commissions are one of the ways that brokerages make their money. Every time a customer executes a trade, the brokerage receives either a fixed fee or a percentage of the value of that trade. Make sure you understand how much you will be paying in commissions and fees in relation to your returns. This will help you in your decision-making process when choosing brokerages.
Margin Accounts and Cash Accounts
There are two ways you can pay for the assets you buy through your brokerage accounts. Cash accounts are more straightforward: your assets are funded by transferring money into your brokerage account.
Margin accounts, however, are used to borrow money from your broker to buy additional investments. The amount you borrow is called the margin loan, and its collateral is the value of your existing investments. Margin accounts hold more risks than cash accounts, making it possible for you to lose more than you initially invested. How does this happen? When the assets loaned to you drop in value, you will need to pay back any money that you owe the broker to cover the costs of your purchases made with the margin loan. If you’re starting out, it would be best to begin with a cash account.
It is always wise to exercise caution in making any investments at all as no single strategy guarantees profit or protects against loss. If it’s too good to be true, it probably is. Come into the game prepared for either scenario. Remember these tips and terms when you plan on investing in your first brokerage, and happy investing!